Q2 railroad earnings: Lessons from a war of attrition — analysis by Tony Hatch

By Tony Hatch

North American freight railroads faced down another quarter of strong headwinds with a kind of blue collar, grind-it-out performance as they continued to probe and test the economy — as well as the regulatory and political environment for growth opportunities in a complex and changing world. 

On the face of it, they didn’t do that badly (see chart below), essentially meeting consensus Wall Street expectations for Q2 2016. The scoreboard reads three slight wins, one loss and two ties — three including Genesee & Wyoming Inc. (GWR); BNSF Railway Co., though, probably would have gone down as an “L.” Overall, the S&P 500 will show a drop in reported earnings, too, but perhaps half of the rail number: in Q2, railroads' earnings per share (EPS) was off about 8 percent year over year (YOY); the S&P 500, off 4 percent.
 
Why are rails underperforming the overall economy? While we, too, continue our search for answers, it’s worth noting that the rails aren’t alone — this is a freight recession and with some exceptions (paper?), railroads are not losing share to other modes (although their coal customers have, of course). The business isn’t going elsewhere. In many cases, it’s simply not going. Which might be worse.
 
Rails face many obstacles, for sure, and that’s before pondering a potentially more active Surface Transportation Board (STB) and/or a potentially anti-trade political environment (although I would expect the rails to fully participate in wall construction logistics).

What are the headwinds? The low-growth (GDP was up only 1.2 percent in Q2); the strong, though declining dollar; the still low and oh-so volatile (great head fake) energy prices; the high inventory levels across many commodities; and the ongoing decimation of the mighty coal franchise (and the small but high-profile crude-by-rail segment, et. al). Add to the list the mystery of intermodal, the growth savior that went off-duty for the quarter. Also: Class Is have a series of new management teams struggling to show confidence with almost no short-term visibility, and a rather restive investor base no longer sold on “renaissance” opportunities but on hunker-down cost cutting (a historic rail strength).

Although every crisis seems new, the rails have been in this situation before. They have at their disposal great financial resources, more and infinitely better information capabilities, and a network in the best condition — and perhaps even more important, in the best relative, to the highway,  condition — in its long history.

Herewith, takeaways from the second quarter:
 
1. Inflection or dejection? Expectations of a second-half volume improvement (the pattern of the North American economy since the Great Recession) were pushed back to Q4, but they're still there, with the proverbial “green shoots” already showing in some cases. First, both Canadian carriers, the loudest being Canadian Pacific, called for an outright inflection in their volume, led by grain and fertilizers, and even some export coal. Going by rather under-noticed among (way) too much discussion of the durability of Mexican excise tax credits was that Kansas City Southern already achieved a flat volume quarter, YOY; and Mexican auto strength will be back in the black in the second half. (As an aside: What do those three rails have in common? Well, lots, really ... but first and foremost, they have very little U.S. utility coal dependence). Even Norfolk Southern, through intense tea-leaf scrutiny, seemed to be calling for volume gains in the winter. 

2. Where oh where? What’s the cause of this rather muted optimism? Over the near to intermediate term, easier comparisons, of course (especially in U.S. coal, but inventories are finally coming down in all of this heat). Autos may be peaking, but not crashing; housing is still below average but high hopes remain; the petrochemical/plastics boom I have been so on about is slated to start showing up in actual car and container loads next year. Ag has likely changed the most in terms of outlook over the past half year, and now U.S. exports look like they'll grow 10 percent in the coming crop year. And intermodal is showing signs that it will return to its old growth ways, given truck sales, bankruptcies and coming driver regs.

3. Rail-grinder — they did well where they had control. Across the board, service metrics and, for the most part, safety measurements showed continued solid improvement. This not only helped productivity lead to those earnings surprises but reduced government interference (admittedly the government has taken its comedy show on the road) and improved customer relations — despite railroads continuing to take price up above their inflation levels (Q2 likely came in up about 2.5 percent — not bad, given the fearful, not to say panicked, expectations of a cave-in).

4. I am throwing in the towel on capex — if CN does, who am I to hold out? NS cut another $100 million out of their 2016 plan this quarter (pretty soon that will add up to real $) but several carriers, under pressure from an analyst community that thinks short term, hinted strongly that 2017 would be a another rather large YOY reduction, in both real and “percent-of-revenues” terms). Of course, many carriers still had locomotive orders and some had rail-car orders this year that are already surplus, and won’t be repeated next year. Of note, Union Pacific Railroad hinted they could take capex down as low as 15 percent of revenues (we do need a new yardstick and they do need to demonstrate they won’t fall behind BNSF). CN’s new management team, meanwhile, clearly backed off from just-retired CEO Claude Mongeau’s defense of long-term higher spending. How do I feel about all of this? It is no coincidence that Mr. Mongeau will be presented with our “Railroad Innovator of the Year” award at RailTrends this November in New York City (www.railtrends.com).

5. Longer term, the story is changing as fast as our world spins — but remains no less bright. I remain confident that none of the carrier capex reductions will involve cutting muscle, and certainly no evidence of a return to the bad old days of reducing  (“deferring”) the maintenance-of-way spend (I expect to learn more at upcoming ops/engineering AREMA and Railway Tie Association conferences). I have long argued that if nothing else, the “railroad of the future” will be lighter and smaller. I hope to hear more on strategic choices in the year's second half than we did in the first.
 
6. Coming up, like a flower: But with all of this talk of slash and burn (and buybacks and capex cuts), note that when the STB reports soon, it appears the railroads’ return on invested capital will again top its weighted average cost of capital (by some 250 or so basis points). And amidst all of this sturm und drang, CSX announced it had at last sited its North Carolina intermodal hub, and would spend to develop it as part of a growth strategy. Yep. It's still early innings, folks.

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.