<< Read Part 1: Railroad Industry - Navigating Through Persistent Challenges

The railroad industry is poised for strong growth in the coming quarters, reflecting the industry’s leverage to the positive momentum in the U.S. economy. The strong earnings performance we saw from the industry in the third quarter earnings season should sustain itself in the current and coming quarters as well. Stocks of railroad operators did extremely well in 2014, but the momentum should continue into the New Year as well.

We are discussing key factors of the railroad sector that investors should consider and look forward to in the coming months:

Rail Investments

Investments in development and expansion plans remain crucial when analyzing the prospects for the railroad industry. These capital investments are a union of binaries. While the investments put significant stress on margin performance, forgoing these would dampen growth prospects.

Railway investments are significant, given the evolving supply chain management and the growing importance of airfreight carriers in offering freight transportation services. These investments help railways in getting the required infrastructure to compete effectively in the railroad industry and with other modes of transport like truck, barges and cargo airlines.

Hence, investments in infrastructural projects have been an integral part of the development of railroads. However, this sector, characterized by huge capital influx, has been drawing funds primarily through private financing.

As a result, investment plans can have a considerable impact on the company’s liquidity position and could lead to a highly leveraged balance sheet. According to Association of American Railroads (AAR), reports, railroads invest approximately 17% of their annual revenue, which compares with only 3% of average U.S. manufactures’ revenues on capital expenditures.

According to Department of Transportation (DOT), the demand for rail freight transportation will increase approximately 88% by 2035. As a result, Class I carriers would have to increase their investments to meet this growing demand.

It is estimated that railroads would require $149 billion to improve rail network infrastructure within this stipulated period.

Given the growing demand and need to upgrade railroad infrastructure to meet new regulations, deployment of fuel-efficient locomotives, upcoming rules on track sharing, railroad safety and high-speed rail services are demanding that railroad companies infuse more capital in development projects. According to DOT, almost 90% of the railway capacity needs to be upgraded to meet the expected rise in demand level by 2035. Hence, it is important for railroad companies to balance profitability levels while investing in infrastructural development projects.

Currently, the U.S. railroad industry dominates less than 50% of total freight in America, indicating a huge opportunity for increasing market share. This opportunity can only be exploited by building railroad infrastructure that caters to the varied requirements of shippers.

Discretionary Pricing Power: The freight railroad operators function in a seller’s market and have enjoyed pricing power since 1980, when the U.S. government adopted the Staggers Rail Act. The idea was to allow rail transporters to hike prices on captive shippers like electric utilities, chemical and agricultural companies in order to improve profitability of the struggling railroad industry. As a result of the Staggers Rail Act, railroad companies are hiking their freight rates by nearly 5% per annum on an average, while maintaining a double-digit profit margin.

Duopolistic Market Structures: Railroad companies have, by and large, gained by practicing discretionary pricing in the freight market. In the prevailing duopolistic rail industry, railroad operators will be able to reap maximum benefits from rising prices when the overall demand grows.

This remains evident from the geographic distribution of markets between major railroads. Union Pacific and Burlington Northern Santa Fe control the western part of the U.S., while CSX Corp. (CSX - Analyst Report) and Norfolk Southern Corp. (NSC - Analyst Report) control the eastern part. On the other hand, Canadian Pacific Railway Ltd. (CP - Analyst Report) and Canadian National control inter country rail shipment between the U.S. and Canada.

Crude by Rail: Emerging Opportunity

Despite the recent drop in oil prices, transportation of oil remains a lucrative opportunity for railroad operators. A lot will depend on how long oil prices remain low, but as long as production volumes don’t come down materially in the near to medium term, railroad volumes should largely hold up as well.
 
Rail-based crude transportation is no doubt more expensive compared to other means like pipelines. But shipper don’t have much alternatives to using railroads given the lack of pipeline infrastructural support in key producing basins like the Bakken Shale Formation in North Dakota and Montana, the Eagle Ford Shale, Barnett Shale and Permian Basin in Texas, the Gulf of Mexico and Alberta oil sand fields.

According to AAR, U.S. crude oil production is expected to grow in 2015 despite lower crude oil prices. While drilling activities are expected to suffer due to poor pricing and less favorable economic factors, oilfield operators will continue to pump from existing producing facilities. In the long run, however, volumes will suffer if oil prices remain depressed for an extended period.

U.S. crude oil production will increase an estimated production of 9.3 million barrels per day by 2015, up from 2014 levels. This surge represents an opportunity for revenue accretion, which the railroads are trying to achieve with infrastructural development.

As a result, inadequate pipeline developments have given rise to higher penetration of railroad transportation for crude oil shipping in Canada. According to AAR’s article ‘Moving Crude Oil by Rail,’ railroads transported over 60% of North Dakota’s crude oil production, which contains the vast majority of new rail crude oil originations.

Further, in terms of safety, railroads offer a better transportation avenue compared to pipeline due to its better spill rate profile. According to DOT, spill rate for pipelines are three times higher than rail, based on crude shipments between 2002 and 2012. Additionally, railroad companies are working toward tightening rail safety measures by appealing to federal regulators to phase out old tank cars if these are not upgraded. They are also seeking improved standards for new tank cars.

Bottom Line

There are various factors that reinstate hope for investors interested in the railroad industry. A company in this industry that investors should keep an eye on is Union Pacific Corp. (UNP - Analyst Report) with a Zacks Rank #2 (Buy). The company’s earnings over the past 10 years have significantly risen and has consistently reported top-line growth. Amid macroeconomic volatility and subdued demand, Union Pacific managed to deliver 7% revenue growth in 2013.