The U.S. freight railroad industry is on the growth trajectory. Freight rail is a “derived demand” industry — demand for rail services is tied to the demand for the products that railroads haul. Rail traffic, therefore, acts as a solid barometer of the overall health of the economy.
Excluding coal and grain, rail cars generally transport raw materials, which are required as inputs for industrial production. As the U.S. economy is steadily strengthening and the broader macro-economic indicators are improving, the rail car volume growth is expected to continue into 2015.
Strong Growth
The Association of American Railroads (AAR), the main industry trade group, reported that the U.S. rail traffic in Nov 2014 including both carload and intermodal volume increased year over year. Despite the expected headwinds associated with coal — one of the major products transported via rail — the sector emerged strong backed by infrastructural developments that supported natural gas, grain crop and petrochemical product shipments.
While carload volume witnessed 1.4% year-over-year growth, the intermodal volume grew 2.7% year over year. Notably, Nov 2014 marked the ninth successive month of carload volume increase. Out of a total of 20 commodity categories tracked by the AAR each month, 11 commodities generated year-over-year carload increases in the month of November.
Combined North American freight carload traffic (including the U.S., Canadian and Mexican carloads) in the first 48 weeks of 2014 was up 3.1% against the comparable period in 2013, while combined North American intermodal volume rose 5.4% year over year.
Significant Private Investment
Investments in development and expansion plans remain crucial when analysing the prospects of the railroad industry. These capital investments are a union of binaries. While the investments put margins under pressure, forgoing these would dampen growth prospects.
Railway investments are significant, given the evolving supply chain management and the growing importance of airfreight carriers in offering freight transportation services. These investments help railway operators in building the required infrastructure to compete effectively within the same industry and with other modes of transport like truck, barges and cargo airlines.
Hence, investments in infrastructural projects have been an integral part of the development of railroads. However, this sector, characterized by huge capital influx, has been drawing funds primarily through private financing.
From 1980 through 2013, freight railroads reinvested an enormous $550 billion to install a best-in-class freight rail system in the nation. AAR has projected that railroad operators will invest at least $26 billion in 2014 alone to improve rail tracks and related facilities.
As a result, investment plans when undertaken, can have a considerable impact on a company’s liquidity position and could also lead to a highly leveraged balance sheet. According to AAR reports, railroad operators invest approximately 17% of their annual revenue, which compares with only 3% of average U.S. manufactures’ revenues on capital expenditures.
According to the U.S. Department of Transportation (DOT), the demand for rail freight transportation will increase approximately 88% by 2035. As a result, railroad operators will have to increase their investments to meet this growing demand.
DOT also projected that almost 90% of the railway capacity needs to be upgraded to meet the expected rise in demand level. Hence, it is important for railroad companies to balance profitability levels while investing in infrastructural development projects.
2 Major Advantages
The U.S. freight railroads currently enjoy two major positives that are difficult to avoid from an investor’s standpoint:
(1) Discretionary Pricing Power: According to Staggers Rail Act of 1980, the freight railroad operators can hike prices on captive shippers in order to improve profitability. Under this rule, railroad companies are raising freight rates by nearly 5% per annum on an average, while maintaining a double-digit profit margin.
(2) Duopolistic Market Structure: In the prevailing duopolistic structure, railroad operators are reaping maximum benefits from rising prices when the overall demand grows. This is evident from the geographic distribution of markets between major railroads. Union Pacific and Burlington Northern Santa Fe control the western part of the U.S., while CSX Corp. and Norfolk Southern control the eastern part. On the other hand, Canadian Pacific and Canadian National control inter country rail shipment between the U.S. and Canada.
The 3 Best Performers of 2014
While year-to-date (YTD) the S&P 500 index has increased 13.64%, several railroad stocks have outperformed the benchmark. Here we will discuss the best performing three stocks, all of which carry a Zacks Rank #3 (Hold):
Union Pacific Corp. (UNP): Based in Omaha, NE, the company is the largest railroad in North America providing rail transportation services across 23 states in the U.S. Union Pacific also connects with Canada's rail systems and is the only railroad, serving all the six major gateways to Mexico.
This stock gained a whopping 43.21% YTD. In the last four quarters, the company generated a moderate positive 0.91% earnings surprise. For fiscal 2015, the Zacks Consensus Estimate for earnings stands at $6.47, reflecting year-over-year growth of 15.14%. The same for revenues is pegged at $25,629 million, up 6.39% year over year.
Canadian Pacific Railway Ltd. (CP): Headquartered in Calgary, Canada, the company operates a transcontinental railway in Canada and the U.S. The stock has gained an impressive 28.77% YTD. For fiscal 2015, the Zacks Consensus Estimate for earnings stands at $9.79, indicating a year-over-year growth of 31.08%. Meanwhile, the consensus estimate for revenues is pegged at $6,417 million, up 9.15% year over year.
CSX Corp. (CSX): Headquartered in Jacksonville, FL, the company is one of the nation's leading transportation suppliers. CSX has gained 27.08% YTD. In the last four reported quarters, the company generated a 3.34% positive earnings surprise. For fiscal 2015, the Zacks Consensus Estimate for earnings stands at $2.15, reflecting year-over-year growth of 12.07%. The Zacks Consensus Estimate for revenues is pegged at $13,159 million, up 3.97% year over year.
The Bottom Line
With the U.S. economy gradually expanding, the fortunes of the railroad industry are also on the rise. Currently, the U.S. railroad industry dominates less than 50% of the total freight in the U.S., indicating a huge opportunity for market share gain. This opportunity can only be exploited by improving the railroad infrastructure that caters to the varied requirements of shippers.
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