Thursday, December 22, 2011

High Green

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High Green Bruce Kelly

All signs point to another year of slow but solid traffic growth, strong pricing power, and continued investment in capacity. Global gloom and a still-fragile domestic economy caused many American businesses to raise caution flags as they sized up prospects for the New Year.

Railroads were not among them. North America's largest railroad, Union Pacific, is looking ahead to 2012 with particular interest: It will be the railroad's 150th anniversary year (dating from the signing by President Lincoln of the legislation creating a transcontinental railroad). UP sees it as a year of continued performance and financial records.

UP enters 2012 with plans to increase its capital spending (up and above the $3.2 billion invested in 2011). Early in 2012 it will pay its shareholders a dividend increased by 26%. Quality service, and the ability to price it for profit, is the essence of the story. Also important is the ability to recover nearly all of the soaring price increases that hit all users of diesel fuel this year.

A railroad that can raise revenues 15% on a 1% increase in traffic, as UP did in 2011's third quarter, is a force to reckon with.

"We're generating record free cash flows and making significant capital investments to add value for customers, all of which is driving improved shareholder returns," says UP chief executive Jim Young. "We remain confident in our business strategy going forward, allowing us to increase the dividend for the second time this year. Dividends per share in 2011 have increased a total of 58%, a significant step toward achieving our target payout ratio of approximately 30% on a declared basis."

Operating characteristics and traffic opportunities vary from railroad to railroad, but the forces that have made this such a profitable year for UP, and that underlie optimistic predictions for 2012, are common to all railroads.

BNSF chief executive Matt Rose says his railroad's capital plan should be robust again in 2012. "As always, we will maintain and improve our network, invest for future growth opportunities, and improve efficiency," he says. "We plan to invest capital in all areas—maintenance first, continuing to renew our locomotive fleet, expanding intermodal capabilities, cars, and other expansion projects. PTC will continue to be 5% to 10% of our total capital commitments. We see continued but slow growth in all business units, and do not expect to return to historical highs until 2013."

CSX chief executive Michael Ward says his railroad "is committed to building the rail capacity to meet America's growing need for efficient, environmentally friendly freight transportation. Our capital investment has, and will continue, to reflect that commitment. The 2012 capital investment plan is being developed and will be announced during the first quarter of 2012. Earlier this year, we committed to invest, on average, 18% of our revenues on capital projects through 2015. We also increased projected 2011 capital investment from $2 billion to $2.2 billion, on top of $8.3 billion invested from 2006 to 2010. These investments include, of course, ongoing work on our 21,000 route-mile network, but also expanded track capacity, new or expanded terminals, additional locomotives, and more railcars."

The largest of CSX's capacity projects is the approximately $850 million National Gateway, the six-state public-private initiative to clear the rail route between Mid-Atlantic ports and the Midwest for doublestacked container traffic. Earlier this year, one of the National Gateway's key projects, the $175 million Northwest Ohio Intermodal Terminal, opened. The additional network capacity, both on the National Gateway and in other key areas, "positions CSX to more effectively serve customers and prepare for what is forecast to be a more than 60% increase in transportation demand over the next 30 years," Ward says.

Work will continue on ongoing initiatives including the National Gateway and the development and installation of PTC. A new, $15 million intermodal terminal at Louisville, Ky., will come on line early in 2012, and the $59 million expansion of the Columbus, Ohio, terminal continues. Plans are being developed for an intermodal terminal in the Baltimore region. CSX also intends to continue acquiring locomotives and railcars.

CSX, along with the rest of the industry, is moving toward the PTC implementation deadline of 2015, and still expects its cost to be more than $1 billion. "We anticipate a very slight reduction in the scope and cost of implementation as a result of the proposed amendments to the Federal Railroad Administration rulemaking, moving the base year for certain hazardous materials from 2008 to 2015," Ward says. "Significant industry-wide challenges exist that include technology development, a rapidly shrinking window for testing and implementation, and supplier capacity to meet hardware and software needs. We have re-assigned dozens of people to this project and hired new employees, all focused on meeting the mandated deadline. We are working on installing wiring, antennas, and brackets on 3,600 locomotives prior to the receipt of final hardware and software. We also are beginning to install wayside devices at more than 10,000 locations, and will be conducting a pilot in the middle of 2012."

CSX expects the economy to exhibit modest growth, reflected across most of the markets it serves. "The Institute for Supply Management's (ISM) Purchasing Managers Index through September indicates a continued expansion of U.S. manufacturing, while the ISM's Manufacturing Customer Inventories Index suggests that respondents believe that inventories are still low. That tells us that the opportunity continues for rail to provide raw and finished materials for manufacturing and replenishment of inventories. As we have discussed in public presentations recently, early indications for 2012 are for strong intermodal growth due to modal conversions and bringing on new customers. Automobile production is growing to pre-recession levels, agriculture is expected to strengthen, and export coal will remain strong. That is expected to offset somewhat slower domestic coal shipments that are challenged by low natural gas prices and stockpiles that are slightly higher than normal. Housing is expected to remain near its historic low through 2012."

Norfolk Southern is coming off a record year, based on an 18% rise in operating revenue, a 24% increase in net income, a 26% increase in income from railway operations, and a 34% increase in diluted EPS in this year's third quarter, compared to 2010. The operating ratio dropped to 67.5%, compared with 69.6% in 2010. "We continue to see modest improvement in most of our business groups, and we remain focused on the long-term enhancement of our franchise," chief executive Wick Moorman notes. Like UP, NS's recent performance is indicative continued improvements and financial records.

Canadian Pacific "is focused on continuously improving service reliability, asset velocity, and productivity," says chief executive Fred Green. "Our capital programs are enabling us to meet our customers' growing needs and continue to lower our operating ratio to create a stronger franchise for the future. I expect our capital spend to remain above our historic spend. Typically, CP's capital plan is set on an annual basis in the range of 16% to 18% of revenues. Over the next three years, however, CP is accelerating some network investments and some information technology investments, to help us in our drive to improve service consistency, lengthen our trains, and move us toward a lower operating ratio. Other than PTC, these network projects and IT enhancements are discretionary and can be slowed down if economic conditions warrant. Over the next three to four years we expect our capital spend to be within the $1 billion to $1.2 billion range.

CP's capital spend is anchored in its longer train strategy, and as additional passing sidings are completed and brought on line, "we will further leverage the strategy, growing capacity without additional train starts," says Green. As part of these plans, CP will invest $75 to $100 million to increase productivity in its Western Corridor, where it sees growth in bulks such as potash, coal, and grain. On the North line in Saskatchewan and Alberta, CP will spend approximately $250 million in track renewal and sidings over the next three years. CP also plans to complete $90 million of capacity and productivity enhancements on its North-South corridor through North Dakota and Minnesota.

CP is augmenting its over the road locomotive fleet with the purchase of an additional 91 units. It also plans to upgrade and remanufacture portions of its four-axle fleet. Projected spend for PTC will be approximately $250 million over the next several years.

Kansas City Southern, coming off a record-setting year, does not see weakness in its markets. "We continue to watch the economy closely, and in spite of ongoing warning signs, our consolidated carloadings continue to be strong," says chief executive Dave Starling. "In fact, three of the top five weekly volume totals in KCS history have been in the fourth quarter of 2011. Coal and intermodal should be especially strong."

CN, coming off a year of "record revenue performance, a good balance between solid volume increase, and good pricing," according to chief executive Claude Mongeau, is "outpacing the general rate of economic growth. We were able to turn in an operating ratio of 59.3% for the [third] quarter. Our earnings on an adjusted basis are up 16%, and our year-to-date free cash flow is in excess of C$1.3 billion."

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