Friday, December 14, 2012

Wall Street view: Stuck in neutral?

Written by  Jason H. Seidl, Contributing Editor
Looking ahead to 2013, we find the same central question facing us that we have over the past few years, and that is what the economic environment will look like. We have maintained the basic premise that the North American economy will grow modestly in 2013. There are several issues that likely will determine the direction of railroad equities in the coming year.

The biggest challenge in 2013 will be the ability to maintain pricing above cost inflation. Over the past eight years, the rail industry has been successful in pushing through price increases that easily exceeded rail inflation. This was in part due to legacy contracts that were being renewed at vastly higher prices, a push from investors for rails to come closer to earning their cost of capital, and a commodity boom. With most legacy contracts already renewed, commodities under pressure, and a sluggish economic backdrop, the rails are finding it harder to price their services as in the past. Our most recent quarterly railroad shipper survey saw expectations for the next 6-12 months fall for the third consecutive quarter—to 3.5%. This marked the first time in nearly eight years of conducting the survey that such an event has happened.

Given that coal shippers accounted for few respondents, we believe our survey more accurately depicts the rail pricing outlook, excluding coal. Unfortunately, the outlook for pricing coal movements does not seem that good. Railroad movements of thermal and met coal for export out of the East Coast of the U.S. have seen drastic reductions in pricing expectations from 25%-50% in recent months. Given this backdrop, we believe it will become harder for railroads to post the type of margin gains that investors have grown accustomed to and should place further reliance on traffic growth in 2013 and beyond.

Traffic growth has been sluggish all year long thus far in 2012, with coal being the main culprit for the stagnation. The 2013 outlook for domestic utility coal should be remain somewhat stable given the easier year-over-year weather comparisons, more favorable stockpile numbers, and the recent rise in natural gas prices. Indeed, comments from some Eastern utilities indicated a willingness and ability to switch back to coal (or more to gas) if the commodity prices dictated such actions. On the flip side, coal exports have been falling sharply of late, and a strong decline in 2013 would undoubtedly place pressure on Eastern rail margins.

In contrast to coal volumes, intermodal volumes have been a bright spot for railroads in 2012. Indeed, intermodal’s yearly growth rate through the first week of November of 4.6% is a big reason that total carloading growth is still in the proverbial black. While a portion of this growth can be attributed by growth (albeit slow) in the broader economy, the remainder is likely due to higher fuel prices and the continued concern in the shipping community over long-term truckload capacity. Although it may be difficult to forecast economic growth and the direction of fuel prices, we believe the fears over trucking capacity will continue into 2013 and could become increasingly heightened if the economy does pick up. Accordingly, we continue to believe intermodal growth will outpace the overall economic growth in North America.

Another major issue that is likely to come up in 2013 is the role of the STB and its decisions. We expect that the STB will give the final approval for Genesee & Wyoming to take full control of the RailAmerica properties, but that decision may come after the STB rules on one of the seven rate cases that are currently in front of it. Five of these are large, complex cases that have been ongoing for some time. If the railroads lose any of these cases it could impact the way they approach pricing future business or even lead to more rates cases, neither of which would be a positive for railroad equities.

Despite the potential negatives that could emerge from some of the issues we have highlighted, we continue to view the railroads as relatively secure investments. Further to my point, railroads offer investors solid and stable dividends (with some dividend records going back more than 100 years) and have consistently supported their shares via share repurchase plans. That being said, our overall view on the equities in the industry can be described as neutral compared to the more bullish stance we had taken over the past eight years. Hence, we would advise investors to be more selective in putting money to work in rail equities, as shares in the group may have difficulty outperforming the broader market.