Railroads' Competitive Advantages Are Solid, but Challenges Lie Ahead
Containers, coal, crude, and codes are investors' current concerns.
A century ago, railroads accounted for more than 60% of the total U.S. stock market valuation--about the same share of today's combined value of technology, industrials, health care, banks, and utilities companies. Today, the railroads' share of that figure has diminished to less than 1%. Anchored by secular margin improvement and powerful competitive advantages, they still attract investor interest.
However, bargains are scarce: Of the railroad stocks we cover, two are priced attractively enough to provide a margin of safety sufficient to garner our 4-star rating ( Union Pacific (UNP) and Norfolk Southern (NSC)). Quality is rarely on sale, and we consider the quality of all of these railroad enterprises to be outstanding. Railroads benefit from wide economic moats based on the cost advantages they offer over other freight transportation modes and the efficient scale of a market that generally has only two rational competitors per geographic region. Today, railroad investors must evaluate four overarching themes: (1) The secular volume driver will be intermodal containers. (2) The secular volume loser will be coal carloads. (3) New energy and crude volume may generate short-term media attention and move short-run share prices, but the long-run volume potential may be decidedly more muted. (4) Regulatory codes and laws continue to influence operations and expenses.
Cargo Shifting, but Wide-Moat Railroads Still On Track to Prosperity
Rail stock prices have retreated from recent peaks as investors mull the impact of diminishing coal and crude volume and fret about delays and cheaper fuel possibly benefiting trucking at rail's expense. While volume expectations affect our valuation estimates, they're not enough for us to question the resilience of the railroads' wide economic moats. As with all wide-moat-rated enterprises, excess normalized returns must, with near certainty, be positive 10 years from now, and excess normalized returns must, more likely than not, be positive 20 years from now. Morningstar's economic moat ratings identify at least one of five sustainable sources of competitive advantage: low-cost advantage, customer switching costs, efficient scale, intangible assets (such as brands, patents, or government permission to operate), and the network effect. In our view, North American Class I railroads benefit enough from sustainable cost advantages and efficient scale to justify their wide economic moat ratings.
Railroads are the low-cost option for shipping freight where no waterway connects origin with destination, particularly for freight with low value per unit weight. Moreover, railroads claim quadruple the fuel efficiency of trucking per ton-mile of freight and make more effective use of manpower despite the need for train yard personnel, in part because of greater railcar capacity and also because trains operate at lengths many times longer than what trucks can achieve. Even for goods that can be shipped by truck, we estimate railroads charge 10%-30% less than trucking to move freight over the same lanes.
We believe no new railroads will be built in North America. This is the premise for our assertion that railroads operate at efficient scale. Efficient scale followed industry consolidation escalated by the 1980 Staggers Rail Act, which permitted extensive rail line sales, abandonment, and combination. In 1980, North America had more than 40 Class I rails. Today, there are just eight (a Class I generates at least $452.7 million of 2012 operating revenue, and functionally independent freight railroads over this inflation-adjusted threshold numbered about 20 in 1980). The Staggers Act also allowed private contracts and rate setting. On all but the busiest lanes (like Wyoming's coal-rich Powder River Basin, where both Burlington Northern Santa Fe and Union Pacific operate), a single railroad generally serves an end-of-the-line shipper, and only two railroads operate in most regions of North America. Indeed, we believe that, absent government intervention, the rational number of competitors on the continent would be two, via additional consolidation, since in most regions customers already have only two capable providers. The steep entry barrier from the need to obtain contiguous rights of way on which to lay continuously welded steel rail spanning a huge continent fends off would-be entrants. Railroads may build new spurs or restore abandoned lines, but because of such prohibitive entry barriers, we don't anticipate any new main lines will be built.
Despite these significant competitive advantages, the massive reinvestment that railroading demands materially constrains free cash flow. Whereas a massive asset-intensive transport like United Parcel Service dedicates around 4% of revenue to capital expenses annually, the Class I railroads typically invest 16%-20% of sales in capital outlays, and we project no diminution in this requirement. We also project all Class I railroads will continue to drive their operating ratios lower, with Canadian National (CNI), Canadian Pacific (CP), and UP approaching 59% (slightly better than where CN has been for years), Kansas City Southern approaching the low 60s as it continues its shift toward owning--rather than leasing--its equipment, and the Eastern rails improving about 500 basis points from their current 70%. The primary mover driving the improvement in each case is more effective use of labor, as has been the trend for a decade, with salary and benefit expense decreasing as a percentage of revenue with nearly annual regularity.
Critical Concern #1: Containers
The Secular Volume Growth Driver
We consider intermodal volume growth to be a dominant trend in transports and containers to be the major long-run growth driver of rail volume. Already, intermodal traffic constitutes 46% of current total railroad units moved in North America and greater than one third of units moved by each Class I rail.
Intermodal is large already and continues to grow even amid 2013-14 congestion issues caused by weather and surging demand. We think the remaining growth runway is long, particularly in domestic moves, due to the large volume hauled by a competing mode, namely trucking. Furthermore, trucking firms are increasingly using intermodal for line-haul segments of long moves (even hyper-quality-conscious FedEx began shipping freight intermodal around 2012). Trucking industry market consultant FTR Transportation estimates intermodal hauls around 18% of long-haul dry van traffic, leaving significant room for expansion. CSX (CSX) indicates there are 9 million annual truckloads moving distances greater than 550 miles in the Eastern region of the United States that could move intermodal (it moves 2.7 million now), and Union Pacific postulates 11 million in its territory (it made 1.7 million domestic intermodal moves in 2014); Kansas City Southern indicates 3 million trucks crossing the Mexican border could be diverted to its network. We don't expect the rails to capture this full volume, but these lofty numbers underscore that there's plenty of room to run.
Intermodal moves at lower revenue per unit than other commodities, but is reported per container; thus a double-stack well car earns twice the revenue reported for a single container "unit." Several rails indicate intermodal margins are on par with the average merchandise (noncoal) commodity. Margins in intermodal (or any other commodity) are not disclosed by the rails, but we believe factors affecting intermodal profitability include length of haul, readily available high-quality truckload capacity, truckload prices, railroad service and velocity, and the portion of the business moving with empty backhaul (intermodal is one of only a few modes where backhaul is not 100% empty). Improving the latter should enable narrowing the price gap between railroad and trucking over the long run to less than the historical 10%-30% discount for rail. Unlike coal, with its large, often captive shippers, an attractive aspect of intermodal business is ready truck competition, which generally shields the business from rate regulation.
Why ship intermodal rather than by trucking's direct dock-to-dock service? We attribute demand primarily to the cost savings over trucking by the aforementioned 10%-30%, made possible in part due to the 4:1 fuel economy per ton-mile advantage over trucking and efficient use of manpower (two drivers hauling 200-plus containers, albeit supported by handling crews at terminals). Shippers also value rail's carbon footprint advantage and its capacity, particularly when truck drivers are constrained. Rails benefit twice over from this condition, in both volume diverted to rails in order to access rail capacity and in pricing power fostered by elevated truck rates even less competitive than when truck supply and demand is closer to equilibrium. Among factors we identify that limit the truck driver pool are relatively low wages, time away from family, lengthy inactivity, elimination from eligibility by new CSA safety scores, DOT physicals now only by approved health professionals, and uncertain hours of service restrictions that threaten to constrain weekly miles, reducing drivers' earning power.
We consider the pending Panama Canal expansion to be neither a major threat nor a particular benefit to Western and Eastern rails, respectively. UP believes as little as 3% of its international intermodal volume is at risk. Container ships already can approach the East Coast on the water via the Suez Canal, albeit with a significant time penalty. For example, Shanghai to Los Angeles is about 13 days (plus 5-6 days to cross the continent to New York City by rail), but to New York City via Panama is about 23 days, or 27 through the Suez. Still, Suez has gained East Coast import share from Panama, from just 34% in 2012 to about 50% in 2014 (per Union Pacific). At this point, with no indication of pricing for large vessels to cross the improved canal, we think it is premature to speculate on volume shifts. However, we assume no heroic growth in our financial model despite our optimism on intermodal's advantages. Not all ports can handle the new large vessels. Some volume may leave the rails entirely if it can be delivered by ship on the East Coast and trucked to its destination within one day.
We assume domestic intermodal growth will outpace international during the next one or two years as a result of the domestic truck driver shortage. Indeed, in 2014, UP increased domestic volume 11% and international 5%, and the Intermodal Association of North America indicates that last year the domestic U.S. intermodal market increased 5.7%, versus 4.4% growth in international. Over the long run, we believe domestic can still slightly exceed international due to the ability to take share from more costly trucking, even during challenging economic times, when saving on shipping should be even more appealing. We model Kansas City Southern to increase intermodal volume 5% annually due to growth at Port Lazaro Cardenas and the firm's exclusive crossing on both sides of busy Laredo, fueled in part by Mexico's fast-growing auto assembly plants. Due to its newly improved service, we expect CP to recover some intermodal volume that might naturally fit best on its network, but which stayed on CN when CP's performance lagged--we believe this can lead to growth faster than the broader market. We also expect that in 2015 BNSF will regain some volume that switched to UP last year when BNSF's network was highly congested. At other rails, we model 2%-3% annual growth.
Critical Concern #2: Coal
In Decline, but Still Well Known
Coal is losing heat as a rail commodity, diminishing from 6.7 million cars and 20% of 2005 volume to 5.4 million and 16% of total 2014 volume at publicly traded North American Class I railroads (excluding BNSF and Ferromex). All coal is not equal, but different negative factors weigh on demand for all the coals these rails haul, and we model persistent annual declines at all Class I's.
Hardest hit are the expensive-to-mine Central and Northern Appalachian basins served by CSX and Norfolk Southern. These two benefited disproportionately from high export coal demand during the past three years of intense Chinese steelmaking for the country's infrastructure construction push. However, when the low-cost nations are on line, demand for more costly U.S. product dwindles. When a cheaper producer stumbles (as with labor disruptions or flooding in Queensland), the U.S. rails will export opportunistically as a swing producer. We assume no such recurrence of fortune in our U.S. export coal tonnage projections.
The 2011 Cross-State Air Pollution Rule and subsequent Mercury and Air Toxics Standards have pushed many noncompliant power plants to retire. Remaining plants then face competition from cheap natural gas. However, those equipped with scrubbers that meet the Environmental Protection Agency standards may be able to burn Illinois Basin coal, leading to a different supply pattern for the Eastern rails (Illinois versus Appalachia). While we are pessimistic on coal volume at all rails due to weak export pricing, cheap natural gas substitution, and more restrictive emissions regulations, the U.S. Energy Information Administration does project that coal will still produce 34% of U.S. electricity in 25 years. We expect Powder River Basin and Illinois Basin coals will dominate Appalachian coals because of the latter's higher cost.
Upside risk to our glum scenario would be greater use of PRB and ILB coal to generate the EIA level of power, and we would probably flip our coal volume projections from slightly negative every year to slightly positive.
Critical Concern #3: Crude
It's Growing, but Not the Game Changer Headlines Suggest
Rapid carload growth and tragic derailments involving crude garner tremendous media attention, but we believe crude delivers less value to railroads than the volume of headlines might confer. Crude by rail, or CBR, is the fastest-growing railroad commodity of late, contributing more than one fourth of the volume gains during the past couple of years. Industrywide crude volume has increased significantly--up tenfold from 2010 until now.
However, crude remains a small part of most railroads and in particular contributes 2%-3% of volume at Eastern franchises CSX and Norfolk Southern, those hardest hit by coal reductions. Even among the greatest beneficiaries (BNSF and CP), we estimate that in the next several years crude will constitute a mid-single-digit proportion of total volume. Still, while crude can't fully offset coal's secular decline, when shipped on unit trains in customer-owned assets, this is attractive business for the rails to haul on already-in-place railroad assets. Generally, customers provide terminals and tank cars (the long-awaited DOT 117 standards were released May 4 for the U.S. and Canada), and the rail commits few assets except perhaps shoring up rail weights and building sidings for high-traffic regions. CP has indicated a third of its book was priced unfavorably before the installation of current management, which makes the movement of a hazardous material all the less appealing. In general, due to the unit train movements, we think margins should be acceptable, even if speed limits prevent optimal operations.
There's more to new energy than merely crude; high-grade frac sand from Wisconsin, Minnesota, and Illinois is desirable in both wet and dry wells. We expect movement to continue, including eventually to Mexico (may be barged in part). All the rails move frac sand to unconventional plays, and during the past year or so, drillers have begun to boost productivity by increasing the amount of sand pumped into new wells.
Not all CBR is the same. While initially CBR moved from North Dakota to the Gulf Coast by rail, increasingly pipeline is taking some share, and the greatest CBR flows from the Bakken to PADDs 1 and 5. Only BNSF and CP have track in the U.S. Bakken, and CN and CP both can serve the Canadian Bakken. Greater movements of light Bakken to refineries on the coasts are on CSX, Norfolk, and BNSF. Heavy oil sands liquids from Alberta are typically moved by CN, CP, Kansas City Southern, and UP. We believe the moves we just described have potential to remain on the rails despite the apparent greater cost. However, that light crude will probably move to the Gulf in pipelines in the long run. Heavy crude needs to be diluted before it will flow in a pipe, which requires transporting diluent and then later extracting it. A shipper can use less diluent (rail bit) or ship neat in steam-heated railcars, but the latter requires (still scarce) suitably appointed shipping and receiving terminals.
At today's oil prices, we expect CBR volume to decline slightly during 2015, because wells already dug will be highly productive during year one, then to shut down more severely in 2016. When oil prices recover even to the $70s, we expect the above high-traffic lanes to continue to carry Alberta heavy to the Gulf and Bakken light to the West and East coasts. We also believe sand volume will slow in 2015 due to fewer oil rigs drilling, but continue to flow to gas-producing regions like the Marcellus. We expect four or five years of delay before Mexico permits the exploration of its shale resources adjacent to the Eagle Ford Basin; then Kansas City Southern and UP may have an excellent business delivering sand from Wisconsin. To date, Mexico has solicited bids for its shallow-water production sites, but little by little, energy liberalization should enhance Mexico's competitiveness even further.
Critical Concern #4: Codes
Regulatory Risk Appears Manageable, but Still Impedes Margins
Every few years, regulatory risk rears its head. Regulatory risk is perpetual, and the rails are already regulated. Two main issues of late are last year's sudden threat by passage of a bill in the Mexican lower house that threatened to undo some aspects of the long-standing concession and a new surface transportation bill in the U.S.
Government is a quasi-supplier to the railroads, granting permission to operate and set rates. The key to economic profits for railroads is pricing adequate to cover costs and reinvestments. In this area, the rails are acting more rationally than in the past. We believe about 75% of volume is under contract and thus exempt from rate regulations. Because rate cases must prove the rails have market dominance, services like boxcars and intermodal are exempt from most regulation because trucking is a ready competitor.
Over-the-road trucking rates constrain railroad pricing for intermodal containers and boxcars, though on routes with no competitive mode, the Surface Transportation Board threatens rate cases. Critical in pricing is beating inflation--compounding the top line 4% and expenses at 3% improves the operating ratio over time. Railroad inflation seems to run around 2.5%-3.0%, and during recent years railroads have typically reported core same-railroad pricing gains of 3%-4%.
So-called reregulation is a risk to pricing power, but one we think unlikely to affect moats in the long run. It is "so-called" because rails have been regulated for decades in many safety, rate, and antitrust aspects. The Federal Railroad Administration and the Surface Transportation Board, the principal railroad regulatory agencies, which are part of the U.S. Department of Transportation, can impose penalties and restrictions on U.S. operations. For example, the Rail Safety Improvement Act of 2008 required railroads to purchase and install positive train control--an IT network designed to automatically stop a locomotive ahead of a dangerous situation. Generally, however, discussion of reregulation really concerns price constraints. The Surface Transportation Board already governs railroad pricing in that list rates for shipments with no competing mode (having "market dominance" over the contested movement) can be contested in a hearing if rates exceed 180% of variable cost. We note that roughly three fourths of rail movements are under contract, and private rate agreements are not directly subject to rate regulations, even if regulations practically constrain railroad aspiration rates. Some of the remaining one fourth of movements have competing modes, so we estimate that less than one fourth of movements can be contested. Only about 50 cases have been filed with the STB since 1996.
In our opinion, the proposed U.S. STB Reauthorization Act, S.808, is unlikely to materially affect shippers' ability to contest rates. Overall, we expect the rails to continue to price at or slightly ahead of inflation, even if shippers can challenge rates more easily. We don't view the current bill as materially punitive to the rails, although from the rails' perspective it's hard to consider any action that makes it easier for shippers to file rate cases as a positive step, unless it pushes off more extreme regulation. Rails have quoted cost inflation values around 2.0%-2.5% in the past five or so years, and we model about 3.0% price gains per annum in the long run. UP was the last to renew a batch of old legacy rate contracts and has indicated there are no more to address. The final material batch of legacy renewals will influence 2015 results as slightly higher-than-normal rate increases or as volume lost to the competition due to competitive pricing (which may reflect simply a better fit on BNSF). Even absent high base rate increases, margins expand if rates and costs increase at the same pace.
Key aspects of the bill increase board membership from three to five members so that any two-party discussion is not a voting majority, allow the STB to initiate some investigations rather than simply responding to complaints as at present, require quarterly complaint reporting, and arbitration for some cases (many cases are "settled" outside the STB rulings already, as can be seen in the STB case list).
Currently it is expensive and time-consuming for shippers to challenge rates, costing a couple of million dollars and requiring several years to file. Not many cases have been filed since 1996, and many of these have been withdrawn (suggesting the shipper would lose the case) or ruled fair rates, but making the filing of rate cases easier could both somewhat constrain pricing power and increase legal expenses, in the worst case.
While we have looked at the bill, we don't view it as a shock to our thesis. In fact, the Association of American Railroads endorsed the bill as well. We believe the AAR endorsed it because it's not a huge change and it's not onerous. A different bill, the Rail Shipper Fairness Act of 2015, S.853, introduced by Democrat Sen. Tammy Baldwin, opens up reciprocal switching, also enlarges the STB, and to us suggests that adding regulators and regulations will improve the rail operations. "Our Wisconsin businesses need a quality and responsive railroad system to effectively get their goods to market," the senator said in a statement. "This legislation will address the challenges faced by local businesses and help drive our Wisconsin economy forward." Clearly the AAR would not be in favor of this act.
A Mexican law signed in January relives the threat of rescinding the right to operate railroads in Mexico as a concession under the originally agreed upon terms. In early 2014, we increased our uncertainty rating for Kansas City Southern to high from medium following the passage of a bill in the Mexican lower house that threatens some aspects of the concession via which the railroad generated 46% of 2013 revenue. The current 50-year concession (which expires June 2047) grants exclusive right of freight operation for 12 more years and offers an option to renew for an additional 50 years. The 2014 bill threatened to make private rate contracts public and to allow other firms to run train sets on concession assets operated by KCS and Grupo Mexico (Ferromex). Had this bill passed the senate, it would have required a presidential signature, surviving a court injunction, and, likely, a NAFTA hearing. The government commissioned the OECD to study the Mexican railroad market, and that entity described the market as quite healthy and well functioning. In January 2015, a new law passed that enacts an agency similar to the U.S. Surface Transportation Board, whereby shippers have a venue to have rate contests heard and adjudicated. This is due within 180 days of the law's passage, but we have not heard this new department is funded, so there may be some delay before it is functional. The railroads operating in Mexico will partner with the new agency to help develop policies, and we think overall this is healthy for the market. Absent such a rate hearing provision, shippers might feel compelled to lobby for another more punitive law.
The Rail Safety Improvement Act of 2008 was written with the intention of preventing train collisions, derailments due to high speed, trains passing onto track isolated for repair, and switching errors. Rails expect to spend more than $9 billion of their private capital to develop and install this yet-undeveloped technology on routes that carry passengers or toxin inhalants. The AAR estimates this includes 60,000 miles and 22,000 locomotives. The efficacy of the system is unknown because it is still in development, but in our opinion, positive train control is perhaps the most egregious "code" demanding shareholder resources.
We've lumped a few other issues into "codes." We believe some safety rules and operating practices are simply make-work or familiar practices for rail labor. For example, on most lines, rules mandate two operators in a road locomotive. With remote control available, broken knuckles can be replaced by one person. Locomotives are equipped with a couple of deadman switches that require being pressed every 20-30 seconds or else the locomotive defaults into an emergency stop. In our opinion, running with only one man per locomotive would improve economics--after all, salary and benefits are the rails' greatest expense line. We note that CP's luminary CEO Hunter Harrison disagrees with this and opines that service can be better with two operators.
There are also a number of work rules that lead to costs higher than they need to be. For example, most railroaders, when called for a shift, can turn down an offer to work that day with no advance notice and no penalty--it's their contractual right. This requires having extra manpower at the ready, at a cost.
We've heard of cases in which track repair workers can't leave their home province or work certain days per week, leading to extended slow zones. Oddly, most train and engine employees are not paid by the hour, but by the run, with a monthly cap on miles. The Illinois Central has hourly pay, and CN reports this is much better for scheduling crews. CP attempted to move to hourly pay in its contract negotiations last year, but the workforce declined. We believe there still exists a smattering of legacy operating conditions that will be made more efficient over the next five to ten years, making the attainment and preservation of our projected OR improvements more likely, even though we don't bank on such changes.
Union Pacific Our Favorite Railroad Stock
We rate the shares of Union Pacific and Norfolk Southern as 4 stars, undervalued by Morningstar methodology; we rate the other four public Class I rails 3 stars. The rails are trading off from 52-week highs mostly because of demand concerns raised during first-quarter earnings reports and weak volume during the second quarter. Union Pacific is trading at about a 12% discount to our $115 fair value estimate and a reasonable 14.5 times times 2016 consensus earnings. Other rails trade at 13.7-17.2 times, but Union Pacific is currently our favorite railroad because it offers the greatest margin of safety to our fair value estimate and has a high-quality portfolio.
UP is the largest public rail, so it can spread fixed costs over a massive revenue base. In 2014, UP's agriculture franchise was larger than Kansas City Southern's entire top line. UP's mix features cheap PRB coal, 10% revenue exposure to/from Mexico, direct lines into the Gulf Coast chemical nexus that should benefit from cheap natural gas, solid frac sand but little uncertain crude, ample heartland grains, fast-growing Texas, and the largest Western intermodal system, including the LA/Long Beach port.
We also like UP's solid price increases this year on the final $400 million batch of legacy rate renewals, helping to offset the effect of lower fuel surcharges all rails will realize this year. The firm recently indicated willingness to increase its typically low leverage, so we won't be surprised if buybacks and dividends accelerate.
We appreciate UP's conservative management team, which set targets and exceeds them time and again, generally several years ahead of schedule. This, the largest railroad, produced an astonishing 63.5% OR last year, leading to $8.8 billion of EBIT. UP has whittled its OR down from 89.4% in 2004 by making steady margin progress every single year save 2011, which tied the prior year despite considerable fuel headwinds.
Will BNSF take back intermodal share in 2015-16 when it recovers its network fluidity? Sure, but we think the domestic intermodal business will be a bit of a rising tide for both, given our expectation of sustained truck driver shortages during the next two or so years. Long run, we model just 2% intermodal growth per annum to reach our fair value estimate.
Another risk is loss of coal volume, despite its being cheap PRB coal. We already punish the coal franchise with a 7% decline this year and 1% annual declines thereafter, so we have tried to account for this risk in our drivers. EIA projects coal to remain a material power generation fuel in the U.S., and we think it makes most sense that cheap PRB coal will be the fuel of choice.
Keith Schoonmaker does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.