Valuentum wrote a comprehensive outlook on the coal industry and railroads in this July 2013 piece here, and to a very large degree, the piece couldn’t have told the future better. Not only did we warn against the most heavily-leveraged coal producers, including James River, Arch Coal (ACI) and Walter Energy, but we threw cold water on the entire coal industry altogether. James River and Walter Energy subsequently filed for bankruptcy.
We pointed to economic and political pressures making coal a less viable utility option in the US, as we stated that heightened competition in the US export market would make met coal a less attractive proposition. Since the publishing of the piece, coal operators have suffered immensely. The Market Vectors Coal ETF (KOL), shown below, reveals the collective performance of coal-related entities, including Consol (CNX), Alliance Resource (ARLP), equipment-maker Joy Global (JOY), Suncoke Energy (SXC), Yanzhou Coal (YZC), Natural Resource Partners (NRP), Peabody (BTU), and Cloud Peak (CLD) among many global operators. The results haven’t been pretty over the past two years.
In the same July 2013 piece, we highlighted Union Pacific (UNP) as our favorite railroad-related idea, and the company has delivered a nice ~25% return, excluding dividends, since then. Though the performance would have been a lot better if Union Pacific had held its recent heights in the mid-$120s, we’re not complaining. As we had indicated in the piece, we were enamored by Union Pacific’s dedication toward improving operating efficiency, and through the second quarter of 2015, the company’s operating ratio has fallen significantly, to the low-to-mid-60% range from over 71% in 2011. The railroad-industry-specific metric represents ‘1 less the operating margin’ and is used to assess operating efficiency and a railroad’s cost structure–when it comes to operating ratios, the lower the ratio the better. Union Pacific remains on track for a full-year target of ~60% by 2019, and while that may be a stiff challenge if pricing does not cooperate, we like management’s relentless focus on managing costs.
Image Source: Union Pacific
We’re huge fans of the ‘moaty’ characteristics of railroad operators, but a glimpse into their second-quarter performance revealed a US economy that is not as healthy as we would like.
In Union Pacific’s second quarter, coal volumes dropped 26%, industrial product volumes fell 13%, while agricultural product volumes waned 7%. The company pointed to soft export demand that led to steep drops in coal volumes shipped from the Southern Power River Basin and out of Colorado/Utah as well as low natural gas prices that reduced utility coal demand. Weak global demand for US grain contributed to weakness, and minerals and metals volumes dropped 24% and 27% during the period, respectively.
We witnessed similar dynamics in CSX’s (CSX) second-quarter 2015 results, and the firm’s outlook for roughly 30% of its volume make-up is unfavorable. Low natural gas prices will curb demand for utility coal, and continued weakness in global market conditions will mitigate performance in the export coal markets. Weak steel production will also hurt the pace of metals shipments heading into the back half of 2015. In Norfolk Southern’s (NSC) second quarter, released July 27, coal volumes fell 23% in domestic utility and 38% in export. The firm also noted steel volumes were weak in the period. Falling commodity prices are taking their toll.
Not all is bad at the railroads, however. Automotive volumes, which jumped 7% on a year-over-year basis, offered a bright spot in Union Pacific’s second-quarter results, and operators continue to improve operating ratios, almost across the board. CSX is committed to delivering mid-to-high single-digit earnings-per-share growth in 2015, and we like the solid core pricing gains that continue to be layered on to customers of Union Pacific. We continue to hold the latter in the Best Ideas Newsletter portfolio, but recent rail performance reveals the US economy is not as healthy as we want it to be. Revenue performance across the group will remain under pressure.