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— by Tony Hatch
For the Class Is, the second quarter was Dickensian. It was the best of times (average operating ratio of 68.4 on 10 percent revenue growth and a 22 percent earnings per share increase) and the worst of times — or if not the worst, not great. Service metrics were still down across the board; some shippers, regulators and politicians were angry. The result: The railroads' "grand bargain" — increased rates and return on the one hand; increased capex, capacity and service on the other — was threatened. Nevertheless, some carriers — notably gold-medal winner CN, which led the group in four of the seven major quarterly categories — showed consistent sequential operational metric improvement. So, I anticipate real improvement in the fall, although not total improvement in the Northern Tier until late next year.
In the context of an improving economy and strengthening volumes, the rails proved that cyclical plus secular growth divided by productivity once again meant beating consistently raised estimates. It also meant beating the S&P by more than three times in earnings and more than twice in revenue growth. One could argue that five of the seven Class Is beat Street estimates (roughly in line with the S&P). But Union Pacific Railroad's Q2 EPS were 17 percent higher year over year (YOY), which merely met Street expectations. Even so, consensus estimates for UP increased each month during the quarter — a pattern every carrier replicated.
The growth and the cost story seems to be coming from the north: If CN won the gold, then Canadian Pacific got the silver by "winning" the other three quarterly categories on the strength of the massive 680 basis-point reduction in its OR. That CN and CP did this despite their own lingering winter effects — not to mention the Canadian government's interference and revenues caps on railroads' prairie ag business — makes it all the more extraordinary. The opportunity to leverage efficient (precision) railroading and growth prospects is already at CN, and it's soon to come at CP.
In the second quarter, intermodal grew 8 percent, despite the well-publicized congestion issues centered around Chicago. That is a positive sign, of course; we may be close to crossing that mythical "supply/demand" line that leads to improved intermodal profitability. And given its size — domestic intermodal is more than 10 percent of the total rail revenue base — it also could lead to improved ROI for the carriers. We have seen this movie before: In the late 20th century, intermodal showed that service and reliability could generate business volume; by the early 21st century, it showed that it could justify rates to achieve accretive ROIs. We are close to the point whereby the capacity shortages and truckload price increases lead to a similar re-evaluation of the domestic franchise, which is still growing at about 8 percent with likely the highest OR of any in the railways' commodity base. But not for long.
The eastern carriers, deep in Appalachia and far from the Bakken, may have reached an inflection point. Coal has stabilized and was a positive during the year's first half. But non-coal growth, particularly domestic intermodal, has surged to compensate in volume and soon — with highway capacity tightening and truckload rates increasing by high single digits — in contribution. Meanwhile, UP and Kansas City Southern had fine quarters, even as they await the benefits of massive industrial expansion in their territories and BNSF Railway Co.'s continual if slow recovery. Of course, they are taking some business, particularly UP — in ag and in some new intermodal service offerings — but not so much that they will choke their own systems further. Also: It's theirs to keep only as long as BNSF struggles.
Demand is there. Can rails safely handle it? An Aug. 16 head-on collision between two UP trains in Arkansas provided an anecdotal pause, but management focus and spend — and track records — suggest they will. In an era of increased scrutiny, the aforementioned grand bargain needs to be constantly refreshed. Rail prices likely hit a cyclical low point this summer (up perhaps 2 percent), but with capacity impacting the rails and the truckers, we should see a return to mid-single-digit YOY increases by year's end and into 2015. That's provided railroads continue to demonstrate over the long term that they are living up to their end of the bargain.
Tony Hatch is an independent transportation analyst and consultant, and a program consultant for Progressive Railroading's RailTrends® conference. Email him at firstname.lastname@example.org.