All Aboard for Railroad Opportunities

In the transportation business, the primary concern has been fuel costs for the past two years. This situation has changed. With a renewed focus on volume strength (level of material shipped around the country) in this depleting macroeconomic environment, many of the same rails that saw buying momentum from the 2008 commodity spike are being absolutely "de-railed" by renewed concerns amid collapsing volumes. While the major railroad companies have been able to beat expectations for the year, is there any reason to be optimistic going forward?

Every week, the Association of American Railroads (AAR) releases updated volume trends in the form of a weekly carload report. While many of the readings have been sporadic (to say the least), the overall theme is of disappointment. Most recently, on December 11th, the AAR announced that carload freight was down 8.5 percent from the same week in 2007, with intermodal shipments bucking the downward trend at 9.8 percent in the red. This comes somewhat as a surprise from companies that were, for the most part, bullish on the future of volumes from just under a month ago. Clearly, the global slowdown is putting downward pressure on carloads… but let’s not panic; to this date, shipments are only down 1.5 percent from last year’s period.

Warren Buffett’s Big Bet

With new positions from Berkshire Hathaway revealed on Monday, December 15th, the stock that has gotten a large share of Warren Buffet’s attention continues to be in the rails with Burlington Northern (BNI). Last week, Buffett used the weakness as an opportunity to add an extra 2.2 million shares through fresh put option contracts. After this most recent spree, Berkshire owns about 20% of Burlington, on top of strong positions in competing rails Union Pacific (UNP) and Norfolk Southern (NSC). Perhaps the stock market guru senses a future opportunity that other investors are simply not accounting for to this date.

Is the Volume Crash Over-Hyped?

With the shares of leading railroad firms trading at multi-year lows, it would seem that these companies have been unjustifiably brought down by a commodity crash and intensifying production fears. Will pricing power continue into 2009? And how about crude oil? Will the commodity bubble burst actually dismiss the once-needed efficiencies of transportation by rail? Perhaps a slowing domestic atmosphere will simply rob rails of their traditional carload capacity optimization? There are many unanswered questions floating around in the heads of traders looking at the railroad industry, but perhaps the sell-frenzy is overdone and things really aren’t as bad as we make them out to be.

Here are a few points that could lead to better than expected numbers:

The Federal Reserve Target Rate Cut: As the U.S. Federal Reserve cut its federal funds rate target from 0 to 25 basis points, we may actually see a benefit in the railroad arena. This recent government action has definitely shown the Fed's interest in keeping our economy stimulated. With any rate cut, our economic environment is stimulated into a flurry of activity… including increased demand for shipments worldwide. It may sound like a bit of a stretch to link a rate cut with boosted demand for rails, but this is something that does in fact fit with the global theme. Don’t overlook the government’s ability to boost demand, albeit somewhat artificial, and help the rails out of a pinch.

Long-term Transportation Consolidation: I am ranking the entire rail industry as the conviction buy of 2009. Why? As other forms of transportation start to melt away into deficits and negative returns, I feel that it is the railroads that will receive major increases from the consolidation. Sure, railroad transportation may not be the newest idea in town, but it is reliable, energy efficient and improving constantly. You just don’t see many hybrid FedEx trucks driving around.

From the third quarter releases: CSX (CSX) grew fuel efficiency by 3% in the quarter, Union Pacific boosted velocity speeds by more than 2 mph to 23.7 mph, Burlington Northern grew fuel efficiency by 2.2% quarterly, Norfolk Southern saw 9% improvement in transit times for their coal division and Canadian National (CNI) saw train speed up 12% with switching productivity up 6% during the quarter. This efficiency-building is a theme that you don’t see in the trucking industry, the air-freight industry or even shipping. As other forms of transportation collapse, railroads may see increased workload from the sole fact that they are the best way to move things around.

Unrealized Fuel Tailwinds: Let’s not forget that crude oil was significantly higher in the third quarter. The same pessimism that we are seeing toward the industry now existed one quarter ago in the form of fuel surcharges. The major domestic railroads saw fuel costs increase anywhere from 55-60% in the third quarter… and this did put a ton of pressure on their pricing power. Regardless, most of the hedging in the industry is on a per-contract basis where deals are negotiated. Railroads should see a significant benefit in their figures from lower fuel costs overall, and this may easily translate into more favorable outlook and earnings.

Previous Guidance Bullish: There are still plenty of strong points in the rails despite current headwinds from a volume slowdown. Turning to the third quarter earnings reports, many of the rails were actually raising their forward-looking guidance last quarter. Some, such as industry-leader Union Pacific, even admitted that volumes would be “soft.” However, this really didn’t detract from much of the profit-seeing as guidance was typically raised across the board in a similar environment. Has volume actually deteriorated enough since then to merit share collapses in the rails of more than 30% on average since the last quarter’s surprising success? Obviously, things aren’t pretty in the transportation stocks as a whole. But the market tends to take news and over-react… the news that we see right now still suggests decent numbers from the railroads.

Recently, Merrill Lynch downgraded their rating for the major railroad, cutting most companies to neutral or sell ratings. In addition, in late November UBS analyst Rick Paterson claimed that anyone who feels volumes are “OK” is “in fantasy land.” He even went so far as to say “get the knives out.” Understandably, a lot of people shrugged off the railroads when they traded at a premium of anywhere from 20% to 35% of current values now in mid-December.

I believe there is enough conviction to place bets on the rails down here with P/Es ranging from 8x to 13x. The best names going forward, in my opinion, will be Union Pacific (P/E: 11x), Burlington Northern (P/E: 13x) and CSX (P/E: 9.5x) on growth initiatives and exposure to the Powder River Basin for maximized coal transportation. In an industry that typically beats on negative sentiment with stable revenue streams and plenty of contract-negotiating power, there may be a considerable amount of upside in the rails.

-Jim Regan

Disclosure: The mutual fund that the author is associated with is long UNP

Comments

[Chris B:]

I'm not so sure about that...

Coal demand:
Like it or not, the new administration/Congres... will discourage the expansion of coal demand in favor of renewables. Coal shipments will remain flat unless deposits closest to power plants are exhausted and longer shipments are required. That's a sketchy bet.

Ethanol transport:
Will grow about 10-15% as much as US gasoline consumption, so still none. Some producers are already going out of business, so pricing power is weak.

Lumber & Building Materials:
Residential construction is overbuilt for a decade. This will only be partially offset if there is a New Deal type infrastructure program, requiring shipment of materials such as steel beams, rebar, etc.

Chemicals / Fertilizers / Foods / Grains:
Possibly weak pricing power with low diesel prices making trucks more competitive. The decline of the big 3 at the expense of Chinese imports will reduce domestic shipping of chemicals and metal.

Vehicle Transport:
Military contracts will decline as the Iraq war winds down. The big 3 automakers will end up a shell of themselves no matter what happens, and RR's might lose some accounts receivable in a bankruptcy. The bright spot for railroads is when the Chinese imports start arriving in 2010 or 2011 and have to be shipped by rail from the West coast to everywhere else. However, credit availability for new car buyers may never again be as loose as it was in the early-to-mid 2000's, so new car demand may not reach those levels for a decade. In any case, consumers are buying smaller, cheaper cars now, because they can't finance anything more expensive. This means fewer railcars to ship the same number of units.

Light rail / Mass transit:
Possible enhanced investment in Chicago-style light rail will probably not affect the freight RR's unless it costs them money due to right-of-way issues, forced sharing of rails, or construction interference. I don't anticipate major revenues from rail construction contracts.

2008 Dec 18 03:04 PM

[Jim Regan:]

This is true that shipments are down, but everyone expected that. Looking at Jim Young, CEO of Union Pacific, he stated in the third quarter call that they already expect volumes to be down significantly in the fourth quarter and first quarter 09... yet they still raised guidance as a lot of the pricing can outweigh it. Don't be surprised with earnings beats in January (when most rails report)

2008 Dec 18 06:45 PM

[Market Folly:]

tons of hedge funds have been in and out of the major rails UNP, BNI, CSX. we track tons of hedge fund portfolios on our blog, so just enter any of those tickers in our search bar and you'll see who owns those rails

www.marketfolly.com

2008 Dec 18 08:13 PM

[Jim Regan:]

CSX has been getting dumped by TCI, and their biggest holding is UNP but they seem to be maintaining their position in the company for the time being. This could be a long-term bullish signal as they price-averaged down at $60/share but are still buyers down at $40

2008 Dec 18 10:31 PM

[auto44:]

It seems to me that railroads are going to thrive on the gov't spending
spree. It also seems to me that green enrgy is still pie in the sky as heat pumps were in the northeast in the last energy debacle. Railroads using less fuel and less labor per ton mile seems like a sensible solution to ground shipping. Good article. Thanks

Merry Christmas and may (YOUR) holidays bring you peace.

2008 Dec 19 01:42 PM

[auto44:]

Chris B,

I doubt that renewable will takeover for coal. I doubt that housing is overbuilt for anywhere near a decade. Trains use the same fuel that trucks do only a whole lot less per ton mile. We will still have to ship cars no matter who makes them. I respectfully disagree with most of what you said,but I didn't give you a thumbs down because you have really put a lot of thought into your opinion. Keep thinking and I hope we can agree more in the future and learn together. Sincerely, Bob

2008 Dec 19 02:02 PM

[davidma11:]

Nice article. In light of the slowdown these companies are trading at 5 year low PE;s and 5 year high dividend yields. Long term growth rate projections of 10% or higher in some cases. One may look to start a position or take a page out of Buffett's playbook and sell an out of the money put. I think Rails at these levels are beginning to look interesting.

dave

2008 Dec 21 05:00 PM

[railroad lo...:]

sorry gents but traffic is declining at rapid rates and so will profits as the fixed costs of railroads are enromous and the revenues are just not cutting it. railroads failed to keep retail freight that trucks have which equates to more commodity based cyclical revenues and traffic regardless of cost cutting, long term railroads will be marginal because they have merged and become less compeditive and are very slow to innovate and be aggressive with adding less cyclical higher end non commodity traffic. railroads still costs sut instead of aggressively sell thier services and act like they are still regulated. rarely do you ever see any railroad sales people looking for traffic. the door to door high profit and high hassle trade they gave up. breaking up railroads into 6 transcontenentials and providing an aggressive national rail policy is the only way to save this industry. the only way railroads currently can survive is to constantly costs cut, eliminate infrastucture capacity for short term gains and continually defer maintenance and never are they aligned with demand curves as they are always behind never maximizing profits like they have potential to do so. railroads basicly fritter away opportunities to triple thier freight volumes because they are negative in thier dealings with employees, innovation and agressive creative sales, they take few risks therefore they will never really flourish just a group of old non innovative costs cutting tightwads never to realize full potential

2008 Dec 27 07:59 AM

[cnwtrainman:]

The stock market is a ponzi scheme and anyone in it will eventually be taken. Even Warren Buffet is losing millions these days. Unless and until this country decides that it has to manufacture goods and not merely produce services, we are in trouble in every sector.

Hopefully this new administration will keep its promise to get us out of NAFTA and GATT and we can admit that selling insurance to each other just wasnt the way to go.

Railroads are in trouble, bottomline we have no money in this country. We cant buy things because we dont make things. Both Obamma and McCain embraced nuclear power and other than coal and stacks what do railroads carry these days? Autos? Yeah tie your future to that bunch!

2008 Dec 28 09:39 AM

[Jim Regan:]

While I won't address the first two paragraphs of your reply, I want to note that we DO in fact "have money in this country" and that your point on automotives is extremely off base because the percentage of ANY rail company's shipments in the auto unit is going to be less than 10% of the total... typically around 5%. Let's not point fingers here without considering who moves what!

@ railroad engineer: I understand the concern... but I think it is fair to say that we all realize things are tough. Management at companies like Union Pacific, Burlington and CSX saw this coming... and actually mentioned it in the third quarter calls. Granted, volumes have been worse than expected... but when you look at how these stocks have traded in the past 3 months, it is getting ridiculous. Things are bad... but not THAT bad, and the future is a lot brighter than analysts are painting it to be. This is a buying opportunity in my professional opinion.




On Dec 28 09:39 AM cnwtrainman wrote:

> The stock market is a ponzi scheme and anyone in it will eventually
> be taken. Even Warren Buffet is losing millions these days. Unless
> and until this country decides that it has to manufacture goods and
> not merely produce services, we are in trouble in every sector.

>
>
> Hopefully this new administration will keep its promise to get us
> out of NAFTA and GATT and we can admit that selling insurance to
> each other just wasnt the way to go.
>
> Railroads are in trouble, bottomline we have no money in this country.
> We cant buy things because we dont make things. Both Obamma and McCain
> embraced nuclear power and other than coal and stacks what do railroads
> carry these days? Autos? Yeah tie your future to that bunch!

Jan 02 02:28 AM

[einstein p ...:]

I agree with Chris B.

Renewable energy will not replace coal, especially with the state of the economy and the present technology. Actually, the emphasis on infrastructure and cheap energy sources both the US and China would tend to lead me to believe the opposite is the case.

Not only are the rails a good investment, but so are the coal companies and the dry bulk shippers. More than likely, the credit crunch and the liquidation of positions by hedge funds is just as responsible for the steep decline in these stocks as is the recession that never was but actually started in December of 2007.


On Dec 19 02:02 PM auto44 wrote:

> Chris B,
>
> I doubt that renewable will takeover for coal. I doubt that housing
> is overbuilt for anywhere near a decade. Trains use the same fuel
> that trucks do only a whole lot less per ton mile. We will still
> have to ship cars no matter who makes them. I respectfully disagree
> with most of what you said,but I didn't give you a thumbs down because
> you have really put a lot of thought into your opinion. Keep thinking
> and I hope we can agree more in the future and learn together. Sincerely,
> Bob

Jan 02 04:38 PM

[JF:]

No mention was made of Kansas City Southern (KSU). Does anyone have an opinion on that railroad?

Jan 06 10:46 AM