Railroads: Low Coal Demand, Oil Price Slump Play Spoiler

Declines in coal shipments and oil prices have been major disappointments for the freight railroad industry. Owing to the mature nature of the industry, railroads require steady investments to maintain competitiveness, which in turn makes it susceptible to a few external and internal challenges.

Also, rail-based companies need to access the capital market on a regular basis, which makes them vulnerable to hiccups in the credit markets as is the case at present in the high-yield bond space. Moreover, the cyclical nature of business coupled with stringent government regulations and volatile exchange rates continue to indicate caution.

Below, we discuss key factors which investors should consider while investing in railroad stocks:

Sluggish Coal Demand

Coal accounts for majority of the business for railroad operators. Thus, a decline in coal demand hurts profits for these carriers to a large extent. Meanwhile, coal also forms a key element for electricity production. However, falling fuel prices has made natural gas a more economic option for electricity generation.

Moreover, stringent regulatory measures to control emissions are having an adverse impact on the unrestricted use of thermal coal for electric power generation. Even the U.S. Energy Information Administration (EIA) expects coal consumption in the electric power unit to drop by 10.3% in 2015 from the 2014 level.

Other headwinds like adverse international coal prices, weaker global demand, strict environmental regulatory norms and growing coal production in other countries tend to affect coal carloads further. As a result, the EIA presented a somber outlook for annual coal production in 2015. It expects production in 2015 to be around 902.7 MMst, down 9.7% annually while in 2016 coal production to reach 873.4 MMst. Even export is projected to fall 20.6% year over year to 77.3 MMst over the same time frame.

Revenues for most rail companies were affected by sluggish coal demand in the third quarter of 2015. Norfolk Southern Corporation (NSC - Analyst Report) and Union Pacific Corp. (UNP - Analyst Report) reported a 10% decline in revenues from the year-earlier quarter, mainly because of a 16% and 15% decline in coal volumes, respectively.  

The glum scenario prompted CSX Corporation (CSX - Analyst Report) to forecast 2015 earnings per share growth at a mere 3% on a year-over-year basis at the Credit Suisse Global Industrials Conference. This presents a significant slash from the previous projection which had hinted at 2015 earnings growth in mid-single digits. Kansas City Southern also believes that  revenues in the fourth quarter of 2015 will decline to high-single digits on a year–over-year basis.

Failed Merger Benefits

Recently, Norfolk, VA-based Norfolk Southern rejected leading Canadian railroad operator Canadian Pacific Railway Limited’s (CP) unsolicited proposal to acquire the company in a cash-and-stock deal, after a thorough evaluation of the offer that was made in November.

A successful merger between Canadian Pacific and Norfolk Southern would have created over 33,700 miles of transcontinental track, thus improving connectivity between three major tidewater transport hubs which include the Pacific Ocean in British Columbia, the Atlantic Ocean and the Gulf of Mexico via Norfolk Southern's network.

Moreover, it would have sidelined the busiest Chicago hub, thereby allowing timely delivery of goods to vendors with fewer stops and at a competitive rate.

One of the major reasons behind the rejection of the proposed deal was the close scrutiny by different regulatory bodies as the U.S. railroads are subject to the jurisdiction of agencies like the Surface Transportation Board (STB), the Federal Railroad Administration (FRA) and other state and federal regulatory bodies. Hence, the transaction would have taken nearly two years to clear all hurdles, thereby significantly disrupting regular operations for both the carriers. Such restrictions are a major reason why there has been no merger or acquisition in the U.S. railroad industry in the last 15 years.

Plunge in Oil Price
Oil prices have been weak for a while now, but have started weakening even more in recent days, with some brokerage houses predicting prices to move into the $20’s at some stage.

High oil prices benefit railroad operators in terms of increased fuel surcharges from customers. Moreover, it also enjoyed competitive cost advantage over other transportation operators. However, a decline in fuel prices not only generates lower fuel surcharges from clients but also intensifies competition as truckers benefit from the price slump. Meanwhile, pipeline developments across oil fields have boosted demand for transportation through pipelines over railroads, thereby denting profits for major rail companies.

Production from the more expensive shale basins like the Bakken has started weakening in response to low oil prices. And it had been mostly these newer fields with limited pipeline capacity that were generating the incremental demand for railroad transportation of crude oil.

Somber Agricultural Shipment Guidance

After recording impressive numbers in 2014, The United States Department of Agriculture (USDA) expects agricultural exports to fall by $12.8 billion to $139.5 billion in 2015 from the previous year. Similarly, in 2016, exports are likely to reach $138.5 billion which is again lower than the last two years. A decline in agricultural exports may impact the railroad business moving ahead.

In addition, USDA believes that U.S. will witness the lowest surplus since 2007 of nearly $16 billion, down 25% from the last-year period. At the end of the third quarter of 2015, agricultural business volumes for Union Pacific Corp. declined 3% year over year.

Capital Intensive Nature: The capital-intensive nature of the railroad industry leads to continuous network upgrades and infrastructural developments. As a result, the need for huge investments becomes the priority for railroad companies. To meet capital needs, these companies borrow significant funds, thereby expanding its leverage position. Moreover, this practice may lead to higher interest rate payments and declining cash flow for railroad companies.

Positive Train Control Mandate: The Rail Safety Improvement Act 2008 (RSIA) has mandated the installation of PTC (Positive Train Control) by Dec 31, 2015, on main lines that carry certain hazardous materials and on lines that involve passenger operations. The Federal Railroad Administration (FRA) issued its final rule in Jan 2010, on the design, operational requirements and implementation of the new technology. The latest regulation is expected to impose significant new costs of nearly $2.3 billion for the rail industry over a four-year period.

However, the safety of the new braking system is in question as the Association of American Railroads (AAR) believes that the brakes to be installed under PTC guidelines have not been proven to be efficient enough to reduce damages. Moreover, the new rule will make crude oil transportation by railroad transportation an expensive affair.

We also believe that the implementation of the GROW AMERICA act, may certainly improve the safety standards of railroad operators. However, the need to invest in advanced research work associated with it may drive costs.

Conclusion

Currently the railroad industry is braving multiple headwinds. Despite CSX Corp. and Canadian National Railway Co. (CNI - Analyst Report) reporting earnings growth in the third quarter of 2015, we are highly apprehensive about about the future prospects of these companies.

Check out our latest Railroad Industry Outlook here for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.