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Railroad Stocks Deliver Stellar Growth

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An outlook and overview of the US railroad industry from an investor's perspective.

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Despite the uncertainties surrounding the demand for US coal, railroads delivered stellar first quarter results. Contrary to market expectations, freight railroads emerged unscathed by coal's woes, with most of the big players surpassing their earnings estimates.

According to market reports, North American Class I railroads registered growth of approximately 29% in their first quarter earnings. Strong pricing coupled with commodities volume, effective cost management and improved rail efficiency helped US railroads to continue their strong performances.

The railroads continue to benefit from the ongoing highway conversion due to the significant rise in fuel costs of truckers. Currently, rail intermodal services are considered one of the most fuel-efficient modes of fright transportation, and therefore remain the backbone of the railroad freight business.

Railroads' Network of Operation

The vast geography of the US is covered by over 600 freight railroads comprising Class I, regional railroads and local line haul operators. These railroads operate across 150,000 miles of railroad tracks and generate over $50 billion in annual freight revenues.

Based on their operating revenues, freight railroads are categorized into three segments: Class I with annual operating revenues above $346 million, Class II with revenues in the range of approximately $27.8 million to $346 million, and Class III for the rest. These operating revenue based classification standards are generally set by the Surface Transportation Board (or STB). However, in light of inflation and the changing macroeconomic environment, the revenue benchmark is subject to change.

Currently, there are nine major railroads in America that are classified under Class I freight railroads. These include Union Pacific Railroad (UNP), CSX Corporation (CSX), Norfolk Southern Railway (NSC), Canadian National Railway (CNI), Canadian Pacific Railway (CP), BNSF Railway, Kansas City Southern Railway (KSU), Ferromex, and Kansas City Southern de México (wholly owned subsidiary of Kansas City Southern Railway).

These carriers can be further categorized based on their network of operations. BNSF Railway, Canadian National, Canadian Pacific, CSX Corp. and Norfolk Southern have their presence in the US as well as Canadian Market. Union Pacific operates only in the US with no footprint in Canada or Mexico. It represents the largest freight railroad that predominantly operates on the western part of the US. While Kansas City Southern Railway operates between the US and Mexico, Kansas City Southern de México and Ferromex cater to the Mexican market.

Although these Class I carriers merely represent 1% of the total freight railroads in America, they dictate more than 90% of the freight revenues and employment generated in the industry. Consequently, they represent the performance indicators of the rail industry and are therefore crucial for analyzing railroad trends.

First Quarter Flashback

As mentioned earlier, railroads' performance in the first quarter of the year was well above market expectation. The Class I carriers made a positive head start that rose above the negative sentiments hovering around them.

Beginning with Union Pacific, the company delivered adjusted earnings of $1.79 per share, up 38.8% from the year-ago quarter. Revenue climbed 16% year over year to a record $5.1 billion.

CSX Corporation reported earnings of 43 cents, up 23% year over year. Revenues registered an uptrend with almost 6% growth year over year. Norfolk Southern's earnings grew 25.6% to $1.13 per share. Revenue also grew substantial from $2.6 billion to $2.7 billion. Kansas City Southern delivered 29.3% earnings growth to 75 cents per share and total revenue of $547.5 million, up 12.1% year over year.

The same story goes for the top Canadian railroads, Canadian National and Canadian Pacific. Canadian National's adjusted earnings in the first quarter shot up 31% to C$1.18 backed by revenue gains of 13% year over year to C$2,346 million. Canadian Pacific reported a robust quarter with a whopping 310% increase to 82 Canadian cents per share from 20 Canadian cents earned a year ago.

Primary Catalysts

According to Association of American Railroads (AAR) reports, North American railroad traffic (including US and Canada) dropped 1%, primarily due to an 8.6% decline in coal volumes. However, Intermodal volumes were up 3.3%.

Apart from coal, agricultural and food products (down 3.7% in the first quarter) and chemicals (down 4.5%), most of the product lines aided the first quarter results.

Railroads benefited the most from petroleum products and automotive shipments that grew 24% and 16.6%, respectively, in the reported quarter. Trailing behind were metals (comprising iron and steel products, ores and scrap) and nonmetallic minerals (includes frac sand, gravels, stone glass products) shipments that grew 9.4% and 7.3%, respectively. Forest products -- constituting wood, lumber, pulp and paper -- also went up 3.1% year over year.

Despite the modest growth in carloads, railroads managed to showcase an outperforming quarter due to the current momentum in freight pricing and fuel surcharges. The upsurge in the rail Intermodal services driven by a demand shift from the truckload market is allowing railroads to gain through higher freight pricing.

Additionally, fuel surcharges allow railroads to pass on higher fuel expenses to shippers and continue to aid revenue. As a result, railroads are witnessing solid yield improvements despite the lacking strength in volumes.

Coal – Concern or Opportunity

As speculations continue to surround coal, it becomes even more difficult to estimate the exact implications of this product on the US railroads. Although current market reports provide a murky road ahead for coal shipments, we believe there are some windows of opportunity that can, to some extent, pull back declining coal carloads.

Coal, representing one of the single-most important commodities, accounts for over 40% of railroad tonnage. Coal gained significant market traction given the emerging position of the US as the global coal export hub. Global supply constraints for export coal due to disruptions in Australia and the growing demand for coal in Asian countries for steel manufacturing elevated the market position of the US coal exports.

However, coal volumes registered a setback from the second half of 2011, given lower coal production by the US producers. Following this, the US Energy Information Administration (or EIA) projected a lower coal production outlook for 2012.

According to the EIA report, US coal exports are expected to decline to an estimated 100 million short tons (MMst) in 2012 from 107 MMst in 2011. The decline is primary related to the recoveries in Australian mining activities. Further, in the domestic market, utility coal which accounts for approximately 93% of the domestic coal demand is witnessing persistent falls.

Lower natural gas prices are largely substituting the demand for utilities. Additionally, higher stockpile levels and warmer winter weather also resulted in lower utility coal demand.

However, in 2013, the EIA projects that electricity generation from coal will increase 7%, as coal prices would moderate while natural gas prices would gain some upward momentum. The EIA also projects coal's share in the US electricity generation to increase 40.9% in FY13 from 39.3% in FY12.

Railroads along with shippers are making efforts to reduce transportation cost to make US coal more economical for the domestic market. As a result, declines in domestic volumes are expected to moderate. Further, the post summer period this year may mark some improvements in the utilities volume given the expected rise in electricity generation and replenishment of stock piles.

Going forward, utility coal exports are gaining momentum with demand mostly from Asian and European markets. Many developing countries are in the process of building electricity grids that are expected to bode well for US utility coal.

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