Railroads: The Ties That Bind
Despite low fuel prices pointing toward the contrary, railroads' competitive advantages remain strong against transportation rivals.
As gas prices have dropped the past year, many investors likely theorized trucking firms would get a boost. After all, if these transportation companies and their drivers were spending less at the pump, their bottom lines should benefit.
That thinking, though, misses the broader investing picture, particularly when it comes to railroads. Rails such as Union Pacific (UNP), CSX (CSX), and Norfolk Southern (NSC) enjoy an average fourfold cost advantage over most modes of transportation, regardless of the price of a barrel of oil.
Surprised? Investors should consider this: A single train with a two-person team can transport as much as 150 to 200 shipping containers of goods. They won't hit any red lights or be slowed down in a traffic jam. And as soon as one crew has done its shift, another steps up to take over. It's a competitive advantage trucking rivals can't emulate.
But that isn't the only reason railroads earn economic moats. I sat down with Keith Schoonmaker, who is the director of industrials equity research at Morningstar and covers all of the Class I railroads, to discuss railroads' advantages and the outlook for an industry that can trace its roots in the United States back over a century.
Rob Wherry: Why don't you start off by explaining how railroads earn economic moats.
Schoonmaker: We consider rails to have wide economic moats. We don't think any new railroads are going to be built anytime soon. Railroads are going to remain the cheapest way to transport heavy freight when no river is available until the commercialization of teleportation, basically.
I joke when I say that, but railroads are by far the most efficient way to ship. Ecologically, railroads emit fewer emissions, so they are greener than trucks. They also have capacity, and that's something that trucking lacks because of the persistent driver shortage. Over long run, we don't think railroads--their economic moats and their ability to earn economic profits--will be compromised.
What are the sources of those moats?
Schoonmaker: We attribute the economic moats to two sources. The first is a cost advantage over other modes of transportation. The only way to transport freight cheaper than by rail is to use a waterway. Rivers and oceans are cheaper because you don't have to maintain them. However, waterways don't serve the interior of the continent very well.
The cost advantage that the rails have over trucking stems from efficiencies of manpower. Think of two engineers running a train that's over 100 cars long with 200 containers double-stacked. They run a little slower than a truck--maybe half the speed of a truck on a highway--but they can transport a tremendous amount of goods with those two people.
The other source of railroads' moats would be an efficient scale. By this, I mean that it would cost too much to erect a new railroad. In order to do that, a firm would have to attract so much volume that they would have to price it cheaply to win customers away from the incumbents. It would destroy the market.
In the market we see served now, each region of North America has just two competitors. In Canada, there are Canadian National (CNI) and Canadian Pacific (CP). In the eastern United States, there are Norfolk Southern and CSX. In the West, there are Burlington Northern, which is a subsidiary of Berkshire Hathaway (BRK.B), and Union Pacific. In Mexico, there's basically Ferromex and Kansas City Southern de Mexico. Kansas City Southern operates in the United States, as well--about half of its revenue comes from the United States. It has a unique network that's just a short north/south network-- not the same type of network that the others have spread throughout an entire geographic region.
Again, those are what I see as the two sources of the wide economic moat--namely, cost advantage over other modes of transport and efficient scale, in this case a rational duopoly structure. The advantage of this is it leads to some discipline in pricing and some discipline in behavior.
One of the details in your research that surprised me was that railroads have a quadruple cost advantage over trucking firms. Even with fuel prices being so low?
Schoonmaker: Cheap fuel is coinciding with market conditions in trucking that are quite unfavorable. That is, a huge capacity crunch that's caused by a shortage of drivers. So, we think it's actually still beneficial for shippers to use railroading, because they're able to move their loads effectively when they're having difficulty finding competitively priced trucking and reliable truckers.
When it comes to fuel, the rails are more efficient because they can move a lot of containers with a small number of operators, but also because steel-on-steel wheels are a low-friction way of shipping. The rails are able to maintain a steady cadence, and there's not a lot of road traffic interrupting them, like there would be on the highways, where there might be a traffic jam in certain hours, and then trucks have to move extremely slowly. That's not good for fuel economy or labor costs. So, the fuel advantage is there, regardless of the price of fuel.
In your research, you outlined what you called critical concerns--four of them. Walk us through those.
Schoonmaker: First, let me say our outlook is positive for railroads. This is still the heyday of railroading, which began in about 2004, with what analysts typically call the railroad renaissance. That's when rails began pricing more rationally and behaving like professional returns-oriented businesses.
Since the railroad industry was deregulated in 1980, the rails have gradually improved their operations by consolidation and by making more effective use of manpower and fuel. Today, all the railroads are really converging on about a 35% or 40% operating margin. This is 10 to 20 points better than where they were a decade ago. So, they've all made tremendous improvements in the past decade or so of operating.
That said, we've identified four key concerns for railroading at the moment, the four Cs. They are containers, coal, crude, and codes. By codes, we mean regulations. Let me just give you the highlights on each of these.
Containers are intermodal shipping, meaning multimode. A container could travel via a steamship line on the ocean plus railroads, or railroads plus trucking. Those are intermodal modes. We believe that container volume through intermodal is the secular driver for railroad volume. On the other hand, we think, by and large, coal volumes will continue to decline, and that volumes of other commodities will grow, depending on population, industrial production, and GDP. Containers are a secular driver because there is a tremendous amount of them already moving on the highway. In economic good times or bad, there's still a ready source of volume that the rails can steal from the highways. We've mentioned some of the advantages that the rails have compared with trucking, and we think those are the motivations for driving that secular shift and the growth of container shipping. Rails can charge lower rates, they have better capacity, and they have a favorable environmental impact.
The second of our four Cs is coal. We believe that coal will continue its secular decline. It's plunging rapidly, even during the second quarter. It's because of abundant and cheap natural gas, particularly from the Marcellus region in Pennsylvania, and from restrictive emissions rules that the Environmental Protection Agency has put in place that really favor gas for U.S. power generation.
That reduces, but does not eliminate, a lot of the coal demand. In fact, the U.S. Energy Information Administration projects that coal demand will still comprise 34% of our power generation, even out to 2040, so that's no small amount. But it's basically a flattish level of production in terms of kilowatt-hours for the next 25 years. Needless to say, we're taking a little more conservative stance, more in line with what we're seeing from recent volume trends and projecting continued modest declines in coal.
The past few years, the Eastern rails in particular have done well with export coal, but the United States is not the supplier of choice for seaborne coal. It really only comes on line when there's a challenge in some other international market--for example, recent flooding in Queensland, Australia--that hinders another cheaper source of supplying metallurgical coal to China. So, we view the past few years of strong export coal volume as more of a benefit from a perfect storm for the Eastern rails. We don't see that persisting, and we don't model that type of growth in our projections.
One of the commodities that has offset coal volume in a positive way is crude. This is our third C. The crude we are talking about comes from unconventional places such as the Bakken region. A lot of crude shipped by rail is sourced in the Bakken region. It also comes a lot from the Canadian oil sands. In the Bakken, though, we think a lot of the production shipping North and South will eventually be transported by pipelines, so we're not projecting tremendous growth there. But we think, on the East and West Coasts, rail will still be the way that a lot of this product moves. It's a relatively small portion of rail volume--usually a low single digit percentage of total volume--but it is still incremental growth for the rails.
And the fourth C?
Schoonmaker: Our fourth C is regulatory codes. We've seen a couple of things pop up in the past 18 months or so. A big one in Mexico was some concern that has now been allayed. A bill passed the lower House in Mexico that threatened to modify the concession conditions under which the railroads operate, including the two big ones, Ferromex and Kansas City Southern de Mexico.
Our concern with changes to the concession rights really was remedied by the passage of another law that sets up an organization something like what we have in the United States with our Surface Transportation Board, or STB. This is a way for shippers to get some relief from predatory pricing. Mexico lacked this sort of relief for its shippers in the past.
In the United States, there is a persistent threat by some for a more aggressive Surface Transportation Board to pursue rate cases against the rails. What we have now is a renewal of the Surface Transportation Authorization that the Association of American Railroads has endorsed, and it is not a huge change to what the past has been. A couple of the changes are things like increasing the number of board members from three to five to allow the board members to have conversation without just two people comprising a voting majority of a three-member board. It also allows the STB to investigate rather than just respond to complaints, and it requires a more frequent reporting of complaints than what the STB has made in the past.
Let's talk about consolidation. You make an argument that we could actually see just two railroads dominating the United States. Can you explain?
Schoonmaker: This is a little bit of a controversial position. In 1999, CN and BN proposed a merger, and it was blocked by the Surface Transportation Board, which has antitrust authority over the railroads. It was blocked because they determined it would be anti-competitive.
In my opinion, we have two rails in each region. In the West, UP and BNSF compete against each other, and then when traffic moves across the Mississippi, it has to be handed off to the Eastern rails, CSX and Norfolk Southern. We believe it would not diminish competition if there were a merger across the Mississippi. For example, Union Pacific could merge with either CSX or Norfolk Southern. But we're not hypothesizing that it would be possible to have a merger within a region, like Union Pacific plus BNSF. That would be anti-competitive because there would be only one carrier, period, in that entire region.
This idea was raised recently because about 18 months ago, on a conference call with Canadian Pacific, I asked the CEO, Hunter Harrison, if he thought there was a possibility of additional consolidation. He indicated he did. This was a very controversial position to take. It certainly set off interest on Wall Street and in the media.
He had a follow-up call with investors about a leaked rumor that CP intended to merge with CSX. In subsequent discussions, CSX expressed little interest in the idea of merging, and so in a follow-up call, Harrison indicated that he wasn't interested in pursuing mergers at this time.
I think the notion of mergers is still attractive to Harrison and appears rational to him. And he is perhaps today's greatest living railroader and has been at the helm of three amazing turnarounds in railroads in the past 20 years. Morningstar awarded him our CEO of the Year two years ago for his remarkable effect on this industry, most recently at Canadian Pacific. But as far as the likelihood of additional mergers, I think Harrison and I both think it is rational, if one looks at the space, but perhaps unlikely given the current environment.
In terms of your coverage list, I'm under the impression that most of the stocks are trading at fair value or close to fair value.
Schoonmaker: Yes, that's right. But we identify Union Pacific as being our top pick. Union Pacific is trading at about $86, and our fair value estimate is $114. It's trading at about a 25% discount to our fair value estimate, which puts it in 4-star range for a medium uncertainty stock. We like this company because it's the largest Class I railroad, and it's able to spread its costs over a much larger revenue base than the other rails have.
It also has a very balanced portfolio. UP's revenue mix is about--I'm using round numbers here-- it's approximately 20% intermodal, 20% industrial products, 18% energy, a similar size in agriculture, and similar size in chemicals. So, it's quite balanced in that regard. It also has a large auto franchise, which has made up about 8% or 9% of revenue in recent years, and it certainly has some secular tailwind in the auto market at present.
To finish up, if investors are considering buying a railroad stock, what do they need to keep in the back of their minds?
Schoonmaker: All of the rails we cover have wide moats, so we think that they all have tremendous competitive advantages. We think the management teams at all the rails are high caliber. We think it comes down a lot to price and one's belief about the future of various commodities. We like Union Pacific because we think it diversifies away a little bit of the commodity risk of being reliant on a particular commodity. If one is in love with the growth story in Mexico, then it makes sense to pursue the IPO at Ferromex or to pursue Kansas City Southern de Mexico. Even if one does like the Mexico growth story, and we do, Union Pacific still makes sense as a play on that because it owns 26% of Ferromex. And Union Pacific earns 10% of its total revenue hauling freight to and from Mexico.
Let me add one other thing there. For those seeking dividends, Norfolk Southern historically has maintained the highest dividend yield. Right now, it is around 3%. Union Pacific has been around 2.5% lately. Because of the wide moat on these names and the tremendous amount of cash that they generate, we think they are safe dividend payers. Management's quite conservative at these railroads, so I don't think they're going to overextend with what they can do on dividend payouts. I think that it's an attractive yield to be had given the high quality and how instrumental the rails are to moving the U.S. economy.
This article originally appeared in the August/September 2015 issue of Morningstar magazine.
Rob Wherry does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.