Economic Moat Crossing Ahead: Railroads Advance to Wide

Economic Moat Crossing Ahead: Railroads Advance to Wide

By Keith Schoonmaker, CFA | 08-26-13 | 06:00 AM | Email Article

We have upgraded the six North American Class I railroad economic moat ratings to wide from narrow because of our increased confidence that the rails will continue to improve operating ratios, and consequently, returns on invested capital. In the past, we considered the railroads’ excess returns too paltry to warrant assurance of long-run sustainable economic profit, but the railroads have demonstrated strong resilience through trials of recession-weakened freight and the decline in coal volume over the past several years. Based on this performance, we now are confident that rails will leverage their competitive advantages of low cost and efficient scale to generate positive economic profits for the benefit of share owners with near certainty 10 years from now, and more likely than not 20 years from now; by our methodology, this defines a wide economic moat.Railroads Derive Economic Moats From Low Cost and Efficient Scale

Barges, ships, aircraft, and trucks also haul freight, but railroads are the low-cost option by far where no waterway connects the origin and destination, especially for freight with low value-per-unit weight. Moreover, railroads claim quadruple the fuel efficiency of trucking per ton-mile of freight and make more effective use of manpower despite the need for train-yard personnel, in part because of greater rail-car capacity and longer trains. Even for goods that can be shipped by truck, we estimate railroads charge 10%-30% less than trucking containers on the same lane.

Railroads operate at an efficient scale, and we believe no new railroads will be built in North America. Efficient scale followed industry consolidation escalated by the 1980 Staggers Rail Act that permitted extensive rail-line sales, abandonment, and combination. North America had more than 40 Class I rails in 1980, and today, just seven (a Class I generates at least $452.7 million of 2012 operating revenue; functionally independent freight railroads over this inflation-adjusted threshold numbered about 20 in 1980). The Staggers Act also allowed private contracts and rate setting. On all but the busiest lanes (like Wyoming’s coal-rich Powder River Basin), a single railroad generally serves an end-of-the-line shipper, and only two railroads operate in most regions of North America. Indeed, we opine that absent government intervention, the rational number of competitors on the continent would be two, via additional consolidation, since in most regions customers already have only two capable providers. The steep barrier to entry formed by the need to obtain contiguous rights of way on which to lay continuously welded steel rail spanning a significant portion of a huge continent fends off would-be entrants. Railroads may build new spurs or restore abandoned lines, but because of massive barriers to entry, we don’t anticipate any new main lines will be built.

We believe large-revenue North American railroads will continue to improve operations and raise rates as they have since around 2004. Operating improvement in the railroad renaissance is well known. Following extensive consolidation, railroads increased the length of hauls–a significant efficiency driver–and once rails got religion on pricing discipline, they renewed legacy contracts with shorter contracts and effective fuel surcharges. From the similar operating ratio trajectories (OR=operating expenses/revenue) and convergence at around 70%, all rails except  Canadian Pacific (CP) have improved profitability materially and similarly; margin is not the distinguishing factor it was just five years ago. Further, based on rapid action taken since his installation a year ago, we believe CP’s new CEO Hunter Harrison will catalyze improvement as he did at both the Illinois Central and  Canadian National (CNI), such that CP reaches the OR range of its peers within the next three years.

The key to economic moats for railroads is pricing adequate to cover costs, including required reinvestments. In this area, the rails are acting more rationally than in the past, as the attitude of “lose money on every car, but make it up on volume” has gone the way of the dinosaur in an era of modern management. Extensive consolidation facilitated pricing rationality, and pricing is much improved from decades past, but it is not unbounded. The Association of American Railroads is quick to point out, however, that real rates are still around 50% of 1980 levels. Market trucking rates constrain railroad pricing for containers and box cars; on routes with no competitive mode like barging or trucking, the Surface Transportation Board threatens rate cases (constraining pricing to 180% of variable costs–we comment below). However, sustained pricing power at a rate greater than what we currently project (perhaps from constrained truckload capacity) and additional progress in labor efficiency could improve margins even further than the remarkable progress made in the past decade. Critical in pricing is beating inflation–compounding the top line 4% and expenses at 3% improves the operating ratio over time. Railroad inflation seems to run around 2.5%-3.0%, and during recent years railroads have typically reported core “same railroad” pricing gains in the 3.0%-4.0% range. For example, Union Pacific still benefits from greater legacy contract repricing than others and improved its core pricing 4.5%-6.0% annually during the past five years. CSX reported that second-quarter 2013 core rates improved 4.1% excluding export coal and 2.3% including export coal–still greater than inflation even while export coal pricing is declining.

Railroads have a stable moat trend and will continue improving operations and raising rates. A generation of management more professional than predecessors are running railroads equipped with technology to evaluate carload profitability, plan routes, schedule crews, monitor maintenance, locate cars, select locomotive throttle position, remotely control yard trains, and save fuel. Importantly, now-disciplined rails have practiced rational pricing since around 2004. However, by now these cost advantage enhancements are de rigueur industry practices, not changes in competitive advantage. Most of the six publicly listed railroads produce operating ratios converging at around 70% and still improving, having improved profitability materially and similarly.

Based on our expectations of persistent pricing power and stronger operations, we project railroads will produce returns exceeding their cost of capital; our confidence in this improvement triggers our change to a wide moat rating. When we initiated railroad coverage in 2008, we assigned narrow economic moats even though excess returns were recent and generally modest. Morningstar defines narrow-moat firms as those we expect to produce excess normalized returns that are more likely than not positive 10 years from now. In addition, there must not be any substantial threat of major value destruction. Wide-moat firms’ excess normalized returns must with near certainty be positive 10 years from now. Further, excess normalized returns must more likely than not be positive 20 years from now. While we project discrete volume and yield for just the next five years, economic profit has become positive and greater during recent years, and we expect this will not reverse due to the aforementioned competitive advantages.

Railroads are amplifying their cost advantage by making increasingly effective use of two of their most expensive inputs: labor and fuel. Regarding the former, railroads are producing more ton-miles per employee than in the past. This is due in part to larger cars, plus increased velocity, reduced terminal dwell time, and more effective work rules and practices. Concerning the latter, the Association of American Railroads reports that in 2012 U.S. railroads moved a ton of freight 476 miles per gallon of fuel, up from 414 ton-miles per gallon in 2005 and double the 235 level of 1980. This was accomplished via larger cars, more-fuel-efficient locomotives (including generator set locomotives that switch on separate engines as loads demand), idle reduction technology, throttle position selection guidance software that learns a route to optimize fuel and safety, distributed power to reduce required horsepower, rail lubrication, and locomotive engineer training and incentives.

Viewed Through Porter’s Lens, Railroads Appear Advantaged
We consider Porter’s five forces all low to medium for railroads, giving them a strong competitive position. Morningstar Economic Moat Ratings rely on identifying at least one sustainable source of competitive advantage from five possibilities: cost advantage, customer switching costs, efficient scale, intangible assets (like brands or patents), and network effect; we characterize railroads as having both cost advantage and efficient scale. Porter’s framework is not our standard methodology, but observations about how well the rails fare in this structure reinforce our confidence in our Morningstar moat source-based opinion.

Threat of new entrants is low. Class I railroads benefit from colossal barriers to entry because of their established, practically impossible-to-replicate networks of rights of way and continuously welded steel rail. Despite this, railroads earn returns only just above their cost of capital, as some noncontractual rates are government regulated, and, on a cash basis, expansive hardware demands a level of capital reinvestment exceeding that of most other industries. When in 2008 Canadian Pacific purchased the DM&E line in the Dakotas and Minnesota, it opened an option to extend its line more than 230 miles and upgrade hundreds of additional miles of track to become a third railroad hauling coal from Wyoming’s Powder River Basin (in addition to Burlington Northern Santa Fe and Union Pacific), but we doubt the rail can secure the requisite billions of dollars of capital for the largest railroad construction project in a century, and indeed, CP indicated last year that it plans to divest a portion of this line.

Bargaining power of suppliers to railroads is low to medium. Most suppliers have low negotiating power with Class I railroads, given the relatively large size of the rails. The vast majority (we estimate 85%) of rail labor is unionized, but relationships with the unions are healthy partnerships for the most part. Work rules are becoming more flexible with new generations of rail workers, and thanks to retirement-driven attrition, we expect railroaders to become even more productive in the near future. While the Class I rails are among the largest consumers of diesel fuel in the world, modern contracts enable fuel prices to be passed through to customers via effective fuel surcharges. Only two manufacturers supply diesel-electric motors to North American railroads:  General Electric (GE) and  Caterpillar (CAT) (Cat acquired Electro-Motive Diesel, for decades a GM operation, in 2010). As part of a set of a limited number of domestic customers, the rails purchase from both suppliers, keeping each from gaining much pricing power. Some rails, like Norfolk Southern, prefer to handle full maintenance and rebuilding in-house, essentially constructing a new locomotive from a retired steel frame when a locomotive becomes unreliable or too costly to maintain.

Bargaining power of railroad customers is low. Rail customers have few choices and thus wield limited buyer power. Persistent rail rate increases since 2004 and effective fuel surcharges are evidence of low customer bargaining power. Rails operate as a duopoly in most markets and may even be a monopoly supplier to the end client in many cases. Large utilities and parcel shipper UPS have some negotiating power ( FedEx (FDX) just began using the rails in scale about two years ago), but pricing has become more rational in recent years as rails abandoned heavy discounting to grab share. Increased government intervention may constrain future pricing and discourage reinvestment, but we believe market rates will prevail in the long run, since many constituencies are well served by railroads (unionized employees, environmentalists, taxpayers funding highways, shippers, and consumers). Among rails, Canadian Pacific has the greatest exposure to a single client, earning about 10% of revenue from coal miner  Teck Resources (TCK).

Rivalry is medium. Railroads operate as a local monopoly or duopoly in most markets. Rails developed increasingly rational pricing during the railroad renaissance; around 2004 we believe rails became more disciplined about chasing profit instead of volume. Only two competitors operate in most regions, and this duopoly in most markets is critical to pricing power, in our opinion, and we don’t see this structure changing. In fact, we believe North America would be most efficiently served by additional consolidation into just two transcontinental railroads, since nearly all markets have only two railroads today. Practically, from the time BNSF and Canadian National proposed to merge in 1999, additional mergers and acquisitions have been forbidden by the Surface Transportation Board, with only small  Kansas City Southern (KSU) likely exempt from this restriction.

Threat of substitute services is low to medium. Few railroad customers have modal options. Shippers of boxcars or intermodal containers can shift to trucking, but generally this comes at a cost premium, and intermodal has been making headway for quite some time. Generalizations about intermodal cost savings versus trucking are imprecise since rates vary by lane and distance; we estimate shipping via intermodal typically saves 10%-30% versus trucking. However, trucking can become somewhat more competitive when the industry has excess capacity, since truckers will bid down rates to low levels to preserve asset utilization. Trucking offers high service, since truckers typically haul directly from shipping dock to delivery dock in a dedicated container, but within a couple of decades we believe intermodal shipping will make long-haul trucking uncommon. Already intermodal lanes like Los Angeles to Chicago require at most a day more than trucking, and we expect trucking to become decreasingly competitive on long hauls because of rails’ fuel efficiency per ton-mile (which is quadruple that of trucks) and perpetual truck driver shortages. Shippers of bulk commodities like coal or stone located near waterways flowing to appropriate destinations have an alternative to rails, but since water is already the cheapest mode (one requiring no owner maintenance, unlike rails), customers able to ship by barge already do so; thus, we consider barging to pose little threat to current railroad volume.

Regulation and Declines in Coal Demand Threaten, but Don’t Derail Railroad Moats
Barring commercialization of freight teleportation, the loss of pricing power and lower coal demand are the greatest threats to railroad moats, but investors ask about risks like excess leverage and high fuel prices as well. We consider the latter two mostly mitigated, and minor by comparison with price and coal. Leverage is not the risk some still may associate with rails. Investors may recall with some trepidation the largest U.S. bankruptcy at the time, the 1970 Penn Central failure (before the 1980 Staggers Act). Today, all Class I railroads are rated investment grade via the independent Morningstar credit rating methodology, and the other common issuer-paid rating agencies as well. Just months ago, Kansas City Southern joined this club. It’s true that railroads are huge consumers of diesel fuel, but they improve fuel economy regularly, and the fuel surcharge mechanism largely insulates rails from the full brunt of price increases, albeit on a time lag of two months, thus affecting quarterly earnings when fuel prices are increasing or decreasing. Trucking also uses fuel surcharges, but high diesel prices favor the rails; the AAR claims rails carry ton-miles of freight per gallon of fuel quadruple that of trucking. Even as rails put through cost increases to customers, they concurrently strive to increase fuel economy.

So-called re-regulation is a risk to pricing power but one we think unlikely to affect moats in the long run. “So-called” because rails have been regulated for decades in many safety, rate, and antitrust aspects. The Federal Railroad Administration and the Surface Transportation Board, the principal railroad regulatory agencies, which are part of the U.S. Department of Transportation, can impose penalties and restrictions on U.S. operations. For example, the Rail Safety Improvement Act of 2008 required railroads to purchase and install positive train control (an IT network designed to automatically stop a locomotive ahead of a dangerous situation). Compliance is likely to cost the U.S. railroads $1.0 billion-$1.5 billion to implement by 2015, then around a couple hundred million dollars annually to maintain, consuming around $10 billion of shareholder capital by 2020 unless some public-private partnership is forged whereby taxpayer funds would be added to those of shareholders.

Generally, however, discussion of re-regulation really concerns price constraints. Rail pricing power is enabled by a duopoly structure in each region. In this advantageous market, professional management teams are acting rationally, enabled by per-load profit visibility. Additionally, effective fuel surcharges are standard industry practice, mitigating diesel price risk. However, customers’ ability to pay is a natural constraint, and railroads in fact lowered price on export coal shipments in 2012 to spur demand. Rational pricing may mean reducing rates to help make a product competitive, but this scenario has not been the norm. In many cases, shippers can put through price changes to their customers. Still, we consider “re-regulation” to be the greatest threat to sustained pricing power.

The Surface Transportation Board already governs railroad pricing in that list rates for shipments with no competing mode (having “market dominance” over the contested movement) can be contested in a hearing if rates exceed 180% of variable cost. If this threshold is breached, the STB applies a stand-alone cost where each side creates a hypothetical stand-alone railroad and determines appropriate rates that would be charged on that stand-alone railroad to earn an adequate return. To us, this sounds like a positive calculation for economist employment and attorney billings, but rate cases have been infrequent. The high cost ($2 million-$3 million) of filing a rate case certainly discouraged past potential filers, and the STB is working to reduce this expense while simultaneously encouraging arbitrage settlements outside of formal rate cases. When rates are ruled to be unreasonable, the order of magnitude of penalties can be large. In 2009 the STB ordered BNSF to pay a $100 million overcharge reimbursement, and capped rates for the next 16 years (cut by 60%), resulting in a $345 million present value award over rates the BNSF charged to deliver coal to a Wyoming power plant. This penalty was much larger than typical. Other flavors of regulation have appeared at times during the past few years, most notably when Democrats held both the House and Senate. Proposed rules pertaining to reciprocal switching and bottlenecks seek to demand that shippers determine where a railroad must hand off shipments to a competitor, and exemption from antitrust regulation looks to move antitrust jurisdiction from the exclusive domain of the STB’s expertise to the broader court system. Shipper organizations like the National Industrial Transportation League and Consumers United for Rail Equity lobby for these laws, and the railroads lobby against them. Some of these policies would eat into railroad profit, even if only via greater legal and administrative expenses. We believe that lower margins and management distraction would be the likely worst outcome of passing these laws, but handicapping the probability of enactment and breadth of effect seems like so much speculation.

We’re not prone to accuse legislators of rational behavior but expect that voters eventually will appreciate the benefits rail shipping offers to society. In the long run, we believe the electorate understands the need to alleviate highway crowding by converting trucks to rail, particularly given aged public interstate infrastructure assets. Railroads also move significant volumes of hazardous chemicals (like ethanol, chlorine, ammonia, and lately, crude) off the highways. Ultimately, we think the electorate has low long-run tolerance for policies that discourage diverting traffic off the roads, and diversion depends on railroads with adequate financial health to reinvest in assets enabling truck-competitive service. Within the electorate of practical concern to politicians are the unionized railroaders who oppose punitive industry legislation. Also, since the 1980 partial deregulation, real rates have declined.

Don’t mistake our moat upgrade for optimism on coal; we already bake modest coal assumptions into our models. Weak coal demand constrains earnings, but rails have produced strong OR in the midst of severe volume declines. Coal is a material commodity, especially for the three largest public railroads. Rail moves about 67% of all produced coal (barge, truck, conveyor, tramway, and slurry pipeline account for the rest). Coal shipments are for thermal or metallurgical applications, depending on energy content. Steam coal for generating electrical power is mined mainly in Appalachia, Illinois, and Powder River Basins (60%-plus of tonnage is concentrated in Wyoming, West Virginia, and Kentucky). North American metallurgical coal for steelmaking is mined mainly in Appalachia and Canada. If coal or any good can be well served by barge, it probably already is, given the cost gradient, so we don’t view alternative modes as a threat; the risk is in declining demand. Thermal coal volume is at risk of significant displacement by fracking-enabled cheap natural gas, and Appalachian coal in particular is declining because of its high cost to mine. Export coal is great business for the rails, but it’s cyclical depending in part on the level of global steelmaking and electricity demand, and benefits from irregular events. For example, Appalachian metallurgical coal is the marginal (high cost) global supplier but expands exports when other suppliers are compromised (Queensland, Australia, floods in 2011).

Railroads generally held steady or improved margins during recent coal shocks. For example, CSX coal carloads declined 31.3% from 2008 to 2012, but OR improved from 75.4% to 70.6%. Norfolk Southern coal carloads declined 19.9% from 2008 to 2012, and OR moved from 71.1% (already quite good) to 75.4% in 2009, then back down to 71.7% in 2012. In each of the most recent four quarters, however, Norfolk Southern’s OR worsened year over year, and its annual OR seems stuck in the (respectable) 71% range. UP energy carloads declined 20.3% from 2008 to 2012, but the OR improved from 77.3% to 67.8%–nearly 1,000 basis points in four years, and that was without an export coal tailwind.

How can the rails preserve profitability so well in the midst of this storm? While the railroads do not disclose profitability by commodity, coal is broadly thought to be higher than average margin freight at most railroads, in part because it runs efficiently in unit trains (single commodity, unlike mixed manifest trains that require sorting) from point (mine mouth) to point (utility or port). Also, the past couple years had a mix richer than normal in export coal for CSX and Norfolk Southern, and we believe that in the past this was margin accretive, especially when export coal was mostly metallurgical. However, CSX management advised on its most recent earnings call that export coal is in fact not more profitable than domestic coal, so managing margin when volumes decline depends on efficient operations and driving down costs. Importantly, neither our thesis nor valuation relies on coal recovery. We model coal weakness in our base scenario that nonetheless yields excess returns.

Our Fair Value Estimates Increase a Bit With New Moat Ratings, and CSX Looks Cheap
At Morningstar, our principal equity valuation tool is a three-stage discounted cash-flow model. For industrial stocks, we generally use a five-year Stage I discrete projection period, followed by a Stage II “fade” during which ROIC declines to WACC over a duration of 10 years for narrow economic moat firms and 15 years for those with wide moat ratings (Stage III is the perpetuity). Ceteris paribus, increasing the moat’s width rating extends the duration of the Stage II fade, and this increases our fair value estimates by 3%-7%. A second implication of the wide moat rating is the eligibility of these stocks to be considered in the Morningstar Wide Moat Focus Index (MWMFT), and the related Market Vectors Wide Moat ETF (MOAT).

Presently, we view CSX as the most undervalued railroad. It’s not hard to reason why the eastern rails are unloved at the moment given the wide cone of uncertainty surrounding coal volume and rates. No doubt less coal means less earnings, but as we’ve shown above, coal volume declines seem only to have slowed moderately CSX’s OR improvement trajectory, and we believe the firm will rationalize its franchise to match capacity and costs to demand. Because coal moves in unit trains consisting only of coal (not manifest trains of various cargo, most of which still needs to move even if some commodities are weak), when demand is low the rail takes out locomotives, fuel, and train and engineering employees in line with carloads. In fact, the less-congested network may facilitate greater velocity and asset utilization.

We project CSX will grow overall volume only modestly during the next five years–around 1% annually, by combining our expectations of 3% intermodal growth from truck conversions, with 2% growth in automotive-related loads and 1% in most other commodities. We model coal carloads to decline 3% each year beginning in 2015 but project steeper declines in 2013-14. This year, we model tonnage declining 10% in domestic utility, 10% in other domestic applications, and 16% in export. Combined, this produces an 11.7% decline in 2013 carloads (note this is steeper than the first-half 2013 decline of 8.3%). For 2014, we model a further 5% coal-car decline. We think intermodal and crude will be the fastest-growing commodities during this time frame, but truck competition constrains intermodal rate increases somewhat more than pressure on other commodities. On the other hand, with trucking as a ready competitor, the rail should be less subject to regulatory scrutiny of its intermodal traffic compared with other nontruck competitive cargo.

Keith Schoonmaker is the director of industrial equity research at Morningstar.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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