Tuesday, September 20, 2011

Short lines and regionals have an important role

Written by  Roy Blanchard, Contributing Editor

What the Association of American Railroads calls “Class II and Class III railroads”—short lines and regionals, in the vernacular, or simply short lines, for short—are rebuilding America’s railroads with a vengeance. Their growing traffic volumes, even in this slow economy, give eloquent testimony to their success.

Halfway through the 2011 third quarter, RMI’s RailConnect Index has short line year-to-date carloads up 7% vs. the AAR figures showing the Class I’s with a 2% gain over the same period in 2010. How can this be?

Two themes are at work. First, the Class I’s are having a record year in intermodal, up 6% through mid-August, while the carload side—everything from unit trains of coal and grain to single cars of iron ore and canned goods—has lagged considerably, up just 2%. The reason is the assets—locomotives, crews, track space—are going where the volumes are, and it’s not the carload side.

Second, and fitting in beautifully with the Class I focus on long trains with few stops, the particular strength of Class II and III railroads is providing customized first-mile, last mile service that the Class I’s simply can’t match. Moreover, many of these regional carriers connect with more than one Class I, giving shippers options they would never have if captive to a particular Class I. So even if volumes in general are diminishing short-term, volumes in specific commodity lanes are increasing.

These smaller roads touch about 20% of all Class I revenue units from coal to corn to ethanol to coiled steel and as such are not going away. Take Norfolk Southern, for example. The carload sector—including coal—still accounts for 55% of NS revenue units, and that’s where the margins are.

At the NS short line meeting in July, NS System Manager for Short line Marketing Chris Spiceland talked about where and how NS short lines are handling more traffic year-over-year and growing at a double-digit pace. I particularly liked what Chris said about the “short line multiplier”: NS short lines operate on more than 18,000 route-miles that, when combined with NS’ own 21,000-mile system, provide a 39,000 route-mile network, of which short lines have 46%.

The growth story is everywhere. Exactly halfway through 2011, the RailConnect Index had short lines with positive year-over-year volume changes in all but one of the 12 RMI commodity groups, with particular gains in automotive (finished vehicles and parts), chemicals, grain, aggregates (much of this “frack sand” for the natural gas market), raw metals (steel and copper) and metal products (coiled and plate steel), and even lumber, in spite of the soft housing market.

The successful short line is now, more than ever, a niche business, whether grain (Twin Cities & Western), ethanol (Iowa Northern) or anthracite coal (Reading & Northern). Two railroads in the Texas Panhandle, the Texas-New Mexico Railway and West Texas & Lubbock Railroad, show what can be done with some imagination and a little luck.

These two names are part of the seven-short-line Iowa Pacific Holdings group headed by Ed Ellis. He describes his approach to short line railroading by saying, “We’re the ‘work-out’ guys. We find a property that we think is undervalued and then work it out to be a money-maker.” These are buy-and-hold operators, in it for the long term, and until their recent sale of the Arizona Eastern to Genesee & Wyoming, had never sold a railroad.

Iowa Pacific’s Texas properties are working out beautifully, Ellis says. “We’re doing a banner business in supporting the Permian Basin oil and gas industry. Between these two railroads, we have landed three new receivers that, added to our existing business base, are collectively moving more than 3,000 annual carloads of drilling sand a year. In 2007, our total volume in this space was minimal.”

But such success does not come cheap. Short lines, being mostly independent and privately held, do not enjoy the same access to capital that their Class I brethren enjoy. RRIF loans are said to be making a comeback, and a few short lines have participated in the TIGER grant program. Pennsylvania’s North Shore Rail Group, for one, was awarded $6.8 million to rehab 200 route-miles of track in the Marcellus Shale service area.

However, there is one program that continues to be extremely valuable and relatively easy to get for infrastructure upgrades: the 45G tax credit. Earlier this year, New England’s Providence & Worcester provided a perfect example of how this tool can help a regional railroad and a shipper create value. P&W reached an agreement with a customer for the latter to fund “qualifying railroad track maintenance expenditures” and to be assigned a tax credit for the full amount—$869,000—which was passed as cash to the P&W.

According to P&W’s CFO, the amount was posted to the maintenance-of-way and structures expense line on the income statement, resulting in $182,000 of net expense. That $182,000 may look like a very low number, compared to the same expense line for earlier quarters, but if one adds back the 45G credit, the 2Q2011 m/w line becomes $1.05 million, a much better fit, though it makes for a much lower operating income number.

That’s a minor point, though. The fact is that the 45G credit was there to be used, and P&W has to be credited with stepping up to the plate with it: making the needed infrastructure improvements, creating value for a key customer, turning a potential operating loss into a gain and producing a six-point drop in the operating ratio in the bargain. All of this goes once again to prove that, at the end of the day, task number one for any business is getting customers, and the woods are full of short lines and regionals that excel at it.