Key Takeaways:
The North American railroad industry is oligopolistic in nature, and we love the barriers to entry and pricing strength that come with it.
North American railroad operators have been hit by volume declines across a wide range of end markets. Currency movements and global economic concerns aren’t helping matters.
Union Pacific remains our choice for exposure to the space. Though others present interesting opportunities as well, we think the firm’s operating ratio has the most upside from current levels in addition to it having some attractive market positioning.
“…we’re not thrilled by the performance of Union Pacific since it was added to the Best Ideas Newsletter portfolio, but the railroad industry offers such a strong fundamental backdrop that we have a hard time removing the exposure. Rails are in many ways the “guts” of the American economy. We plan to continue to hold shares of Union Pacific in the Best Ideas Newsletter portfolio.” – Brian Nelson, CFA
By Kris Rosemann
We like railroads for a number of reasons, including the oligopolistic nature of the industry, material barriers to entry, and pricing strength attributable to ownership of transportation routes. When looking at the railroad landscape, we’ve selected Union Pacific (UNP) to satisfy our exposure due to its ties to growth in Mexico and the US West Coast, its broad port access, and its scale and accompanying solid operating ratio (1 less operating margin). We’ve been huge fans of the trajectory of its efficiency initiatives and pricing power, but volume declines have been hurting a core component of our thesis of late, the performance of its operating ratio.
Image Source: Union Pacific
It’s not entirely Union Pacific’s fault though. Operating ratios remain in flux across the railroad industry in 2016 as a result of some pretty steep volume weakness. In the third quarter of 2016, Union Pacific’s operating ratio added 1.8 points of unfavorable growth in its operating ratio (the lower the ratio, the better), resulting in a reported figure of 62.1%, and CSX (CSX) reported a similar move, but of lesser magnitude.
On a reported basis, Canadian Pacific’s (CP) third-quarter operating ratio increased 1.8 points, but when considering a gain on asset sales in the comparable quarter of 2015, its adjusted operating ratio fell 2.2 points to an impressive 57.7%. Though it has yet to turn in third quarter 2016 results, one might expect Canadian National to remain the leader, at least based on its recent outperformance of peers. Canadian National’s (CNI) full-year 2015 operating ratio came in just over 58%, while its second quarter 2016 operating ratio was an impressive 54.5%.
Lower fuel prices across the industry continued to help operating ratios in the third quarter of 2016, though efficiency benefits and pricing strength were not enough to offset industry-wide volume declines. Union Pacific, for example, reported a 13% drop in its quarterly diesel fuel price, while Canadian Pacific reported a 15% drop compared to the third quarter of 2015. However, pricing strength was not as widespread a benefit, with Canadian Pacific reporting a negative price/mix impact of 1% on its top line while Union Pacific and CSX delivered solid gains in pricing.
Volatile energy resource pricing remains a headwind for volume trends across North American railroads, as suppressed crude oil and natural gas prices have not only reduced the amount of crude (USO) demanded to be shipped, but have also further impacted coal (KOL) demand due to the more attractive pricing profile of natural gas (NGAS) for energy consumers. Grain volumes varied across the continent, with US operators Union Pacific and CSX reporting a near record grain harvest and strong growth in agricultural product shipments while Canada Pacific reported a 15% decline in Canadian grain revenue due to a delayed grain harvest in its markets served. Intermodal volumes also varied across North America, as weakness in demand for consumer goods existed in both the US and its export markets, which pressured Union Pacific and CSX. Canadian Pacific also reported weak domestic intermodal demand, but its international intermodal revenue increased a healthy 5% in constant currency.
Despite the recent pressures on volumes and its operating ratio, Best Ideas Newsletter portfolio holding Union Pacific remains our choice for exposure to the railroad industry. We continue to like its efficiency initiatives, including increasing average train speed (2% increase in the third quarter of 2016) and reducing terminal dwell time (2% decrease in the third quarter of 2016), and pricing power, even if recent volume weakness has been overwhelming. The best operators in the railroad industry continue to set themselves apart via free cash flow generation, which goes hand in hand with strong operating ratios. Despite the unfavorable impact on Union Pacific’s operating ratio, the firm turned in solid free cash flow growth of more than 24% through the first nine months of 2016 from the comparable period in 2015, to nearly $2.9 billion.
Looking ahead to the rest of 2016, the difficult market environment can be expected to continue, though certain business segments are anticipated to improve as we move into 2017. Even the beleaguered coal market could see a slight recovery. Union Pacific is projecting fourth quarter 2016 volume to be down in the low-single digit range while management continues to train its focus on things it can control such as pricing and productivity and cost improvements. If, or when, a strong recovery takes place, the value of Union Pacific’s recent productivity improvements will be compounded, in our view, as the positive aspects of the operating leverage in its business re-emerge, “Fundamental Strength To Outweigh Short-Term Volatility (May 2016).” A rebound in volumes will serve as the catalyst for the firm to achieve its 2019 operating ratio goal of 60% and its ultimate, long-term operating ratio goal of 55%.
All in though, we’re not thrilled by the performance of Union Pacific since it was added to the Best Ideas Newsletter portfolio, but the railroad industry offers such a strong fundamental backdrop that we have a hard time removing the exposure. Rails are in many ways the “guts” of the American economy. We plan to continue to hold shares of Union Pacific in the Best Ideas Newsletter portfolio. We’re reiterating our $87 per share fair value estimate for shares at this time, and we can’t fail to mention that merger talk across the industry may surface yet again. Canadian Pacific, CSX, and Norfolk Southern (NSC) have all been a part of the rumor mill in the past 12-18 months, “Railroad Merger Talks (November 2015).” Whether a deal happens or not may not matter in the event equity prices are bid up.