Tom Slee writes:
The railways are on a roll! We could even be seeing a replay of their Gilded Age more than 150 years ago. Spurred by strong housing related and auto shipments, the major carriers are racking up impressive earnings. They are also tapping new markets. Carloads of petroleum products jumped 47% year over year in the first quarter and should exceed 250,000 barrels a day by the end of 2013. This is a permanent, growth business. "Rail pipelines" have added a new dimension to the energy industry by giving refiners access to crude from different regions at different prices. Now they can shop!
North American railways emerged from the worst economic recession since the Great Depression in good shape. As a result they have relatively strong balance sheets and substantial cash flows to support dividends and share repurchases. This alone makes them attractive for investors seeking income and growth. It gets better. The railroads are also one of the few groups able to make price hikes stick in this still spluttering economy. More important, these companies are no longer just another cyclical industry dependant on coal and grain shipments. They are rapidly evolving into a major growth sector with sustained earnings power. Just take a look at their capital spending programs.
Almost unnoticed amongst the debate about decaying infrastructure, U.S. railroads are in the midst of a building boom. This year alone, they plan to pour US$14 billion into new yards, refueling stations and additional track. Here in Canada, CN Rail intends to spend almost $2 billion upgrading its facilities by making major investments in trans-loading and distribution equipment linking rail and truck. Even at Canadian Pacific, where new CEO Hunter Harrison is slashing and trimming, there are plans to spend $1 billion a year until 2016 on capital improvements. Obviously these are not just repairs and maintenance programs. Massive structural change is underway.
Some companies are building vast terminals that resemble inland ports. They are also turning their tracks into double-lane freeways to capture a large chunk of total U.S. freight business, a business that the Department of Transport estimates will double to US$27.5 billion by 2040. We are going to see dramatic changes in the handling of intermodal traffic. At present companies conduct most of this lucrative business with single container shipments. Stacked containers are the next step and this involves substantial changes to the systems as companies enlarge their mountain tunnels and raise the height of bridges. "SuperHub" arrangements, copied from the airlines are being introduced and allow trains to be sorted and redirected to various destinations.
At the same time, there is a concerted effort to reduce running expenses. Several railroads, including CN Rail, are testing natural gas powered locomotives. To put that into perspective, a gallon of diesel fuel costs about $4. The equivalent of natural gas can be had for 50 cents. Enough said. Meanwhile, trucks and airlines face increasing transportation costs.
It's all very encouraging. The really big news, however, is that railways promise to be the next great resource play. The major carriers are perfectly positioned to benefit from rising shale oil and gas production, especially in the Bakken region, which covers parts of Montana, North Dakota and Saskatchewan. This is a game changer. It is estimated that the Bakken formation could hold as much 4.5 billion barrels of recoverable oil, a size that would qualify it as a member of OPEC. Production could hit a million barrels a day by 2020 and solve many of North America's energy shortages.
There is just one snag: insufficient pipelines. Producers are already facing long-term bottlenecks. So they are turning to the railways in a big way. According to the National Bank, rail pipelines already account for 5% of total Canadian railroad traffic, a tenfold increase from three years ago. Canadian Pacific, for instance, anticipates moving 70,000 carloads of crude this year and expects to increase this traffic to about 200,000 barrels by 2016.
Originally the idea of railways carrying oil seemed like a stop-gap measure - a burst of short-term business until the pipeline companies got organized and started shipping production. Instead it's turned into major long-term traffic for the railways. New pipeline proposals are running into all sorts of political and environmental opposition. The days of crews moving in and quickly laying new links are long gone. Railways on the other hand are able to build spur lines without much trouble and operate them profitably with relatively little volume.
Of course, this is not going to be money for jam. At the end of the day, it costs about twice as much to ship oil by rail as opposed to pipeline, some $5 to $10 more a barrel. The pipeline companies will persist and eventually build facilities to siphon off a lot of this shale production. However, it's worth keeping two things in mind. First of all, frakking, as it is known, is a two way business for the railroads. They ship oil out and carry sand and gravel used for fracturing shale on the return trip. Second, shale oil and gas production is underway in lots of remote places essentially isolated except for a railway. It will never be economic for pipelines to link these small operations. The producers will have to rely indefinitely on railroads to move their output and bring in raw materials.
What does it all mean for investors? Well, these structural improvements and the new business are already being reflected in the companies' operating results. Overall first-quarter carloads were up 1.7% on average for the six major Class 1 railroads. If you exclude the highly volatile coal and agriculture business, the volumes were even more encouraging. For example, the lucrative merchandise segment was up 4.1% for the quarter compared to 2012 and intermodal traffic grew at a robust 5.7%. All of the six major carriers turned in good numbers.
Union Pacific (UNP), operating the largest route network of any Class 1 railway, reported a profit of US$2.03 a share, up 13.5% year over year and well ahead of the US$1.95 consensus estimate. Revenues were higher than expected and UNP's operating ratio (the portion of top line income used to run the system) came in at an impressive 69.1%. This is an excellent stock but currently trading at US$158.13, it's fully priced.
CSX (CSX), the largest operator east of the Mississippi, earned US$0.41 in the first quarter, slightly more than the US$0.39 analysts were expecting. To celebrate, the company announced a 7% dividend increase to US$0.60 and a new US$1 billion share buyback program. Earnings could reach US$1.85 a share this year but I am a little concerned by management's relatively subdued guidance. Coal remains a drag on volumes. Its current market price is $25.02.
Kansas City Southern (KSU), the smallest Class 1 carrier, made a first quarter profit of US$0.94 a share, beating the US$0.88 consensus forecast. This is a company well-placed to benefit from oil shipments because its rails link the Bakken play with refineries on the Gulf of Mexico. Here again, however, the stock at US$110.47 is relatively expensive.
Canadian Pacific (TSX, NYSE: CP)'s new management team turned in a remarkable first-quarter performance. Earnings of $1.24 jumped more than 50% from $0.82 the year before. Obviously this is a company in transition and we should see further improvements during the next year or so as CEO Hunter Harrison breathes new life into the system. For example CP aims to renegotiate over $200 million of inadequately priced contracts. Sales of excess real estate could generate more than $1 billion of new cash and some analysts are looking for a 25% dividend increase by early next year.
I missed the dramatic move in this stock because the chances were that productivity improvement would be gradual. Instead, Mr. Hunter waved a magic wand and started turning things around immediately. The shares soared. Now priced at $129.16 they are trading at just under 21 times this year's forecasted earnings of $6.25 a share. I am not inclined to chase them although some investors may want to take a position on weakness and bank on Hunter Harrison producing more pleasant surprises.