Over the course of past few months, I have been featuring the Sector Overview series, where I take a sector (or an industry) and provide some basic/background information about the sector. In addition, I present the major companies in the field and profile at a high level comparing the peers. These articles are supposed to be what the title claims – an overview. It is up to each investor to compare and contrast individual companies and decide which one to pick if needed. These articles have garnered a lot of attention from readers (Thank you once again 🙂 ) and the feedback really helps me in making this a better blog for more quality articles. Lately, I have been thinking on the other side of these investment opportunities and decided to highlight the sectors to present the threats and challenges in current environment. I begin this series with a Sector Overview Challenges – Railroads.
The article Sector Overview – Railroads is available here. In that article, I explored the idea of investing in the railroad sector and presented the major railroad operators in N.America – which includes Union Pacific Corp (UNP), Canadian National Railway Co (CNI/CNR.TO), CSX Corp (CSX), Canadian Pacific Railway Ltd (CP), Norfolk Southern Corp (NSC), and Kansas City Southern Inc (KSU). In addition, there is Burlington Santa Fe (BNSF), but the company was bought by Warren Buffet’s Berkshire Hathaway and taken private.
Caveat: Before I get into the details of the challenges faced by the sector, I would like to highlight that this is by no means a recommendation to short the stocks. Remember each investment carries risk, and all I am trying to do with this article is to try and highlight the existing risks in current market conditions and during this part of the economic cycle. These conditions may disappear in due time as the economy goes through its ups and downs.
For a quick recap, the Class 1 railroads of N.American are summarized below.
|Ticker||Market Cap||Rail Network|
Burlington Santa Fe Railway
Union Pacific Corp
Canadian National Railway Co
|CNR.TO / CNI||$47.95B||20,000 miles|
Norfolk Southern Corp
Canadian Pacific Railway Ltd
Kansas City Southern
Sector Challenges – Railroads
The railroads sector is currently facing a few challenges that investors or potential investors need to be aware of. Some of the main challenges I see are:
Trade traffic is considered a leading indicator of the overall economy. Investors and policy makers keep an eye on trade traffic to get hints of how the overall economy is performing. One of the trade numbers to watch for international trade is the Baltic Dry Index, which has lately collapsed falling to an all-time low, thanks to the slowdown in trade in/with China. The other trade figure the investors look at is the rail traffic. So far, there has been no collapse in the overall rail traffic (although there is slowdown, thanks for drop in coal and petroleum products – more on this below). But with an economy that is apparently “firing on all cylinders” as the Fed begins tightening the interest rates, the rail traffic is far from booming.
Collapse of Commodity Markets
We are all well aware of the collapse in the commodity markets. Oil prices crashed last year due to surplus oil in the market and this has had a knock-on effect on the rest of the commodity markets. In addition, China is slowing down to a slower GDP growth rate, which has put a depression on commodity markets such as coal, grain, metals, minerals, etc. All this bodes badly for rail traffic which relies on carrying carloads of these commodities across the continent.
The following chart is the total rail traffic for petroleum products and you can see the steady decline over the past few months.
Note that crude-by-rail was the single fastest growing segment of the railroad sector over the past decade. The rise in crude-by-rail traffic was nothing short of phenomenal (as can be seen in the chart above) and the industry was feeling very confident with the growth prospects. This, of course, is now not possible as the oilfields are being shutdown across the continent as is evident with the drop in oil rig count.
One of the reasons why railroads are such good investments is because of the wide moat. New entrants are almost unheard of, and companies have been consolidating for years – trying to stay competitive. As a result, we are left with just six or seven Class 1 railroads in N.America. Any way you look at it, the industry is capital intensive in nature and requires infrastructural developments and network upgrades regularly.
Between 1980 and 2014, American freight railroads have spent $575B in infrastructure spending. That’s 40% of all revenue plowed right back into investment to make the rail network more efficient and competitive. As an example, last year Berkshire Hathaway announced a $6B capital program to boost capacity and avoid congestion in the BNSF rail network.
Following chart is taken from AAR’s Freight Railroad Capacity and Investment illustrating the rise in infrastructure spending.
The reason crude oil gets transported by rail is because of lack of pipeline infrastructure. Transporting oil via crude is safer and more economical – even though there is a higher initial cost.
Railroads are prone to accidents or spillage which not only cause damage to the environment and/or result in human & animal/bird injury or death, but also attracts a lot of bad press from the media. While spills are also possible with pipelines, the probability is much lower. (On a side note, it is really ironic that the environmentalists protest against using pipelines to transport oil. Just goes to show that they are just swayed by the political rhetoric and the media easily).
Railroads also have to deal with weather delays, congestion or other issues that do not apply to pipelines.
The economic factor is also big. Transporting oil via pipeline is cheaper (about $5/barrel) vs. transportation by rail (about $10-$15/barrel).
So, as more pipeline infrastructure gets put into the ground, crude-by-rail loses more marketshare. The drop in shipping has caused the two Canadian railroads – Canadian National and Canadian Pacific to cut crude freight rates to lure shipments. It has been reported that shipping rates have been cut by as much as 25%!
Environment & The Green Initiative
As discussed in the pipeline section above, railroads are prone to accidents and can result in damage to environment due to spillage of oil or other payloads.
More importantly, the major factor as far as environment goes, is the dirtiest of all fuels – Coal. Coal is still used across the country by utility companies as a cheap source of energy and transportation of coal has been a big part of railroads over the years. I present the breakdown of each company later in the article to show how much coal each company transports, but the following chart shows the overall coal traffic over the last few months/years and clearly shows a major decline.
The Obama government recently mandated power plants to cut carbon emissions by 32% (by 2030) on the 2005 levels. Most of the CEOs in the utility industry have accepted the terms and do not intend to fight against the mandate. As a result, we are already seeing an effect on the rail traffic as utility and power generation companies move to greener options such as solar, wind, natural gas etc for its energy needs.
Other Regulations & Mandates
Regulation was passed that mandated railroads to invest in and implement in Positive Train Control (PTC), which was to be completed by Dec 31, 2015. The PTC is a safety control system to prevent train-to-train collisions; derailments caused by excessive speed; unauthorized incursions by trains onto sections of track where maintenance activities are taking place; and the movement of a train through a track switch left in the wrong position. However, the rail industry lobbied to have that deadline pushed back by three years as the safety system was not ready and Congress agreed to extend that deadline. More details on PTC can be found here and here.
A year ago, the Canadian government took the unprecedented step of mandating volume requirements for moving grain by rail to protect Canada’s farmers and maintain its reputation as a reliable grain shipper. Missed volumes would result in fines of upto $100K per day! The Canadian railroads protested and did not like this mandate (who does?!) but were able to keep up and bring the shipments back to stability. Earlier this year, the Canadian government decided not to renew this mandate. In the future, any such mandates can cause more regulatory issues and fine for the railroads. Other Canadian regulations can be found here.
All of the above means that companies are now facing more pressure from investors to squeeze out the most amount of profit. The railroad sector is doing a great job right now and the current operating margins speak for themselves. But thanks to hedge fund managers and activist investors putting more pressure on, companies are now exploring the mergers and acquisition (M&A) route to grow. Canadian Pacific was shunned by CSX Corp when it proposed a merger and lately has now proposed a hostile bid on Norfolk Southern. Even if that deal is accepted by Norfolk Southern shareholders, it has to pass regulatory approval. And if it does, it may set off challenges and/or more competing bids by rivals.
The overall challenges of the industry to each of the companies, but for each company I also highlight unique challenges below.
Burlington Santa Fe
Burlington Santa Fe is the largest of the Class 1 railroads in N.America. The company operates a rail network of approx 32,500 miles. BNSF is a subsidiary of Berkshire Hathaway, and was valued at $44B in 2009 when the deal was struck.
BNSF directly competes with Union Pacific in western US although BNSF has a bigger network and also has tracks in north-western states that UNP doesnt have. BNSF last year announced a Chicago-Mexico intermodal service with FerroMex (which is partly owned by UNP). Overall, BNSF was a drag for overall Berkshire Hathaway in 2014 due to delays caused by weather and congestion. Berkshire announced a $6B capital program for 2015 to boost capacity and avoid congestion.
Coal is a huge part of BNSF than any other railroad in N.America. In 2014 BNSF, carried 1 in 10 carloads of coal shipped across the continent and as such forms 22% of overall revenue. As coal shipments drop, BNSF will face more drop in revenue in this segment.
Union Pacific Corp
Union Pacific Corp (UNP) is the largest railroad company in North America. The company operates west of the Mississippi river and has a rail network operation of approx 31,000 miles.
The biggest challenge UNP faces is from Berkshire Hathaway’s Burlington Santa Fe Railway (BNSF), which has serves almost all regions that UNP serves plus more in the northern states in western US. So, by investing in UNP, you will be competing against the best investor of all time – Warren Buffett. While there is enough of a market for two operators to co-exist, UNP will continue facing challenges as Berkshire invests more money into upgrading BNSF and gets more competitive.
Coal is a big part of UNP’s revenue. According to the 2014 annual report, coal makes 18% of the total revenue freight. That is a huge percentage and although coal traffic has recovered slightly, the cards are stacked against the coal industry – thanks for cheap alternatives which are cleaner and regulatory requirements discussed earlier.
One advantage that UNP has is that it also owns a 26% stake in FerroMex – a Mexican railroad network which has an extensive network and the sole operator in north western Mexico.
Canadian National Railway Company
The Canadian National Railway Company (CNR.TO, CNI) is the second largest railroad company in North America. It is the only company operating rail networks serving three coasts – Pacific, Atlantic and Gulf coasts; a network of approx 20,000 miles. Bill Gates’ Cascade Investments LLC is the largest shareholder and owns ~12% of total outstanding CN shares. The company occupies the second largest position in Casacade’s portfolio (#1 spot goes to Berkshire Hathaway).
The direct competitor is Canadian Pacific, which has operations mostly in Canada. But now that CP is exploring M&A options, that could give Canadian National a run for their money. However, CN has some advantages in that it has a great set of rail network servicing three coasts and has the bypass across Chicago which is a major congestion point for railroads.
Another plus for CN is that the coal traffic forms a very small part of overall revenue (6% in 2014 revenue mix).
CN has faced regulatory pressure from the Canadian government as discussed above in the general challenges section. The mandate was hard for CN (and CP) and resulted in forcing CN to run grain shipments instead of more lucrative options for the business. Similar challenges may arise in the future.
The collapse of crude-by-rail has caused CN (and CP) to cut crude freight rates by up to 25% to lure customers.
CSX Corp (CSX) is the third largest railroad company in North America – with rail network east of the Mississippi river serving 2/3 of the US population with a network of approx 21,000 miles.
CSX Corp directly competes with Norfolk Southern and has an almost identical map layout. One advantage CSX has over Norfolk Southern is that it services the state of Florida and can provide seamless service to that region and across the eastern US.
As was with UNP, coal makes a big part of the traffic for CSX (about 18% according to 2014 revenue mix). With the regulatory clampdown on coal by the Obama administration to meet green initiatives, CSX will have to make up for the traffic elsewhere.
Norfolk Southern Corp
Norfolk Southern Corp (NSC) operates a rail network east of the Mississippi river directly competing with CSX Corp. The company operates approx 20,000 miles of rail network.
As discussed earlier in CSX Corp section, Norfolk Southern directly competes with CSX Corp. Norfolk Southern does not have services to the state of Florida like CSX Corp. In addition to what’s shown in the map, Norfolk Southern has the Meridian Speedway railroad – a 320 mile track between Meridian, Mississippi, and Shreveport, Louisiana – in a joint venture with Kansas City Southern. One advantage CSX has over Norfolk Southern is that it services the state of Florida.
Coal makes a big part of NSC (17%) similar to UNP and CSX.
Norfolk Southern is currently fighting off a hostile takeover from Canadian Pacific.
Canadian Pacific Railway Ltd
Canadian Pacific is the smaller of the two Canadian railroads operating mostly in Canada but with some extensions into the US market. The company operates approx 13,700 miles of railroad.
Canadian Pacific lagged its competitors over the years, especially its most direct competitor Canadian National Railway. The current CEO at CP – Hunter Harrison served as the CEO of its rival CN from 2003 to 2009 and went into retirement at the end of his tenure. In 2011, Bill Ackman’s hedge fund Pershing Square Capital Management acquired a 14% stake in CP and proceeded to require several changes in the management and governance of the company. The CP board resisted but eventually lost the proxy fight. Pershing managed to convince Hunter Harrison to come out of retirement and take over the helms as CEO and President starting June 2012. The non-competition clause from CN was apparently breached and CN launched a lawsuit against Harrison. Hunter Harrison is currently the CEO but is currently taking a leave of absence due to a serious illness.
Over the years, CP has done very well improving its operating margin from a lowly 19% at the end of 2011 to the current 38%, just behind the sector-leader CN. Pershing Square Capital still remains the top shareholder, currently at 8% of total outstanding shares.
However, with the hedge fund/activist investment comes the challenge of squeezing the most out of the operations and the push for M&A. CP approached CSX Corp for a merger, which was rejected outright. Now, CP has launched a hostile bid for Norfolk Southern – which has been rejected by NSC to begin with. Whether this will be escalated and taken to shareholders remains to be seen. CP has good leadership, but is clearly looking for scale to grow going forward.
Coal forms a 10% share of revenue mix in 2014 traffic. That number although higher than its direct competitor CN, is however considerably less than other Class 1 railroads.
CP has faced regulatory pressure from the Canadian government as discussed above in the general challenges section. The mandate was hard for CP (and CN) and resulted in forcing CP to run grain shipments instead of more lucrative options for the business. Similar challenges may arise in the future.
The collapse of crude-by-rail has caused CP (and CN) to cut crude freight rates by up to 25% to lure customers.
Kansas City Southern
Kansas City Southern (KSU) is the smallest of the public railroads – serving the Southern US and Mexican markets. The company operates a rail network of approx 6,500 miles.
Kansas City Southern has diversified traffic and has seamless cross border rail network. Challenges include competition from FerroMex (which is partly owned by Union Pacific) inside Mexico. FerroMex has a more dominant network in western Mexico while overlapping a bit with Kansas City Southern.
Kansas City Southern own 100% of subsidiary Kansas City Southern de México, S.A. de C.V. (“KCSM”), which has a 50-year concession from the Mexican government and could expire in 2047 unless extended – to operate the KCSM arm.
(Warning: This is purely speculation) I think because of the size and the seamless network they have between US and Mexico coupled with a strong growing Mexican economy and exports, KSU is a prime target for mergers and acquisition. The network provides a complementary fit for networks of other Class 1 Railroads such as BNSF, CN, CP, NSC or CSX. Note that UNP owns a 26% stake in KSU’s direct competitor – FerroMex, so if UNP wants to increase investment in Mexico, they will probably go after FerroMex instead of KSU/KCSM.
Ferrocarril Mexicano, or FerroMex as its called, is the smallest of the Class 1 railroads in N.America. The company operates a rail network in Mexico of approx 6,200 miles. FerroMex is a subsidiary of Grupo México, Mexico’s largest mining company – which owns 74% of the company. The other 26%, as mentioned earlier, is owned by Union Pacific Corp (UNP).
FerroMex’s direct competitor is Kansas City Southern de Mexico (KCSM), which is a subsidiary of Kansas City Southern (KSU) and provides seamless crossborder transportation. The advantage FerroMex has is that of a greater presence in western Mexico while also overlapping with KCSM’s network on the east.
Railroads provide a great long term investment opportunity as they boast a wide moat and are a critical part of the economy. But the sector has its own challenges that need to be addressed and considered by investors. The companies have to adapt to the changing landscapes presented and deliver to the shareholders. Currently, the biggest challenge facing is the declining volumes of crude, coal and other commodities. Coal could potentially see the shipments in steady decline and never come back as new regulations cause power producers to move away from the dirty fuel. Crude will find long term challenges from the pipeline industry.
Did I miss any other challenges? Do you own stocks in this sector? Which ones do you own and what are your thoughts on the future of the industry and companies mentioned. Share your thoughts below.
Full Disclosure: Long CNR.TO. My full list of holdings is available here.
Image Credit: Jerry Huddleston