Railroads primer
– GLI101
Overview
Freight railroads form the backbone of any economy and a significant trade en-abler through international containers in and out of North America. They transport essential goods from agricultural products, industrial equipment, energy products and automotive, as well as consumer products and intermodal. In North America, the listed railroad companies own, maintain and operate the vast majority of track, bridges and tunnels which spans 145,000 miles across the region like a spider’s web (see Figure 1).
Evolution
The North American railroad system dates back almost 200 years. Over that time, the number of companies expanded to over 2,000 by the 1920s, but from the 1930s the sector began to consolidate and rationalize. From almost 190 Class I railroad companies in 1920, North America experienced consistent decade-on-decade consolidation.
Deregulation and the resulting increased competition among the railroad companies led to increased focus on operational efficiencies and drove mergers within the sector. The period between 1980 to 1995 saw further consolidation, as 39 Class I companies became 14 by 1990. The 2004-2008 period is known as the ‘rail-road renaissance’ as rail rates inflected positively and new efficiency gains led to improved operating and financial ratios.
In 2020 we have seven key Class I rail-roads in North America, of which six are in the GLIO Index. The only non-GLIO Index railroad is BNSF (unlisted) which became a subsidiary of Berkshire Hathaway in 2010, perhaps further proof to the point that the sector is a prudent long-term investment.
Economic necessity
North America’s Class I freight rail industry is one of the most effective and cost-efficient transportation networks in the world. Fueled by billions of dollars in annual private investment at least $25bn on average (see Figure 2) – railroads maintain and modernize the 145,000-mile private rail network to deliver for the region. Listed railroad companies own 112,000 sq miles, or approximately 80% of the total network by miles.
A railroad’s competitive advantage is in-separable from its track location. With-out railroads, North American firms and consumers would be unable to fully participate in the global economy as they do now, as railroads provide the arteries of economic activity.
The network
At an aggregate level, the GLIO railroads have posted very impressive performance over the long term, consistently returning between 15-18% on an annualized total return basis ($) for long-term holding periods. This significantly outperformed the broad GLIO Index (8%-11% range) and global equities (5%-10%).
Source: GLIO, Reuters, MSCI. Data as at December 31, 2019
It is important to note that the GFC saw a railroad sell-off as companies were viewed as cyclical, but railroads broke through misconception as investors began to understand company valuations are driven by company specifics. Subsequently investors see lower cyclical
risk going forward. Efficiency, cost, ESG considerations and an improving rail service will all play a role if the sector is to continue its excellent record.
Ben Morton, Cohen & Steers, explains: “We see the railroad companies as a key component in an infrastructure investment strategy. They are critical to the economy, boast incredibly high barriers to entry, plus they are increasingly focused on infrastructure capex and operational excellence. Subsequently they have posted impressive total returns during the latest economic expansion which are simply better than those of general equities. Moreover, as investors turn their microscopes on ESG factors, the railroad’s track record for increased fuel efficiency versus other forms of transporting goods will position them well for the future.”
Railroads companies carry out their day-to-day business predominantly on the ‘mission critical’ infrastructure they own. In addition to track, railroad companies also own and manage approximately 90,000 bridges, plus hundreds of tunnels, crossings, intermodal facilities, connected real estate and buildings as well as locomotives and rolling stock. Critically, they serve ports up and down North America.
Future growth
Future growth
As the North American economy grows, the need to move more freight will grow too. Recent forecasts from the Federal Highway Administration found that total US freight shipments will rise from an estimated 17.8 billion tons in 2017 to 24.1 billion tons in 2040 – a 35% increase. Railroads are seen by many the best way to meet this demand. The ATA estimate that there is a shortage of nearly 60,000 mostly long-haul truck drivers and that shortage could reach 160,000 by 2028 they warn. ESG issues aside, this sole factor could hamper the trucking industry’s ability to meet future demand.
Regulation
Today’s rail regulatory system protects rail customers against unreasonable rail-road conduct, while allowing railroads to earn the necessary returns on their substantial annual expenditures to maintain the integrity of their networks and invest for future growth. If a balanced regulatory environment is not maintained, there could be potential negative impacts that would reduce ongoing rail infrastructure and equipment investments.
Investing in the future
It is important to understand that listed railroads develop, maintain and finance infrastructure themselves through the global capital market. Freight railroads operate almost exclusively on infrastructure that they own, build, maintain, and finance themselves. From 1980 to 2018, North American railroads spent more than $700bn – of their own funds, not government funds – on capital expenditures and maintenance costs related to critical infrastructure: tracks, bridges, tunnels, network safety and resiliency improvements, plus investment in locomotives and freight cars. Capital expenditure compared against revenue among the Class I railroads is 16-18% according to mid to long-term estimates. Short-term is approximately 20%.
In short, it means that the public is not burdened funding the infrastructure that effectively underpins their livelihoods. Conversely, AAR estimate that the taxes and fees paid by commercial trucks falls far short of covering the cost of the high-way damage they cause. In the American Society of Civil Engineers (ASCE) latest infrastructure report card, (freight and passenger) rail scored a B, which was the highest-ranking category for US infrastructure. Praise indeed. However, the B grade does not tell the full story.
The report highlights two different tracks for freight and passenger rail. We believe that separating freight rail from passenger rail would result a in an A–B rating for freight railroad network and a C–D for passenger rail, which relies heavily on the government for funding which has been insufficient.
The rise of PSR
Technology
Regulation
Technology
Analysts believe the rail industry is ripe for technological innovation. From advanced locomotive technology to zero-emission cranes, freight railroads lever-age technology in all aspects of their operations to limit their impact on the environment. According to the Association of American Railroads (AAR), in 2017 alone, US freight railroads consumed 732 million fewer gallons of fuel and emitted 8.2 million fewer tons of carbon dioxide than they would have if their fuel efficiency had remained constant since 2000. They have clearly come a long way and they have done this by:
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Fuel Management systems – real-time recommendations to engineers to maximize fuel efficiency
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Tier 4 locomotives – sensors help prioritize maintenance and limit poor performance
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Anti-idling technology – cut fuel wasted during down periods
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Enhancing operating practices – optimize network plans to route cars more directly to destination and re-move out-of-route miles
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Zero-emission cranes – transfer goods and recharge their batteries each time they lower a load7
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Redesigned railcars – help increase average tonnage. The average train carried 3,630 tons, up from 2,923 tons in 2000.
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Preventative maintenance – an Inspection Portal system substantially improves effectiveness of not only railcar inspections through high resolution 360-degree imaging of the railcar, but also incorporates critical security features.
ESG
As mentioned, railroads are the most sustainable way to move freight over land, with the AAR reporting that moving freight by rail instead of truck lowers greenhouse gas emissions by 75%. In addition, US Environmental Protection Agency data shows freight railroads account for only 0.6% of total US greenhouse gas emissions and only 2% of the transportation-related sources, while accounting for well over one third of intercity freight ton-miles.
As the world comes to terms with the ur-gent need to tackle climate change, Government and businesses must work together quickly to innovate and enact policies that address the environment and sustainability. It would make sense to incentivize shippers to move freight by rail to help this transition. As global investors are increasingly focused on ESG issues, the benefits of the railroads versus truck and other modes of transport are crystal clear.
The railroad companies are increasingly focused on on-time service performance for every rail car, execution accountability, and lean resource utilization. The industry calls this Precision Scheduled Railroading (PSR), pioneered first by the legendary railroader E Hunter Harrision at CN in the late 90s, and it was later adopted by many of the other Class 1’s.
Harrison’s railroading ethos centered on eliminating inefficiency and keeping locomotives and wagons on-the-move. In a nutshell, PSR consolidates networks, abandons less-efficient services and lines, and shifts traffic wherever possible from hub-and-spoke operations centered on freight yards to point-to-point train movements.
Investment case
The sheer scale of the North American rail-road network means barriers to entry are extremely high – arguably insurmountable. The geography and ownership of the network means that competition among the railroad companies is rational and limited, and in some cases they work together to optimize their networks. In effect, they operate an oligopoly.
Research & Markets forecast that the rail freight transportation market in North America will grow at a CAGR of 5.6% during the period 2017-2021, and this is expected to grow at similar rates going forward. By comparison, the American Trucking Associations (ATA) estimates trucking will grow by 2% CAGR between now and 2030.
We believe that users and investors are increasingly concerned with making the right choices in ESG terms, and the railroads look attractive compared against other modes of moving freight and could gain market share. According to the AAR, moving freight by rail is four times more fuel-efficient than moving freight on the highway, and moving just 5% of freight from truck to rail would result in nine million fewer tons of greenhouse emissions.
The right direction
The railroad industry is long established as a key artery of the North American economy. The GFC decoupled from the industry with the belief that it was cyclical, but the under-lying infrastructure business and earnings came to the fore as the key determinates to value the business. Subsequently, many investors believe that the railroad companies form a key role in a diversified infrastructure strategy. Importantly, railroad companies offer an environmentally friendly route to build that allocation compared to other modes of goods transport. Moreover, the sheer scale and massive barriers to entry of the North American railroad network mean listed companies are investors’ only point of access.
Industry veteran Walter Spracklin, Equity Re-search Analyst covering the Transportation sector at RBC Capital Markets sums up the attractive story. “We are and remain very constructive on our long-term outlook for the rails. The companies offer a vital service – the quality of which improves every year,” he says. “Freight pricing is steady and predictable. Margins are expanding as additional efficiencies are captured – and technology provides upside for more. And finally, the high barriers to entry lock in these favorable characteristics, giving investors’ confidence around future shareholder returns. What’s not to like?”