In this episode of Industry Focus: Energy, Nick Sciple chats with contributor Lou Whiteman about the railroad industry. They provide an overview of the railroad industry, the major players operating in this sector, the goods they carry, their impact on the economy as a whole, and much more.

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This video was recorded on May 28, 2020.

Nick Sciple: Welcome to Industry Focus. I'm your host Nick Sciple. For today's show, we'll be taking a look at railroads and their prospects for investors. Joining me to help break it all down is Motley Fool contributor, Lou Whiteman. Lou, welcome back on the show.

Lou Whiteman: Thank you. Good to be here.

Sciple: It's great to have you on, as always. As I mentioned, we're going to talk about railroads today on the show. This is an industry that's been around 160 years or so. Very consolidated, only a few major players in North America.

When you're looking at this industry today, obviously, not a lot of incredible growth prospects going forward. When investors go to invest in railroads today, what are they looking for?

Whiteman: Well, for one thing, yes, there's not a lot of growth for the industry, but we shouldn't gloss over how important this industry is. I mean, this is the industry that is the backbone of this country and you can read a lot into what's going on in the broader economy by looking at the railroads.

This is an industry that, yes, it's consolidated, we still have some of the companies that have very mashed together names to reflect their history. We have basically four publicly traded major railroads in the U.S. and other two in Canada, and then Warren Buffett owns a railroad. That's all we have for the entire U.S.-Canadian transportation system. They are carrying the bulk of the goods that are going around this country. They do have some opportunities for growth, they do have some risks to what they've done historically, but it's an interesting sector to, both, look at the broader economy.

And as I think it was Norfolk Southern, they had an ad in the late-90s, back in the dot-com boom. They said, you can't move steel via the internet. It's a subtle little way to remind you that the economy changes, the world changes but we still need rail. And I think that's very true, that's true as today as it was in 1999.

Sciple: Absolutely, it's key infrastructure when it comes to letting trade happen in the U.S. and really across the world. I pulled a quote from Warren Buffett; it was an interview back in 2009. CNBC journalist asked him if he could have one economic indicator that he could check while he's stuck on a desert island? He answered, freight car loadings. And that just shows how important the railroad industry can be to gauging the overall macroeconomy. When you look at freight car loadings, obviously, this year has been significantly impacted by COVID, but we've seen declines through 2019, isn't that right, Lou?

Whiteman: Sure. Things were already trending in the wrong direction before COVID hit, you know, it's an open debate and we can figure it out 10 years from now when we're looking back, whether or not it was a sign the economy was slowing or if it was some of the trade wars tariff issues were just waiting on it, would've been short-term.

Certainly, what might have been short-term has now become prolonged, and COVID isn't helping. The industry trade group, the AAR, the Association of American Railroads, they do weekly stats. Total carloads were down 30% year-over-year for the week of May 16th. That's the biggest year-over-year weekly decline since 1988, when they started compiling the numbers. I mean, even if you go back to 9/11 and all the disruption there. That is what we're dealing with here, it is unprecedented.

And as I said before, as the economy goes, the railroads go. Certainly, with everything going on in the macro environment, the railroads are feeling it.

Sciple: Absolutely. I mean, any time trade slows down, whether it's because of tariffs or because of a global pandemic, that's going to impact freight volumes and impact the railroads. When you look at the prospects for railroads going into the future, one of the big talking points when it comes to their role is, how energy efficient they can be relative to other forms of logistics. Can you talk about that, Lou?

Whiteman: Sure. And it is important to remember that transportation by its nature is a contributor to greenhouse gases and global warming. So, this is the best of the worst, but yeah, railroads, compared to other forms of transportation, are very efficient, about 4X more fuel efficient than trucks.

And the logic for that is simple, you can carry a lot of freight in one train with one or two locomotives versus one truck. Moving freight by rail versus truck reduces greenhouse gases. I think there are estimates for about 75%.

In 2018, one gallon of fuel moved one ton of freight by rail, an average of 473 miles, which is up more than 100% since 1980. So, I mean, this is an efficient way to transport to begin with, and also, there's been a lot of energy and a lot of investment into locomotives in recent years if they continue to become greener.

Sciple: Absolutely. And so, when it comes to one of the most energy-efficient ways to transport goods, railroads really have a role to play and there's a little bit of a tailwind there. However, the other side of that green energy coin is negatively impacting railroads. When you look at total railroad grossed revenue in 2018, about 14% of that came from coal, about 31% of the tonnage carried by U.S. class one railroads comes from coal. Obviously, coal is one of the dirtier fuels we produce, and its share in our energy production in the U.S. has declined in recent years. When you look at secular decline in coal consumption and its effect on the railroads, how is that impacting these businesses?

Whiteman: Yeah. And just to underline that number, because it really is an amazing number, 31% of the tonnage for class one railroads. And you know, it's even worse than that, because a lot of that, that's not split evenly among the railroads. There are two East Coast focused railroads, that is a huge part of their business.

Coal is on the decline, and that's a good thing. But that will, either the railroads will be smaller or they will figure out alternatives, other things to do with their trains in the years to come, because they did very well through history by being reliant on coal, but I don't think that trend is reversing, the railroads are very aware of that. They are assuming it's going away over time. And that is a huge chunk of their business that needs to replace or they are smaller companies going forward.

Sciple: Right. And that ties into some of the operating decisions railroads have made in recent years as these volumes of coal and other goods have declined somewhat, the railroads have had to make up for that by getting their cost structure under control, which brings into this precision railroad scheduling initiative that lot of railroads have adapted in recent years. Can you talk about that, Lou?

Whiteman: Yeah, PSR they call it, and this is almost a religion sweeping through North American railroads. If you want to understand the industry, you've got to spend a little time with PSR. The idea of PSR is to simplify your operations. Railroads, traditionally, have been an on-demand business. They are moving stuff through their huge hubs as you need it. If you run a big company, if you need to transport stuff, you call up my railroad, I will make it happen.

PSR is the process of moving the schedule to the railroads' terms and to a more point-to-point where we are going to run this train on this day. If you want to book your space, let us know. That's a very oversimplification, but the idea of it is, instead of being an on-demand carrier, we are going to have fixed schedules, operate point-to-point where we can make money. And it started in the late-1990s, it took off in Canada first, because it started in a railroad that has now been acquired by one of the Canadian ones.

It really came to the U.S. in 2011 -- or came to North America. Bill Ackman, the famous activist/investor got involved in Canadian Pacific and brought the architect of PSR to Canadian Pacific and saw a great turnaround. That guy was then poached by one of Ackman's proteges to run CSX which is also an activist situation.

Almost all the railroads now are in some portion of implementing PSR and they are bringing down their operating ratios, which is just the expenses divided by revenue, they are trying to become more efficient, in part, because to keep up with peers, but in part, because some of the secular pressures against the businesses.

Sciple: Yeah. And that you're seeing significant headcount reductions, you're seeing in some of these railyards that were less profitable, those getting shut down, really consolidating the operations to where things are most profitable. You mentioned pretty much every railroad has adopted this PSR strategy, the one notable exception is BNSF, the railroad that Warren Buffett owns.

Whiteman: Yes. And I think that's really interesting, because this is basically -- and again, to be blunt about it, the good news is, you have fewer employees, fewer locomotives, lower cost throughout the network. The bad news is, you are making your customers operate under your schedule. Now, that is very good for the near-term and for the quarter-to-quarter it makes you run a lot better.

Will you alienate your customers? Do they have no other choice? That is the big, sort of, unknown. Also, how much can you grow off of this? I mean, at some point, if you have to add trains, if you have to add infrastructure, is this a one-time hit that slowly erodes or is this a permanent thing?

Warren Buffett, in February, talking to CNBC was asked about PSR. He said, you know, we've been watching it, it makes the customer adapt to the railroads more than the railroads to the customers, practically everyone has done it, it has improved margins dramatically. On the other hand, we've gained market share because railroad customers apparently like us better.

He said, you know, we can always add it later, if we need to. But I do think -- I mean, I understand, if you're a publicly traded company and you see your peers bringing down expenses and operating more efficiently, especially since there's been so much activism. Yes, you're going to do this too.

I think Buffett has. You know, without the quarter-to-quarter mileposts, they have more ability to take a wait-and-see and see how it goes. I don't know who's right and I'm kind of glad we have an outlier so we can see over the years, but I do think there's definitely near-term gain, there is long-term risk that investors need to be aware of.

Sciple: Yeah, when you talk about getting all those costs under control and maybe some potential downsides, we didn't discuss this before we came on the show, but it makes me think about some of the issues that maybe came across 3G Capital with their investments in Kraft Heinz, they had really focused on cutting costs over time and that really left them flatfooted when the industry changed.

Whiteman: Yeah. No, I mean, I think, this is always the trade-off, and you've seen this time and time again, especially in companies that have activist pressure. The right decision, the kneejerk decision is always the short-term decision. Sometimes that's a good long-term decision and there's companies that have had great turnarounds, sometimes you are costing yourself further growth or setting up long-term risks.

You certainly see where the potential is, you can't build more railroads, you can't build more rail lines. So, in a way, they need to get more efficient, even if they end up throwing more trains on it. So, to some extent, this drive for efficiency makes sense.

But, look, when CSX started this, they were called before the regulators because there were so many complaints. Some of that's been even out and part of it is, when you're trying something new there are going to be issues at the beginning. It's not a reason to stay away, but it is something, if you're even considering looking at the railroads, you need to be cognizant of this, watch this, because I don't think it's a foregone conclusion, it's just good and there isn't a downside.

Sciple: One of the things I wanted to touch on from the efficiency part of the business, before we talk about some of these major players in the railroad industry. We talked about, before the show, this idea of increasing autonomy when it comes to the railroad industry. Obviously, you have a fixed route, you are attached to the rails, so it's much simpler to automate your process relative to, say, you know, a self-driving car.

Obviously, if you can automate your rail line, you can reduce even more expense, particularly you don't have to have a conductor on the train, but when we were talking about this before the show, you mentioned one aspect of that when it comes to efficiency that I didn't think about when it comes to their competition with trucking.

Whiteman: Yes, you're definitely right, the track is a wonderful thing [laughs] as far as self-driving. It makes sense for it to come to trains before cars. But I think the stat earlier was, what? You can take a lot of trucks off the road with one train.

By definition, the trains run with fewer employees, massively fewer employees. Yes, it's good; yes, you save a little; and, yes, you have more automated control and you can maybe avoid accidents, but you're not going to see -- if you're going to eliminate truck drivers, there's a lot of truck drivers out there. Relatively speaking, as a cost part of the business, one train employees are not that big of an expense for the railroads. It's probably also people back at headquarters running these things anyway.

So, you know, I mean, yeah, so I think it's a step in the right direction, it's where we're moving. I think it's going to do more for fuel management and issues like that just running a steady training than it is headcount.

Sciple: Right. It's just, you know, when you take into account the cost structure, how much goes into employment for a railroad relative to a trucking company, really, really significantly different. And so, that's a boost, but it's not nearly a boost that it might have for other parts of the logistics infrastructure.

So, we talked earlier about how the railroad industry is significantly consolidated. Obviously, it's been operating for in excess of 100 years, very capital intensive. That'll help consolidate your industry over time. Really hard to separate these folks out when it comes to their operations, because, really, they're just functionally providing logistics for all types of goods. But regionally, I think that's one area where you can separate these businesses apart.

Whiteman: Yes, you can. And think about it toward the coasts. You have two railroads operating basically the West Coast to Midwest, you have two going from the Atlantic into the Midwest, and then you have two in Canada and one hybrid.

On the West Coast, you have Union Pacific (NYSE:UNP) along with Warren Buffett's railroad. On the East Coast you have Norfolk Southern and CSX. CSX, of course, a government-created company basically that is a combination of dozens of railroads that went out of business in the 70s.

You have a duopoly in Canada between Canadian Pacific and Canadian National, and then you have Kansas City Southern (NYSE: KSU) which has the most unique route map. They, as the name implies, they are very big in the Midwest, but they have an extensive route network down through Mexico and, kind of, down the spine of North America. That gives them some interesting competitive dynamics.

But basically, CSX, for the most part, is not competing against Union Pacific. And Canadian National is not competing in Florida with Norfolk Southern. They are competing against each other, but it's mostly duopoly everywhere you go.

Sciple: Absolutely. You know, I'd say one on CSX, there's a CSX line literally right behind my house, right behind my apartment, that comes by every single day. And I think this is an example of how important these railroads can be on coal. Two days ago, I looked out my back window and we had about a two-mile train come by. Two locomotives on the front, two locomotives on the back and about 100 coal cars in between. So, an entire CSX train carrying that coal.

And, I think, those folks in the Eastern part of the country are exposed to that maybe in a more significant way than a company like Kansas City Southern being tied into that U.S.-Mexico trade part of the business.

Whiteman: Yeah. I mean, this is speaking very broadly, but you can say, the East Coast railroads are the most exposed to coal, they also, just by the nature of the geography, they are dealing with a lot of 200-year-old tunnels almost. There's a famous tunnel in Baltimore that for years was costing CSX 5% on their operating ratio, because it was so old and they had to go slow and single-track through it. There's a lot of urban congestion, a lot of short stage lengths, which tend to bring up costs.

The West Coast, you have much longer stage lengths; imagine if you get to travel between Denver and the West Coast versus traveling between Washington DC and Boston. Again, it's a bad example, so you do have more efficient operations that way. Less coal, they have some coal, but they have in recent years been very exposed to fracking and the shale, especially in the Dakotas. So, they do have energy exposure. The ports are very big. You know, Los Angeles, in particular, for the West Coast railroads.

Canada, some of the same dynamics, because they do have some energy, but Canadian railroads tend to be very tied to agriculture. They tend to have nice long stage lengths. And historically, they've run better than the U.S. ones, the U.S. railroads have been playing catch-up.

And then, as you said, Kansas City Southern is going up-and-down the coast. Kansas City Southern has an interesting dynamic. They have a port in Mexico and they basically run the port and they can bring things right up through Texas to the Midwest. And for shipping efficiency, compared to going through Los Angeles, that can be the quickest way to get stuff to Kansas City, it's certainly the quickest way from the Mexican ports to get things from the Gulf Coast and into the Midwest. They are a really interesting company, especially when you're talking cross-border trade, and that's going well.

Sciple: Yeah, I think, one of those other aspects when you talk about Kansas City Southern, there's been a lot of conversations around, during COVID, of this idea of bringing more supply chains back to North America. And when you look at their routes, their location in Mexico, particularly, after the USMCA has been passed, this new NAFTA that Trump put into place, there are some potential tailwinds for them to grow if onshoring really does come to pass.

Whiteman: Sure. They, for years, have been the most politically charged company. I mean, you can look at their stock chart at the beginning of the Trump administration when walls and borders and breaking down NAFTA were a lot of the headlines. That stock did not do well during that period and it was very volatile as these headlines came and went.

Now, they're getting some of those tailwinds. And, yes, there is real potential. If you believe that some of the supply chain is going to move, maybe not back to the U.S., but at least North America, they have a very good network to connect Mexico to the industrial Midwest.

You know, who knows what's going to happen. The early days of the Trump administration when we were talking the other way are a reminder of how fleeting these trends can be or how ideas don't necessarily come to pass. But it's a very interesting thing. We should also note that these companies tend to trade in multiples similar to each other. Kansas City Southern, when times are well, and right now does trade at a premium. So, there is -- we're not the first to have this revelation, obviously.

But if you believe in that, if you believe strongly that we are going to see some sort of ensuring, at least, through North America, Kansas City Southern is a great way to play that.

Sciple: Okay, Lou, we're, kind of, wrapping this all, we've, kind of, given a high-level look at the industry, how its role in the macroeconomy, the goods that it transports and the major players in the industry. We've talked about how they differ from each other. If you had to pick one of these companies to invest in today, which would you choose and why?

Whiteman: And we should say, like I said, they tend to trade together for a good reason. I mean, they're all reinventing together now. So, there are different ways to run a railroad, but at the end of the day, this is a pretty base company with a pretty simple business model.

They can be hard to differentiate. I think Union Pacific has been, over the long-term, the best-run railroad that you can buy into. They also give you the top dividend, as of close yesterday, it was 2.18%, which isn't bad in this environment. CSX was down 1.3%, so there is separation there.

I prefer to watch the railroads, and I haven't bought into the railroads, if I was to buy one, it would probably be Union Pacific. Some others to look at; as far as on the East Coast, I think, Norfolk Southern offers more upside because they are newer into this PSR, so they're going to see more of the benefit in the quarters to come. CSX has done all the low-hanging fruit by now.

And we just talked about Kansas City Southern, but depending on where you think trade is going and where U.S.-Mexican relations are going, that is a jewel of a franchise. And, yes, you're paying maybe 25X earnings for them versus 17X to 20X on the rest of them, so you are paying a premium. If all goes well, they should be able to justify that premium.

Sciple: Yeah, I think, for me, it has to be Kansas City Southern. Just because that's the one I can really articulate a growth thesis for them, a tailwind for them separate-and-apart just from the broader macroeconomy firing on all cylinders. But I think, whether you want to invest in this sector or not, I think the railroads are an important sector of the economy to understand given how important they are to trade, and they're not going away anytime soon.

Whiteman: Right, they'll be here.

Sciple: Yeah, we talk about David Gardner's Snap Test, you know, the test of whether these companies are structurally important. Snap your fingers, if they disappear tomorrow, would you notice it? And I think every one of these industries you would notice very quickly. People don't realize how important this industry is to getting all those goods that you buy and use every day, but if they went away, you would notice real quick.

Whiteman: Absolutely. And again, in this environment, a 2% dividend to sit around and wait for the good times too is not bad.

Sciple: Alright, Lou, thanks as always for coming on the show.

Whiteman: Pleasure.

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.

Thanks to Austin Morgan for making us sound so nice. For Lou Whiteman, I'm Nick Sciple, thanks for listening and Fool on!