For railroads, a new capex norm — by Tony Hatch

Tony Hatch

This year seemingly has brought more challenges than any year in recent rail history, although I continue to believe there are many or more opportunities. But ambiguity begets insecurity, and the “i” word is anathema to the financial community, one of the larger stakeholders in the “railroad renaissance.”

To be sure, rails have outperformed the broader as well as related transport markets during the past 15 years. Nonetheless, words such as “volatility” and “uncertainty” and “scale” — previously unheard in staid and traditional railroad circles — have replaced “stability” and even “guidance” in today’s investor-management dialogue. In fact, new phrases such as “stranded assets” have become part of the discourse.

Always audible to some degree, the calls to cut capex and the drum beat to “rightsize” the networks and reduce the overall level of spend have been getting louder each quarter (three and counting) of general railway underperformance. Some in the press and government continue to state that rails have under spent and continue to do so, particularly at the height of last year’s service issues. But by far, the loudest drum beat has been for the rails to justify the current level of capex given the changes in traffic expectations and mix. Meanwhile, global capex (i.e., for the S&P Global) is finally beginning to increase, and railroads’ self-described over-exposure to energy is now an issue as they continue to pivot to consumer/manufacturing.

Of course, Class I management teams — most of them are new — aren’t just fielding questions about capex. There’s plenty more on their minds and plates:

• Safety remains the hot-button word in D.C. and Ottawa. The PTC deadline likely will be extended, although the May 12 Amtrak derailment unjustifiably has caused the freight carriers no end of bad P.R.
• Service recovery is critical for share, productivity and retaining regulatory freedom — is the mega-spend the reason for either (or both) the steady or too-slow recovery? In my view, BNSF Railway’s results and the overall steady, consistent recovery actually go a long way to proving the “bull” case for capex.
• Coal has yet to stabilize, even if it is showing signs it might soon — it’s still likely to be 30 percent of the utility fuel source in 2030. The brave new world does come with long-term change potential, some perceived as good (reduced MOW capex) but more known to be bad (stranded assets, mix shift/margin impact).
• Crude by rail (CBR) and frac sand haven’t proved to be the volume replacement for rails that some thought they’d be. The global pricing story highlights the unpredictable nature of the oil business, and we have yet to see the positive impact of cheaper gasoline.
• Grain also will remain unpredictable and episodic, joining CBR in creating nightmares for demand planners, even if global populations and income growth fuel the need for protein and
  arable land amounts shrink.
• The “end of the commodity super cycle” and the China gold rush also impacts rail volumes, from (increasing?) imported containers to (pressuring?) exported raw materials.
• The nature of the current cyclical status is unclear: Where are we in the auto cycle? Housing? Steel?
• Intermodal remains the growth hope of the industry, but questions remain regarding rail service capability as length of haul shrinks in the domestic segment; changing and unpredictable international trade flows; and lingering doubts about intermodal pricing, margins, OR impact and ROI.
• Shareholders increasingly are calling for direct payouts. While “short-termism” and “quarterly capitalism” are being called into question by some pundits and players given recent volume trends, rails are having trouble resisting the investor call for cash — especially with activist investors piling up huge war chests.

Regardless, “big spend” will be the ongoing trend. The new capex norm has implications for the types of spend, in a lighter (lower gross tons/mile, lower weight per axle load) but more service- and I.T.-intensive world. Improved service, a steady economy and rail’s secular prospects will justify the longer-term capex goals of 15 percent to 17 percent (or more) of revenue.

The 2016 spending plans will be the most interesting — and perhaps telling — of this century. We should get a few hints at what they’ll be at the major rail industry conferences that’ll be held in the months ahead.

Tony Hatch is an independent transportation analyst and consultant, and a program consultant for Progressive Railroading's RailTrends® conference. Email him at abh18@mindspring.com.