Lower Volume Hits Rail Valuations

We decreased our fair value estimates for Class I railroads as we lowered our 2016-17 projections to reflect recently reported volume trends and updated expectations from Morningstar analysts of pertinent industries. North American coal carloads declined 12% in 2015, and other freight also proved dour as the year came to an end, with total carloads down 13% in the final four weeks, concluding a 6% decline for all of 2015. Intermodal units improved 2% in 2015, despite declining 2% in the final four weeks. To us, this looks like a significant freight slowdown, if not a recession.

Given low commodity prices (in particular, natural gas that is sufficiently cheap to make coal relatively unattractive in power generation), lower commodity demand from China, reduced oil and gas investment, projections from fellow analysts, and the U.S. Purchasing Managers Index's steady decline since July (breaching 50 in November and December), we have adjusted our volume estimates downward for the next two years. In 2016, we expect revenue per carload to decline for most freight, as fuel surcharges decrease as a result of cheaper fuel. We believe the rails will cover inflation via rate increases, manage costs to expand margins, and repurchase shares. However, after a few years of improvement, we model margin gains to flatten; thus, growth depends on volume, which we expect to expand a modest 1%-2% per year.