Friday, February 14, 2014

“Underlying rail fundamentals are very solid”

Written by  William C. Vantuono, Editor-in-Chief
Fourth-quarter and full-year 2013 Class I financial results and accompanying railroad management commentaries have reinforced Wall Street’s favorable view of the rail sector, according to Cowen & Co. Managing Director and Railway Age Contributing Editor Jason Seidl. “While weather should be a bigger drag in first-quarter 2014 than it was in the prior quarter, we believe the underlying rail fundamentals are very solid,” he says.

“Rail earnings results increased our confidence in our favorable sector view for 2014,” says Seidl. “This may seem paradoxical given that five out of seven publicly-traded carriers posted lower-than-expected 4Q 2013 profits. However, our increased confidence can be attributed to three key earnings season takeaways. First, unusually severe winter weather had material negative impacts on all carriers. Second, many of the non-weather issues that impacted the quarter were nonrecurring, temporary, or company-specific. Third, all companies were more positive on the macro environment and freight demand than they had been for several quarters. Pricing, except for coal, remains solid and in some cases may be improving.

“The net weather impact will likely be negative on rail earnings when all is said and done. However, we believe it is not all bad news, especially for the eastern carriers. The persistence of below-average winter temperatures and rising natural gas prices seem to be putting a dent in domestic utility stockpiles, especially in the South, where stockpiles remain well above normal levels. Norfolk Southern noted in a February 13 presentation that southern utilities are now likely to reach normal stockpile levels sooner than the 3Q 2014 time frame the company had suggested on its 4Q 2013 earnings call. Coal volumes on the North American Class I’s are down 0.6% quarter-to-date, compared to the 1.0% decline in total traffic excluding coal. Of course, this is not enough to significantly alter the subdued coal narrative for the eastern carriers, at least not while export coal weakness persists or becomes even more pronounced, but any upside to the dismal coal expectations, however minor, could aid earnings.

“The shift from the highway to intermodal appears to have picked up in recent months. Indeed, about 32% of shippers participating in our Jan. 15 4Q 2013 Rail Shipper Survey said they shifted to intermodal in the past twelve months, compared to 27% in our previous survey. Rail management teams spoke of the accelerating shift on their earnings calls, and the numbers support the story, with 4Q 2013 North American Class I intermodal traffic up 6.7% year-over-year, well above the 1.7% increase in the aggregate of all other carloading groups. Quarter-to-date in 1Q 2014, intermodal is down 0.6%, compared to the 1.1% decline in the remaining volumes. The narrowing of the growth disparity in 1Q 2014 is likely due to intermodal traffic being more susceptible to weather events due to the involvement of multiple modes of transportation.

“This shift could eventually lead to stronger earnings if the railroads’ ability to price their freight higher takes hold. Higher intermodal pricing is looking more and more like it will happen. Truckload pricing has always been the most restrictive factor for the languishing pricing trends in intermodal. However, recently truckload carriers cited meaningful increases in spot rates, which are a good precursor of contractual pricing. The economic malaise of much of the past two years had kept a tight lid on truckload pricing, which hovered around a meager 2%. Most companies now appear to have their eyes set on a range closer to 3%. The improvement is being driven by both demand and supply dynamics. At the same time that the uptick in economic growth is aiding freight demand, rapid-growth industries such as fracturing and construction are attracting truck drivers, and the Hours-of-Service regulations, which went into full effect in July 2013, are further straining capacity, as more carriers conform to the new rules. Accordingly, we believe that intermodal pricing will slowly improve in 2014, benefiting carriers with high exposure to truck competitive traffic, such as CSX and NS.

“Six weeks into the quarter, all the Class I’s except Union Pacific are trailing our full-quarter traffic growth assumptions. Quarter-to-date, UP’s volumes are up 3.2%, compared to our full-quarter assumption of 2.5%. With seven weeks yet to be reported in the quarter, we are hesitant to jump to conclusions, but we are encouraged by UP’s performance. Additionally, this quarter’s results will likely be judged based on investors’ perceptions of earnings, excluding the unusually severe weather.”