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.

Our fair value estimates have declined as follows:  Canadian National (CNI)/(CNR) to $50/CAD 72 per share from $59/CAD 78,  Canadian Pacific (CP)/(CP) to $124/CAD 179 per share from $164/CAD 213,  CSX (CSX) to $33 per share from $37,  Kansas City Southern to $77 per share from $97,  Norfolk Southern (NSC) to $97 per share from $102, and  Union Pacific (UNP) to $95 per share from $110. We believe stock prices also reflect merger considerations, with CSX and Norfolk trading at slightly elevated multiples and Union Pacific and Canadian Pacific at slightly depressed levels (relative to levels with no M&A in play). Canadian Pacific is still pursuing Norfolk Southern, but the latter rail's management has rebuffed all offers, shippers are objecting, and the antitrust regulator remains mum. We still believe all six rails merit a wide economic moat rating.

North American traffic declines are sobering. Year-over-year volume dropped in 2015 with few exceptions (autos and parts improved 3% for the year). The 12% decline in 2015 coal was the most material, but full-year carloads in metallic ores and minerals declined 14%, nonmetallic minerals declined 4%, chemicals and petroleum declined 2%, forest products declined 50 basis points, and agriculture and food products declined 20 basis points. Worse yet, declines in the final four weeks of the year were more severe, with total carloads down 13% and intermodal down 2%. Given that we updated our models during the fourth quarter, our estimates already reflect much of the weak 2015 demand. At this time, we are shifting down our forward volume projections.

Morningstar analysts' expectations for 2016 and 2017 follow in broad terms. We expect coal cars in the Powder River Basin and Illinois Basin to decline 4% in 2016 and 1% in 2017, but to decline in Appalachia by a much steeper 8% in 2016 and 6% in 2017. We expect potash will be up 2% each year, nitrogen and phosphate will be flat to up slightly both years, and automobile production will be up about a percentage point in each year (Ward's projects that first-quarter production will increase 1.2%). Our expectations for agriculture consider the U.S. Department of Agriculture projections for a decline of 130 basis points in harvested acres during each of the next two years. In the long run, we consider intermodal containers to be the secular volume grower at the rails, but even intermodal inflected to negative comparisons at the end of the fourth quarter of 2015. In October and November, truck tonnage grew at modest 1.8% and 0.2% year-over-year rates, respectively.