Railroad Investors May See Some Bumpy Rides Ahead

Without some capacity expansion, railroad companies may see slow growth even as the economy continues to pull ahead.

May 6, 2014 at 7:18AM

Railroad companies, especially major Class 1 rail carriers such as Union Pacific (NYSE:UNP), Norfolk Southern (NYSE:NSC) and CSX (NASDAQ:CSX), have had mostly a smooth ride since the current economic recovery. To be classified as a Class 1 carrier, a company's annual operating revenue has to be over an annually adjusted threshold, which is $452.7 million for 2012. Freight revenue at the these three companies ranges from several billions to tens of billions of dollars each over the past five years, making them the leading Class 1 rail carriers. However, the percentage of revenue that all railroad companies generate is only in the teens over the aggregate revenue from all means of transportation.

Meanwhile, freight volumes by railroads as measured by ton miles are over 40% of the total freight moved in the U.S., more than any other mode of transportation. But future growth at railroad companies may be inhibited because of current, underdeveloped railroad capacity that has caused rail traffic congestion and delivery delays amid rising shipping demands. New investments are likely needed even if they may put a dent on earnings initially. With increased capacity and improved services, investors may see faster revenue growth from both higher freight volumes and greater rail pricing power.

Rail revenue and shipping charge
Speaking of pricing power for different types of transportation carriers, railroad companies seem to have the least of it, and freight services by rail are the most inexpensive means of transportation, especially compared to trucking. Revenue for railroad companies can add up because the calculation takes into account the long distance that shipments travel when carried by rail. Premium shipping charges usually are based on timely delivery, something typical of short or mid-haul transportation by trucks. Actually, trucking has increasingly become part of rail freight services via intermodal transportation whereby the intended, but otherwise unreachable, rail points are connected to truck routes. Having to be assisted by other forms of transportation may further limit rail carriers' ability to set higher rail shipping rates.

Shipments that travel by rail often are not time-sensitive deliveries. Here shippers primarily are concerned about a carrier's ability to move bulky cargoes safely to their final destinations and have to be flexible in dealing with uncertainties in rail travel time. Surprising delays can also happen because of overbooked rail capacity sometimes. Unreliable delivery time is a main reason that railroad companies don't have much negotiating power with shipping charges, which partly undermines revenue growth. Average five-year sales growth is barely 4% at Union Pacific and just over 1% for both Norfolk Southern and CSX.

Rail revenue and shipping capacity
While slow freight train speed affects delivery time, many delays are caused by congestion at major rail hubs and insufficient total rail capacity to meet increasing shipping demands. As the economy continues to grow, railroads have to keep pace with the rising need of moving more freight around. Since rail tracks were first laid more than 180 year ago, America's railroad landscape hasn't seen much of a staggering transformation. Today, freight trains still share tracks with passenger trains and must grant Amtrak and other commuter trains the guarantee of passage. Without further expansion, the current 200,000 miles long U.S. rail network may be running out of reach as the economy continues to pull ahead of it.

Unlike public highways, waterways and airways, railroads are maintained privately by railroad companies that build and own them. To be fair, railroad companies spend far more than average U.S. manufacturers in capital expenditures. Data show that railroad companies spend 17% of their revenue on capital expenditures, compared to 3% for manufacturers. Also, largest U.S. railroad companies each year spend more on their tracks and infrastructure than most states spend on their highways.

Rail investments and growth
But most of the spending is on maintenance of current tacks and equipment, rather than on new investments to expand capacity and increase efficiency. New investments are what will more likely lead to improved services and generate more sales, and more revenue can feed right back to further investments, creating a positive business cycle. Without continually growing revenue to support, at least, the massive maintenance costs, current business practice at railroad companies may not be sustainable in the long run, and risk having poorer quality of services and potentially staggering sales.

Major railroad companies largely operate within their own rail networks, with Union Pacific and BNSF mostly in the West and Norfolk Southern and CSX in the East and Midwest. So, despite low shipping charges, operating margins at railroad companies are rather satisfactory, all in the 30% range, when the lack of competition creates no additional pricing pressure.

But without eventual increases in the amount of freight they can haul each year, railroad companies will see less earnings growth and thus, slower expansion of shareholders' equity for their investors. Growing shipping demands have to be met by increased rail capacity that can only come from building additional track routes, even though the investment costs may cause some earnings bumps in the short run.

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Jay Wei has no position in any stocks mentioned. The Motley Fool owns shares of CSX. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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