Railroad stocks, while not immune to the severe market malaise, have held up much better on a comparable basis. Indeed, the Dahlman Rose & Company Rail Stock Index is down just 16%. In our opinion, railroads have proven to be more investor-friendly due to a consistent flow of strong earnings reports throughout the year. These results were even more impressive when one considers the environment in which they were obtained.
The first half of 2008 had its unique set of earnings landmines that the rail industry was forced to navigate. Diesel fuel prices skyrocketed to unprecedented highs, leaving a shortfall of tens of millions in fuel surcharge recovery (investors may recall that railroads have roughly a two-month lag in recovering fuel costs). In fact, fuel became the largest expense line item for many of the railroads for the first time in their histories.
Additional costs hit some of the railroads in the form of severe flooding in the Midwest (the worst in 50 years) and foreign exchange rates (mainly the U.S. vs. the Canadian dollar). While overall industry volumes continued to come under pressure, the rail industry was able to more than offset this by increased base rates and improved operational metrics.
Through mid-November, industry volumes have seen further pressure, from a delayed grain harvest in Canada that drove agricultural loading down, to weakening consumer demand that slowed intermodal units. Diesel fuel prices continue their retreat from all-time highs as West Texas Intermediate has fallen to less than $56 per barrel. The same fuel surcharge mechanisms that hurt the industry in the first half of 2009 are now aiding the industry. Foreign exchange rates are still an issue but caution has switched to the U.S. dollar/Mexican peso outlook. Pricing should remain fairly strong in the back half of the year, while most of the railroads continue to post strong service metrics. This welcomed combination should act as somewhat of a buffer for the respective bottom lines of the Class I’s.
Most of the re-regulation worries heading into 2008 seemed to abate as the economy worsened, pushing the attention of Capitol Hill elsewhere. However, not all has gone the railroads’ way. CN is still waiting for approval to complete its purchase of the Elgin, Joliet & Eastern. Political pressure by wealthy neighborhoods (who appear to have the backing of President-elect Obama) may have acted as an anchor to achieving a timely solution to this transaction, despite all of CN’s public and private prodding. Unfortunately for CN, we doubt that the resolution to this conflict will be a 2008 event. Meanwhile, new safety legislation will force the entire rail industry to spend more on modern technology and deal with revised safety rules.
Looking ahead to 2009 feels like crossing a stream by foot, insomuch as you know you are going to get wet but want to make sure you do not get in over your head. We do not profess to know the depths of this recession; however, we feel comfortable in saying that rail volumes should remain under pressure for at least the first half of the year and expect the railroads to attack what they can control, namely, costs and spending. The downward pressure on the economy will likely extend itself beyond the usual suspects of forest products, automotive, and intermodal loadings. Just how much some of the bulk commodities like coal and grain are negatively impacted will, to some extent, determine how much pressure rail earnings come under.
Nevertheless, we remain somewhat upbeat that the railroads will be one of the few industries that are able to grow earnings in 2009. Like in years past, pricing will be the linchpin that keeps the rail story intact. That said, our current estimates call for pricing gains to moderate to 4.0-5.5% in 2009 compared to the 6-7% realized by the carriers in 2008. As long as the railroads can maintain their productivity growth, we expect them to post improvements in their operating ratios.
The political climate will undoubtedly change as the Democratic Party has control of the White House and a firmer grip on both the House and Senate. Although President-elect Obama has been relatively quiet with regard to railroads (other than the aforementioned opposition to CN’s proposed EJ&E transaction), many feel that a having a Republican President would have been more beneficial to the industry. That said, we do not believe there will be an overly negative tone in terms of re-regulation with a Democrat in office. Indeed, we believe that there will be far more pressing issues (financial bailout package and the pending bankruptcy of auto-related companies) to tackle in the first year of Obama’s Presidency than anything directly related to the railroad industry.
Over the longer term, however, several issues that may come up are the role Sen. Jay Rockefeller (D-W.Va, a long-time vocal opponent of the rail industry) may play on the Commerce Committee; the support (or lack thereof) of clean coal technology; the long-term outlook for mountaintop mining in the East; and the makeup of the Surface Transportation Board.
At this point it is far too early to predict the outcome of any of these items, but we will endeavor to keep a close eye on each one.
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