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Rail earnings were pretty terrific in the fourth quarter. But this time, with the six majors having reported and some non-operating distractions, it could be argued that three beat consistently raised Street expectations, two matched and one slightly disappointed — yet earnings were up on average 41 percent (33 percent without Kansas City Southern's near double). That continues to compare so well with the S&P 500 (plus-17 percent so far), as do the rails' volume and revenue growth averages (10 percent and 16 percent, respectively — the difference between volume + price to get to revenues was a slightly negative mix and increased fuel surcharges).

The six roads' operating ratios improved by an average of 312 basis points (264 without KCS). The stocks traded off on first earnings (Union Pacific) and have treaded water amidst a slew of analyst reports chronicling met expectations.

What was disappointing in the quarter?

You can’t win forever. In terms of Q3 earnings, the “beats” were six for six! Eventually, the Street will raise earnings enough to no longer be so surprised. But the Street, as I continue to remind, missed earnings badly during the last decade’s boom years, way over-reacted to the Great Recession’s impact on the rails, and has missed the recovery pretty consistently so far.

Earnings quality was not terrific. There was weather, tax, other income, all sorts of stuff — on both sides of the line.

There wasn’t much guidance — just a bit more than there was a year ago, when we were still reeling from the recession.

Some stories remain a bit confusing — particularly Norfolk Southern and Canadian Pacific, which somewhat disappointed the Street on an operating basis and couldn’t (or wouldn’t) discuss why a sense of treading water was seen by investors. NS had the lowest operating improvement (thus the lowest incremental margins — see below), and I am plugging in plus-3 percent on price as they don’t (won’t) disclose. CP’s pricing was up only 2 percent and its metrics were down a bit.

Incremental margins — the party is over? The Street understood putting cars back on an existing train, low incremental costs, etc., but as the economy continues to recover and the consumer comes back, new train starts, new services offered, new levels of service — they all cost money. The days of plucking such low-hanging fruit are over.

Capital expense is going up. Now, aside from expense associated with positive train control (the “unfunded mandate”), I actually think this is a good thing, considering the improved/improving returns and the decline of the re-reg threat. And, the fact that free cash flow is growing enough to support increases in dividends per share and share buybacks at the same time at most carriers (UP, CSX, NS, CN). Overall capex is due to rise 20 percent after a very expensive 2010, but that masks a wide range — from flattish (CN, KCS) to up 51 percent at NS (still up 19 percent without PTC and a change in rolling stock ownership strategy). The Street likes its “balanced approach” for use of cash to balance towards buybacks and dividends per share (currently, it's about 80/20 in favor of capex).

What went right during Q4?

Capex is going up. I believe when the STB (finally) releases its “revenue adequacy” statistics (return on investment capital vs. the cost of capital), the rails will have their best year yet — and with so many opportunities (domestic intermodal, international intermodal, grain, export coal, etc.) and less threat of capped returns, I believe that this is a great set of investments.

The guidance, such as it is, is getting more upbeat. There's no talk of “double-dip” but of sustained recovery, strong (mid-single digit) volume growth, above rail-inflation pricing, targeted OR improvement goals (that should prove conservative).

Cash flow is growing to support a shift toward investors (70/30?) and still support growth capex.

Washington looks less scary. I'll be at the STB hearings (the first later this month), but I am not overly stressed. The flip side: Just as governments as a whole began to embrace rails, they ran out of money.

FedEx. The trucker that wouldn’t use intermodal became the last big name to capitulate via contracts with NS and BNSF.

The incremental margin story isn’t over. For the most part, the rails showed improved velocity through the quarter despite the volume and the weather. As they continue to maintain these high levels of service and operating performance (helped by all those capex dollars and by information technology), the next level of productivity and incremental margin growth will be explosive. We saw an example in CSX, whereby at last, train starts were up a bit more than volume yet the margin (operating ratio) improved 380 basis points, better than the industry as a whole. As an example, running the same system-wide velocity on 20 percent to 30 percent more volumes will generate an explosive productivity/service/earnings/free cash flow story completely not recognized or understood by the Street.

Tony Hatch is an independent transportation analyst and consultant, and a Progressive Railroading columnist and program consultant for Progressive Railroading’s RailTrends conference. E-mail him at abh18@mindspring.com.