Railroad Industry Remains on Growth Trajectory – Industry Outlook

Following third-quarter results, railroad stocks appear to be recovering from the operational hazards faced earlier this year. The industry’s operational efficiency despite uncertain market conditions positions it favorably.

Despite the expected headwinds associated with coal — one of the major products transported via rail — the sector emerged strongly backed by infrastructural developments that supported natural gas, grain crop and petrochemical product shipments.

Intermodal

While most of the other commodities, including Automotive and General Merchandize, have shown uncertainty in growth for 2014, intermodal volumes are strong. As a result, we expect railroads to significantly focus on intermodal expansion and tap underserved markets with highway-to-rail conversions.

Railroads are now looking to the Mexican market, which is witnessing regulatory reforms, including rail reforms, initiated by President Enrique Peña Nieto to lure foreign direct investments to boost economy. Union Pacific, which serves all six gateways between the U.S. and Mexico, is likely to seek this opportunity to increase its penetration into the Mexican market.

Moreover, there are major investments to look forward to this year involving intermodal growth. These include BNSF Railway Company’s $900 million spending on terminal, line and intermodal expansion and CSX Corp.’s (CSX) investments in nine projects, Montreal terminal, capacity expansion of its northwest Ohio intermodal hub, and terminal expansion in New Orleans and Savannah.

According to the Energy Information Administration’s (EIA) reports, crude oil growth may go up to 10 million barrels per day from 2020 to 2040. In addition, Association of American Railroads (AAR) reported that railroads transported 407,642 carloads of crude oil in 2013, up from 234,000 carloads in 2012. Further information suggests that crude oil accounted for around 1.4% of total Class carloads in 2013, compared with 0.03% in 2008 when the concept of crude by rail started gaining importance.

Major railroad companies like Norfolk Southern Corporation (NSC) are looking for expansion strategies mainly due to development of the energy sector, including the gas exploration projects in Marcellus and Utica shale plays as well as ventures associated with coal and power generation. Over the coming years, the company plans to introduce 32 energy-related projects in 14 states under its service areas.

In the upcoming months, we expect the railroad companies to increase investment to create adequate service capacity for the oil and gas markets. This would lead to exponential growth in crude oil shipments across the rail industry. Consequently, we expect petroleum shipments to remain favorable and emerge as a significant revenue contributor over the long term.

Mexico is currently a growing market for automotive production and assembly, given the lower cost of production in the region. We believe that the plants established by Honda Motor Co., Ltd. (HMC), Nissan Motor Co. (NSANY), Mazda and Audi would boost auto production in Mexico.

The growth will provide carriers like Kansas City Southern (KSU), which operates across the Gulf of Mexico, ample opportunities to ship raw material to Mexico and return the finished products to the domestic market as well as to the U.S. and Canada. The company has access to 12 automotive production facilities and is in talks with automotive companies to build five more near its rail network.

Auto makers such as Audi AG, Kia Motors Corp., Mercedes-Benz, Infiniti and BMW AG are expected to open their facilities in Mexico, boosting shipments for Kansas City Southern. According to reports, the new automotive production plant is expected to increase production capabilities by 923,000 units produced per year.

Reduced electricity generation from coal turned into a major concern for rail freight carriers. According to the EIA’s latest Short-Term Energy Outlook, U.S. coal production will increase 1.2% in 2014, lower than previous forecast of 4.1%. Further, it is expected to remain flat in 2015.

Coal consumption in 2014 is expected to grow 1.2% to 868 million short tons (MMst) in 2014 but drop 0.4% in 2015, owing to retirement of several coal power plants.

The EIA projects coal exports to decline to 96 MMst in 2014. In 2015, exports can go further down to 83 MMst owing to weak global economic conditions, slow demand growth rate in the Asian markets, rising coal production in other countries and lower international coal prices.

These data currently indicate a bleak outlook for railroads business from coal shipments.

Grain Shipments

While 2014 remained a good year for rail in terms of grain shipment, 2015 forecast is comparatively modest. According to The United States Department of Agriculture (USDA), agricultural exports in 2015 are forecasted to be $143.5 billion, down $9.0 billion from 2014.

The decline will result from an expected fall in grain and feed exports owing to lower production of corn, wheat and certain feed products. Further, imports are anticipated to decline. As a result, we expect agricultural products to have a negative impact on railroad carloads in the coming year as grain shipment represents one of the key commodity segments.

Within the Zacks Industry classification, railroads are broadly grouped within Transportation (one of 16 Zacks sectors).

We rank all the 260-plus industries in the 16 Zacks sectors, based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more, visit: About Zacks Industry Rank. https://www.zacks.com/stocks/industry-rank

As a guideline, the outlook for industries with Zacks Industry Rank #88 and lower is Positive, between #89 and #176 is Neutral and #177 and higher is Negative.

The Zacks Industry Rank for the railroad industry is currently #92, implying neutral outlook. We believe while some of the product lines succeed or suffer, depending on seasonality or other external factors influencing market demand, intermodal remains on the growth trajectory.

Further, the surge in petrochemical shipments has bolstered the industry, thereby leading to earnings improvement. However, tepid growth in coal shipments continue to affect industry prospects, rendering a cautious outlook.

The broader Transportation sector, to which railroads belong, reflects a sustainable growth trend. All the sector participants have reported third-quarter results, which have been stable in terms of both beat ratios (percentage of companies reporting positive earnings surprises) and growth.

The earnings and revenues “beat ratio” for the quarter was 72.7% for the transportation sector. On a year-over-year basis, total earnings for the companies in this sector rose 10.4%, while revenue growth was 6.6%. The sector is expected to register full-year earnings growth of 15.7% in 2014. In terms of revenue expectation, the sector is expected to record 5.7%.

For a detailed look at the earnings outlook for this sector and others, please read our weekly Earnings Trends reports.