Read Part 1: Railroad Industry – Navigating Through Persistent Challenges
The railroad industry is poised for strong growth in the coming quarters, reflecting the industry's leverage to the positive momentum in the U.S. economy. The strong earnings performance we saw from the industry in the third quarter earnings season should sustain itself in the current and coming quarters as well. Stocks of railroad operators did extremely well in 2014, but the momentum should continue into the New Year as well.
We are discussing key factors of the railroad sector that investors should consider and look forward to in the coming months:
Rail Investments
Investments in development and expansion plans remain crucial when analyzing the prospects for the railroad industry. These capital investments are a union of binaries. While the investments put significant stress on margin performance, forgoing these would dampen growth prospects.
Railway investments are significant, given the evolving supply chain management and the growing importance of airfreight carriers in offering freight transportation services. These investments help railways in getting the required infrastructure to compete effectively in the railroad industry and with other modes of transport like truck, barges and cargo airlines.
Hence, investments in infrastructural projects have been an integral part of the development of railroads. However, this sector, characterized by huge capital influx, has been drawing funds primarily through private financing.
As a result, investment plans can have a considerable impact on the company's liquidity position and could lead to a highly leveraged balance sheet. According to Association of American Railroads (AAR), reports, railroads invest approximately 17% of their annual revenue, which compares with only 3% of average U.S. manufactures' revenues on capital expenditures.
According to Department of Transportation (DOT), the demand for rail freight transportation will increase approximately 88% by 2035. As a result, Class I carriers would have to increase their investments to meet this growing demand.
It is estimated that railroads would require $149 billion to improve rail network infrastructure within this stipulated period.
Given the growing demand and need to upgrade railroad infrastructure to meet new regulations, deployment of fuel-efficient locomotives, upcoming rules on track sharing, railroad safety and high-speed rail services are demanding that railroad companies infuse more capital in development projects. According to DOT, almost 90% of the railway capacity needs to be upgraded to meet the expected rise in demand level by 2035. Hence, it is important for railroad companies to balance profitability levels while investing in infrastructural development projects.
Currently, the U.S. railroad industry dominates less than 50% of total freight in America, indicating a huge opportunity for increasing market share. This opportunity can only be exploited by building railroad infrastructure that caters to the varied requirements of shippers.
Discretionary Pricing Power: The freight railroad operators function in a seller's market and have enjoyed pricing power since 1980, when the U.S. government adopted the Staggers Rail Act. The idea was to allow rail transporters to hike prices on captive shippers like electric utilities, chemical and agricultural companies in order to improve profitability of the struggling railroad industry. As a result of the Staggers Rail Act, railroad companies are hiking their freight rates by nearly 5% per annum on an average, while maintaining a double-digit profit margin.
Duopolistic Market Structures: Railroad companies have, by and large, gained by practicing discretionary pricing in the freight market. In the prevailing duopolistic rail industry, railroad operators will be able to reap maximum benefits from rising prices when the overall demand grows.
