Railroad Companies: Good, Better, Best 16 comments
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It is well known that Warren Buffett is bullish on the railroad industry. But among the top four American railroad companies, Burlington Santa Fe (BNI), Union Pacific (UNP), CSX (CSX) and Norfolk Southern (NSC), he has clear preferences. BNI is no doubt on the top, UP comes as the second, and NSC and CSX are much less favored. Through this article, I will try to provide my understanding of his logic behind his preferences. I will attempt to answer three questions, 1) Why does he pick the railroad industry? 2) Why are CSX and NSC less favored? And 3) Why is BNI more favored than UP?
To Question 1: Railroad has to be the future of American freight transportation
When we talk about moving freight around without incurring hefty costs, normally there are two options, trucks and locomotives. In the old days, thanks to the low energy cost, the advanced highway infrastructure and their point-to-point flexibility, the trucks dominated the shipping market. But now the picture is changing. I believe in the long run, the railroad will become the backbone of the American freight transportation network, while the truck companies will be confined to short distance shipping, operating between railroad stations and the customer locations as a support to the national railroad network.
The above statement is based on the following facts and beliefs.
First, railroad is simply a more efficient way to move freight. According to BNI, one intermodal train removes more than 280 long-haul trucks from the nation’s highways.
Second, based on the type of freight (industrial material, agriculture product, coal, etc) , the rail is 2-8 times more fuel efficient than trucks.
Third, Rail is more environmentally friendly. It emits only 2.6% of the total U.S. green house gas emissions, while trucks, 21%.
Fourth, the progress of information technology helped the railroad companies build more sophisticated train control systems, resulting in increased accuracy, efficiency and flexibility, continuously narrowing the advantage of trucks over railroad.
Fifth, I believe the coming era will be featured by high energy price, which will continue to consolidate rail's cost advantage over the trucks.
Sixth, intensified environment concerns will drive stringent regulations, which will drive up the operation cost for both rail and trucks, but the impact will be a lot more punishing for trucks than for rail, thus the cost advantage of the latter will be further consolidated.
Seventh, under the recession, the cost awareness of the customers makes rail an even more attractive alternative to trucks. This will help rail companies gain market share against trucks, better position themselves to take advantage of opportunities created by the economic upturn, thus further build its dominance over trucks.
To Question 2: For BNI and UNP, the geographic layout of their railway network gives them insurmountable competitive advantage over NSC and CSX
The competitive advantage of BNI and UNP is of a unique type. It has nothing to do with branding, technology superiority or management excellence, but originates from the simple fact that BNI and UNP happen to be the ones that operate the railroad network in Midwest and West America. To be more specific, the advantage lies in the following aspects:
1) Intermodal. For all four companies, intermodal is a significant portion of their revenue. CSX and NSC operate in East America. They connect with ships from the Atlantic Ocean, transport shipments originating from or destined for Europe and Latin America. Whereas BNI and UNP connects to the Pacific ports, eventually with Asia and Australia. Now the picture is clear. Across the Pacific ocean, BNI and UNP has China. On one hand, China is the world factory, manufacturing virtually everything required in American daily life, on the other hand, an emerging economic giant, thirsty for all sorts of goods produced from the American land, especially energy and agriculture products. This type of import and export is projected to grow strong for the coming dozens of years, thus offering BNI and UNP vast growth potential.
2) Agriculture. In the past several years, externally, Asian countries need to import grain from the US to feed their people, and internally, America needs corn to make ethanol. The soaring demand for these types of goods created the agricultural boom. The recession slowed things down, but will it change the domestic and international demand pattern of American agricultural products? My answer is No. Again, BNI and UNP happen to own the railroads that run through the enormous American farmlands, and there is no means that is more cost effective than trains to move grain, corn or beans. The farmlands now give BNI and UNP another growth opportunity that their two brothers in the east can only dream of.
3) Geography and industrialization. In East America, the territory controlled by CSX and NSC, we see higher industrialization, dense population, numerous big cities, a slew of ports along the Atlantic Ocean, in other words, a well developed environment for all means of transportation to prosper, including trucks, ships and rail. Therefore, for CSX and NSC, in addition to competing with each other, they have to compete with other shipping means, which normally are already mature and well managed. While in the west, the Rocky mountains and the desert somewhat confined the industrialization to the strip along the Pacific Ocean. It is the vast plain running deep into the heart of the continent. Here we see small population, sparse cities, tiny towns and infinite farmland. It is never the preferred means to move the common goods, such as coal or grain, around with trucks, because the volume would be small, the cost would be high, and normally you have to move long distances. In summary, this is an environment where only the rail can manage to survive and prosper. For BNI and UNP, except competing with each other in certain regions, they don't face any other serious challenges.
To Question 3: The black gold gives BNI the edge over UNP
In western America lies one of the largest coal reserves in the world - Power River Basin (PRB). Once it was estimated to have 200 billion short tons. The newly published study revised the number in a shocking manner, claiming 190 billion tons of reserve, about 95% of the original assessment, as economically unrecoverable. So there is only 10 billion tons left, let's accept it for now. In 2008, around 40% of American coal production came from this area, around 450 million tons, and most of them were used for power generation. With 10 billion as the reserve, it is safe to say the supply is guaranteed for at least 10 years.
And for the next 10 years, I believe the amount of coal that the railroad ships out of this area will grow year after year.
First, the growing demand of power generation requires greater coal output.
Second, currently the fuel types for power generation include petroleum, renewables, nuclear, natural gas and coal. For renewables, there is still a long way to go before they become reliable and significant sources for power generation. For nuclear, there is always the key concern about safety. For petroleum and natural gas, they are turning too expensive, and there is no chance for the trend to reverse considering the worldwide demand will only intensify. So coal somewhat becomes the only option. I see power generations will rely more and more on coal, which adds further demand for the output from this area.
Third, coal from this area has extremely low sulfur content. Thus, many coal-fired power plants in the U.S. buy PRB coal to blend with other coal with higher sulfur content to meet the environmental regulations. We foresee the environmental regulation will become stricter, which may become another contributor to the higher demand of PRB coal.
Now comes the last and the key question. Who has the privilege to move the PRB coal? Checking the railroad network map, you will find BNI has almost exclusive coverage in the area. In 2008, 22% of BNI's revenue was from coal, and now it seems this big chunk of revenue is not only guaranteed, but also guaranteed to grow. Therefore, right here, lies the ultimate advantage of BNI over UNP.
Disclosure: Long BNI, No Positions in UNP, NSC and CSX
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This article has 16 comments:
How long before we have significant increase in passenger trains?
In addition, both BNI and UNP serve other coal origins outside the PRB. In 2008, BNI handled 2.5 million carloads of coal, generating almost $4 billion in revenue. In the same year, UNP handled 2.35 million carloads in its "energy" category, which is almost all coal, generating $3.8 billion in revenue. The two railroads are, in fact, very closely matched in the western coal market.
The author also favors BNI and UNP over CSX and NSC because of their proximity to China. This has been a big advantage for both railroads over the past decade but is becoming less so in today's changing global trade environment. Shipping lines have begun to shift some of their Asia-U.S. routes to the east coast over the past five years. NSC executives have recently said that about 50% of their container business now comes in through east coast ports, as opposed to only 20% a few years ago. The port situation on the west coast has changed, too, with the opening of modern container facilities at Prince Rupert, B.C. (served by Canadian National [CNI]) and Lazaro Cardenas, Mexico (served by Kansas City Southern [KSU]).
1. I completely agree with point #1. As peak oil approaches, fuel costs will rise and rails will look wonderful compared with trucks and planes.
2. The article focuses on freight rail. However, passenger rail will be the big money maker at some point - unless the government kills it. If this is the case, the Eastern rails will have a clear advantage because of the higher population density.
3. If you look at the long term chart of the six major rails, starting int 1980, you will see that CNI has the best return. It currently has the highest ROI and profit margins. It is also the most expensive. It is an Eastern rail with the inclusion of the old Illinois Central.
the next best returns are the NSC and the CSX. these are both Eastern. BNI leads UNP and CP. UNP is the worst.
Perhaps UNP is laggard because of the southern pacific acquisiton?
4. CNI and BNI are currently the most expensive. CSX was extremely expensive but has recently declined. CP is cheap and sells practically at book value.
5. If you look just a geography you might see that the Eastern ones have an advantage in terms of density and less maintenance. Shorter distances between points means less maintenance. Also fewer mountains to go up and down - saving on fuel costs.
6. Eventually, I see the government taking the rails back over again when they recover. The US government loves to destroy successful industries (i.e., rail - decades ago, auto - in the 1950's and 1960's, oil - currently, big Pharma) and reward inefficient ones (i.e., banks and autos currently).
A couple minor points:
- The long term battle between trucks and train has gone something like this: Trucks are faster and more reliable, Trains (or intermodal services) are cheaper, particularly for longer hauls. (>500 miles). Over time, train service speed and reliability has improved, displacing trucks. This can be expected to continue.
- As one poster correctly points out both BNI and UNP have excellent access to PRB coal. I don't belive there is a true advantage of one over another, but the advantage over the eastern rails is real.
- For those who are asking about passenger rail... keep dreaming, the economics just doesn't work very well, except for shortish trips between congested urban centers (e.g. the NE corridor) where time "to and through" the airport makes up the majority of the travel time. Think about it this way: People's time is valuable; it makes more sense to move people by the fastest means possible (e.g. airplanes) while letting lower value stuff move by slower means such as trains.
It has been an essential link in the coal chain between mines, rail and end user for more than 35 years. Shipments regularly go to about 24 countries and bring $2 billion or more of wealth each year to Canada.
In 2005, Westshore celebrated its 35th anniversary and remains the busiest coal export terminal in all of North America.
www.westshore.com/
A couple of comments on the article: BNI and UNP have a huge advantage with Powder River coal but don't have a particular edge over each other. Look for the possibility of exporting coal to China, they've expressed interest but there isn't real infrastructure to handle the business now. International intermodal can be expected to rise and fall directly with the economy. Domestic intermodal as a long term trend is moving to a "hub and spoke" system where rail will handle shipments over 500 miles and trucks will handle from major intermodal terminals. Agriculture will continue to grow due to increased exports. Ethanol could be great or could fizzle out, that will be a completely political issue. Industrial products will also rise and fall with the broader economy. Passneger rail is a long way from being a big part of the business, if it ever will be.
Long term there is a lot of potential and little downside simply because it would be impossible for trucks to handle the tonnages that rails move. Also look for technology to continue to improve efficiency and lower costs.
Finally, the big elephant in the room is re-regulation. Since the industry was deregulated in the early 80's efficiency and cost to the customer have improved drastically but with the current government climate who knows if Congress or the Administration will notice. Maybe once we're done socializing the financials and the auto industry we'll turn to wrecking healthy companies as well...
Thanks for the informative article. TCI hedge fund just jumped out of CSX. One wonders why- if not only for the ability to move to other investments that have the potential to move more/faster... In any case, I'm sure few will dispute Mr. Buffet's picks over the long haul...Pun intended... BNI is the market leader with UNP the next best----but---- That little ol' R&R KSU- Sure think to over look this guy is a missed opportunity. It tends to move in share price faster in either direction. That volatility makes for great plays in the short terms and at 15.00 is undervalued compared to it's bretheren.
KSU makes plenty of it's revenue on intermodal between the east and west, totes ALL energy sources to and from the Gulf and is poised to take great advantage from the Port of Lazaro Cardenas as it will probably continue to gain freight away from South Cali. That won't change until something is done about the Unions at the American ports! I've played KSU since before they spun off Janus Funds and it's STILL my favorite. Would sure like to see some other opinions on KSU....
Thanks,
My only concern with BNI is that the market cap is about $22 B and they don't have free cash flow of much more than $1 B. That is a 5% free cash flow yield.
Do you think much of this relates to Cap-Ex expansion that will slow down in the future. Or is the heavy cap-ex a recurring item.
It seems like I can find other businesses with higher cash flow yields. All that being said, it is a Buffett favorite, and the demographics and secular nature of this industry are strong.
1.) Passenger transport is a overall loss to frieght railroads. One major reason all of them abandoned hauling people in the late 50's and early 60's. Routing passenger traffic on the same lines that move frieght creates lots of conflicts and cuts into the revenue potential of the lines. Commuter rail on dedicated routes in densely populated areas makes sense, but I don't expect to see a "Super-Amtrak" anytime soon. All of the frieght roads will avoid it if possible. (See CSX's response to giving up or sharing it's route across Florida for a light rail proposal.)
2.) PBR coal is important and will no doubt give BNI an advantage. But blending it with Appalachian coal is what power plant operators want, so NSC still has a lot of coal to haul too (best BTU output with a pollution level currently acceptable to the EPA.) NSC got the better end of the deal when ConRail was split between them and CSX.
3.) Eastern roads still have a lot of customers to serve and a container loaded in California can easily get unloaded in Florida with no fuss, and no muss. Handed off from one carrier to the next. The railroads have got intermodal frieght down pat. The density of the eastern roads cuts the size of their physical plant, which works in their favor.
So... for me the best plan is to have positions in both an eastern and a western road. NSC & BNI work for me.