Friday, June 18, 2010

Class I’s “exceeding expectations”: Dahlman Rose

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Dalman Rose & Co. has raised its second-quarter 2010 and full-year EPS (earnings per share) estimates for all Class I railroads “a ssignificantly better-than-expected volume growth should translate into strong incremental margins,” according to Director-Equity Research and Railway Age Contributing Editor Jason Seidl (pictured). “It is our belief that the railroads will utilize strong free cash flows to support higher dividends and share repurchases.”

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"Traffic growth is still in high gear,” says Seidl. “Up 17.7% quarter-to-date overall, North American Class I traffic has exceeded most investors’ expectations. As we believe this rate will continue for the remaining three weeks of the quarter, second-quarter 2010 volume growth will likely be significantly higher than the 8% year-over-year increase seen in first-quarter 2010.”

As for pricing, “We continue to believe that first-quarter 2010 has marked a bottom. The rate environment will likely continue to be favorably impacted by improving volume levels, strong intermodal traffic, tightness in the truckload industry, robust growth in Asian markets, and therailroads’ focus on improving service. Indeed, [CN and Canadian Pacific], which recently stressed their ability to achieve pricing in excess of cost inflation, also highlighted their efforts to enhance service levels through a wide spectrum of network improvement efforts. Truck-competitive traffic is also receiving a boost from rapidly rising truckload rates, which enable railroads to garner more for their services in the competing lanes. This trend of positive truck pricing should continue throughout 2011, based on supply and demand factors in the truckload sector.”

Railroad volume growth, which began at the end of 2009 after 18 months of declines, “has continued and strengthened progressively in 2010,” Seidl notes. “Such growth has been the product of improving demand and easy year-over-year comparisons. At some point in 2010, however, comparisons should begin to get tougher. We believe the first signs of such a trend are likely to surface around week 28, which should see a drop in the growth rate by a few percentage points. The deceleration will likely continue, with the rate of volume increases declining to the high single digits around week 34, after which the rate should fluctuate between the high single digits and low double digits for the remainder of the year. That said, the deceleration should be largely optical as traffic strength will likely continue as a function of an improving global economy and continued truck conversion traffic.”

“In the near term, revenue growth for most of the railroads will continue to significantly outpace growth in operating expenses, leading to high incremental margins, and ultimately robust earnings,” Seidl says. “We estimate that many carriers can still accommodate 15% to 20% morefreight without having to significantly ramp up operating resources. In short, we believe the rail carriers will continue to post strong incremental margins in 2010. While this operating leverage should eventually begin to diminish, we believe that one of the recent recession’s silver linings is that it taught the railroads what costs they can live without, ultimately forcing them to run muchleaner networks.”

Due to the strong quarter-to-date performance and an improved 2010 outlook, Dahlman Rose is raising earnings estimates and price targets for the Class I’s, “which should also be able to put their strong cashflows to work in 2010 via share repurchases and increased dividends for investors. Accordingly, we continue to be favorably disposed to investing in the rail sector.”