REF 2023: Push for Modal Share Pursuit Most Palpable in Years

Written by Matt Elkott, Transportation OEM Analyst, TD Cowen
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The call on the Class I’s by other rail industry stakeholders to pursue modal share gain more aggressively is nothing new, but this year at Railroad Financial Corporation’s annual Rail Equipment Finance conference, it feels more palpable than at any time in many years.

We had one-on-one and group meetings with several railcar manufacturers, lessors, shippers, investors and other experts. Rail service remains suboptimal and volume outlook underwhelming. The Class I’s need to improve service further and go after highway freight more effectively. That’s the reverberating message conveyed more emphatically than at any time many years.

We heard it from railcar and locomotive industry stakeholders, some shippers, and even a short line railroad. We believe some of them may feel emboldened by the rail service issues of the past three years, which may have shone a light on PSR’s shortcomings and the rails’ margin fixation, although we note that global and port disruptions were also key culprits behind the rails’ inability to fully accommodate the pandemic’s freight demand surge.

Source: TD Cowen and SEC filings

The possible—but still not definitive—link between recent derailments and PSR operating practices may be yet another factor emboldening industry stakeholders in their call for a more balanced approach to margins vs. growth. The Class I industry has improved its operating ratio from ~80% in 2005 to ~61% in 2022. During the same period, rail traffic is down slightly, in large part due to the coal secular decline, partly offset by intermodal increases, although not recently. The lack of growth has meant a decline in rail’s land transportation share, but the decline is much less dramatic excluding coal. With further margin upside limited relative to what has already been achieved, modal share pursuit becomes even more important for the carriers themselves.

Tightness across a wide array of freight cars has continued; and with supply chain challenges limiting the industry’s ability to produce to demand, the lease rate momentum looks sustainable. We expect an 11th consecutive Q/Q improvement in spot rates 1Q and continued strength throughout 2023. Disruptions for the manufacturers appear to have eased modestly in recent weeks, but not necessarily more than they had expected on their most recent earnings calls. The production consensus among industry participants appears to be 40-45K units this year (we’re modeling for 48K units) and a similar level in 2024.

Secondary market valuations remain strong but with slight easing in some pockets. The lease rate strength appears to be offsetting the negative impacts from high interest rates, keeping valuations elevated. While further rail service improvement is necessary for meaningful modal share gain, one intermediate-term risk to equipment demand is if service does improve dramatically this year but does not result in the intended volume additions if the economy and/or key end markets soften further. That would be a double headwind for railcars and locomotives. While an important risk, it is not our base assumption.

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