Key Takeaways:
- North American railroads operate as an oligopoly, benefit from substantial barriers to entry, and boast significant pricing power. Free cash flow generation trends are strong at the largest operators–Union Pacific (UNP) and Canadian National (CNI)–but industry-wide free cash flow margins (free cash flow divided by revenue) average in the mid-single-digits as elevated maintenance capital costs weigh on conversion rates.
- Canadian National and Union Pacific are currently the most efficient operators (as measured by their respective operating ratios), while Genessee & Wyoming (GWR) and Canadian Pacific (CP) trail the pack.
- Coal is the single most important commodity to the railroads, accounting for more than 20% of class I railroad freight revenue. Though US coal volumes should advance over the long haul (thanks in part to the availability of low-cost, low-sulfur Powder River Basin–PRB–coal), we expect natural gas to continue to grow its portion of US electric power generation market in coming years.
- CSX (CSX) and Norfolk Southern (NSC) are most exposed to a decline in US coal-fired power plant retirements (and higher-cost Central Appalachian–CAPP–coal), given their rail networks in the eastern US. We expect the pace of dividend growth at these two firms to face pressure in coming years on the basis of their poor Valuentum Dividend Cushion scores and weakening free cash flow conversion rates.
- We’re staying far away from the domestic coal mining industry, especially the most heavily-levered producers: James River (JRCC), Arch Coal (ACI), and Walter Energy (WLT). Economic and political pressures are making coal a less-viable thermal (electricity) option in the US, while heightening competition and myriad risks are making the US export market for metallurgical coal (steel) less attractive. US coal exports account for only about 10% of US coal production, so thermal coal consumption trends in the US remain paramount. We’re also staying away from FreightCar America (RAIL) where 90%+ of the railcars the firm delivers each year are used to haul coal.
- Shale-oil related energy transportation demand in the Bakken, Eagle Ford, and Niobrara should help offset declining coal carload shipments, as will improvements in the domestic housing and auto markets in coming periods. We point to Mexico as a growth opportunity for both Union Pacific and Kansas City Southern (KSU).
- Ideas
- Each railroad has its own unique strengths and weaknesses, but Union Pacific seems to have the most things going for it. We expect the firm’s operating ratio to be among the best in the group by the end of this decade, and we like its exposure to growth in Mexico as well as future export expansion on the West Coast. The firm is levered to coal, though we note its mix is more of the PRB variety, which should continue to take share from CAPP coal in the domestic market. The firm also boasts a strong Valuentum Dividend Cushion score and a decent annual yield.
- Canadian National is a close second. The firm has the strongest free cash flow margin and operating ratio and boasts a solid Valuentum Dividend Cushion score. Its exposure to declining coal shipment volumes is the lowest in the group.
- Kansas City Southern is our favorite acquisition candidate, given its position in Mexico, where rail carloads are advancing at a much faster pace than in the US. The firm owns the most direct rail passageway between Mexico City and Laredo, Texas, where more than half of all rail and truck traffic between the US and Mexico cross the border. We think either an eastern US railroad, CSX or Norfolk Southern (given long-term pressures with respect to declining US coal volumes), or Union Pacific (given its strategic interchange points on the US-Mexico border) may be a potential suitor. Burlington Northern Santa Fe (BRK.A) may be interested in expanding its rail network into Mexico as well. In any case, a proposed transaction would face significant regulatory scrutiny.
- If investors need exposure to coal directly (which we do not prefer), Cloud Peak (CLD) offers the least-risky proposition given its capital structure and pure-play position in the Powder River Basin.
- No firm in either the railroad industry or coal mining group registers a 9 or higher on our Valuentum Buying Index at the time of this writing. Our best ideas are always included in the portfolio of our Best Ideas Newsletter.
Tickers mentioned: UNP, CNI, GWR, CP, CSX, NSC, JRCC, ACI, WLT, RAIL, KSU, BRK.A, BRK.B, CLD, CNX, ANR, BTU, NRP, BHP, WLT, HCLP, GBX, ARII
Why Are Railroads Strong Businesses?
Railroads generate revenue from transporting freight and other materials such as coal, grains and a variety of industrial products and chemicals across North America. The industry largely operates as an oligopoly and benefits from substantial barriers to entry as investing and maintaining track is no small capital investment.
But while scale and investment requirements keep new rivals at bay, it does mean that the railroad industry is more capital intensive than most. After all, railroads own the rail that they transport goods on, unlike trucking firms that run on highways that are subsidized via tax dollars. We estimate that between 50%-60% of a railroad’s capital investment goes to replacing and improving existing capital assets—this is something that the group can’t easily cut back on (think derailment). As such, the industry boasts a good (but not great) free cash flow margin in the mid-single-digits, though the larger operators such as Canadian National (click ticker for report: ) and Union Pacific (click ticker for report: ) tend to put up better performance.
Free Cash Flow Margin (%)
Source: Valuentum, Factset
Still, track ownership usually means pricing power, something that we find to be an indication of the group’s significant competitive strengths. For example, the US’ largest railroad Union Pacific has consistently been able to price ahead of the rate of inflation regardless of the economic environment. Even during the depths of the Great Recession (2008 and 2009), Union Pacific posted core pricing gains in the mid-single-digits.
We think further pricing gains will continue across the industry, as average inflation-adjusted US freight rates are still just half of what they were when the Staggers Rail Act of 1980 came into play. Steady improvement in core pricing has been the norm since the bottom in 2003 and 2004, and implementing fuel surcharges has not been an issue for the group.
Image Source: American Association of Railroads
But while pricing expansion is a key profit lever, the strongest railroad operators are those that also keep costs in check. The majority of a railroad’s operating expenses come from labor costs and fuel expenses, about 30% and 25% of total operating costs, respectively, and most industry constituents have underfunded pensions—meaning the respective projected benefit and OPEB (other post-employment benefit) obligations to employees are less than the fair value of pension plan assets, as of the end of 2012. The operating ratio—or operating expenses divided by revenue—is a metric used across the industry that gauges the efficiency of a railroad’s operations—the lower the ratio the better. By this measure, Canadian National is best-in-breed followed by Union Pacific, which plans to reach a sub-65% operating ratio by fiscal 2017. This would put the two firms head-to-head for the top position in operating efficiency by the end of the decade.
Operating Ratio (%)
Source: Company Filings, Valuentum
Coal Is Under Pressure — and It Isn’t Turning Into Diamonds
Perhaps the biggest benefit that rails provide is the energy-efficient transportation of heavy, bulk commodities over long distances. Estimates suggest that one ton of freight can be hauled 480 miles on just one gallon of fuel!
Such performance makes it quite uneconomical for competing modes to ship certain freight and commodity subgroups, though motor transport and inland barges still present competitive threats to the group. Out of these commodity subgroups, nothing, however, is more important to the railroads than coal.
It is our contention that, while there are other areas for volume/carload expansion for the rails, a long-term investment in the North American railroad industry is joined at the hip with one’s long-term outlook with respect to 1) US domestic coal consumption and 2) US coal exports. A snapshot of 2012 class I railroad ‘tons originated’ and ‘gross revenue’ reveal the importance of coal to the group:
Image Source: American Association of Railroads
Image Source: American Association of Railroads
US Domestic Coal Consumption
According to the Energy Information Administration, roughly 93% of all coal consumed in the US is for electric power generation, so the cost effectiveness of coal as a source of electricity relative to natural gas is a critical driver behind domestic thermal (steam) coal demand and carloads. Electric power operators dispatch power plants to meet demand on the basis of their variable costs of generation. When natural gas gets cheaper (or extremely cheap when it reached $2 per thousand cubic feet equivalent in early 2012), coal burn is substantially reduced, resulting in fewer coal carloads for the rails.
Though logistical costs can alter our estimates in certain regions of the US, we think that any price under $2.50 per thousand cubic feet equivalent of natural gas, low-cost ~$10/ton Powder River Basin (PRB) coal can become a relatively expensive thermal option, and any price under $5 per thousand cubic feet of natural gas, Central Appalachian coal (the highest cost coal variant) is a relatively expensive thermal choice. Illinois basin coal is expensive under $3.25 per thousand cubic feet of natural gas, in our view. Our long-term forecasts for natural gas prices mirror those at the tail end of our 5-year horizon, or slightly below $5 per thousand cubic feet of natural gas. Under our base (and downside) case forecast, the long-term outlook for more-expensive Central Appalachian coal is grim.
Long-term Range of Probable Outcomes for Natural Gas Prices (Henry Hub) – $/Mil BTUs
Source: EIA, Valuentum
Image Source: Downstream Strategies
If economic considerations weren’t enough for the demise of high-cost CAPP coal, political pressures in the US aimed at reducing greenhouse gas emissions will help perpetuate the ongoing shuttering of carbon-heavy coal plants, mostly in the eastern US. Between now and 2016, as much as 27 gigawatts’ worth of coal generation (about 8.5% of the coal fleet) will retire. This percentage could rise to nearly 17% (one-sixth) by 2020, according to the Energy Information Administration. CSX (click ticker for report: ) and Norfolk Southern (click ticker for report: ) will have a difficult time escaping weakened coal carloads associated with the downward trend in the eastern US, which encapsulates the core of their respective rail networks.
Image Source: Energy Information Administration
There may be one offsetting dynamic for the railroads with respect to US coal consumption (we’ll get to US coal exports in a bit), however, and it has to do with an ongoing mix shift of the composition and the location of coal produced. Low-sulfur, subbituminous (low energy/heat) coal from the Powder River Basin (PRB) in northeast Wyoming and southeast Montana (‘Western coal’) is significantly cheaper than high-sulfur Central Appalachian coal (CAPP) as dollar/ton extraction costs are significantly lower for this ‘Western coal.’
Though we note that many metallurgical mines are located in Appalachia (the price comparison is not apples-to-apples given the higher grade), most of the easy-to-access and less-costly coal reserves in the eastern US have already been tapped, while the PRB boasts thick coalbeds still lying close to the surface. And while subbituminous PRB coal has lower energy content (low BTU count), it remains the cheapest source of coal on a dollar/energy content basis, by our estimates. PRB coal’s share of total US coal production continues to advance (now 40%), and we expect it to help replace a portion of the production lost from CAPP coal in coming years (but not all), as low-sulfur PRB coal becomes a more attractive option for domestic power utilities that will need to comply with increasingly stringent air pollution standards.
Image Source: Federal Energy Regulatory Commission
This higher-cost dynamic of CAPP coal is evident in the profit and loss statements at a few of the larger Appalachian coal miners, including James River (click ticker for report: )–which is focused in eastern Kentucky and southern West Virginia–Consol Energy (click ticker for report: )–a leading producer in the Appalachian basin–and Alpha Natural (click ticker for report: )—which recently acquired Massey Energy, one of the largest coal producers in Central Appalachia.
Legacy Liabilities
Image Source: Company Filings, Fac