Fitch: Healthy Economy Should Fuel U.S. Rail Performance in 2005
CHICAGO--(BUSINESS WIRE)--Dec. 7, 2004--Following a record
year for freight volumes and revenues in 2004, Fitch Ratings expects another
strong showing for the U.S. railroad industry in 2005. Fitch's economic
forecast predicts a 3.3% increase in the U.S. gross domestic product in
2005, which should translate into continued growth in rail volumes and
revenues. At the same time, efforts currently under way to improve
operational efficiency should result in improved margins and, in turn,
modest increases in free cash flow.
However, it is not expected that the railroads will use this increased free
cash flow to make significant reductions to their debt loads in 2005. Recent
activity suggests that the major class I railroads currently place a higher
priority on returning excess cash flow to shareholders than they do on
reducing debt. This, combined with the capital markets' continued appetite
for railroad debt, suggests that, in general, the railroads do not feel
pressure to substantially reduce their debt levels. Although the railroads
will likely pay some debt maturities with cash on hand in 2005, as they did
at times in 2004, Fitch believes that they will continue to focus primarily
on finding ways to return cash to shareholders.
Macroeconomic forecasts for 2005 suggest that strong freight demand patterns
will continue and that some modest rate hikes, likely in the 2% to 4% range,
can be supported. Fitch's forecast of 3.3% growth in the U.S. gross domestic
product is one percentage point lower than its full-year forecast of 4.3%
for 2004. As the U.S. economy begins to throttle back somewhat from the
relatively high growth level seen in 2004, rail demand should remain
relatively strong. However, year-over-year carload and revenue growth
figures will likely be lower than those seen in 2004.
Demands Outlook
Shipments of raw materials and finished goods are expected to remain strong
as U.S. manufacturing output continues to grow. Coal volumes, which are
responsible for approximately 21% of the revenue at the top four class I
railroads, are expected to be robust. Coal demand from electric utilities,
in particular, will remain strong due to a growing need for electrical power
in the U.S., combined with a preference for using coal while natural gas
prices remain high. If foreign demand for U.S. coal remains strong, CSX and
Norfolk Southern, two class I railroads that operate predominately in the
coal-rich eastern U.S., should continue to see strong export coal volumes,
as well. Intermodal volumes, which lately have driven about 18% of revenues
at the largest class I railroads, will also continue to increase, largely
due to strong U.S. demand for imported goods and foreign demand for U.S.
exports.
The one significant line of business in which Fitch expects potential
revenue weakness in 2005 is auto shipments. With questions surrounding
inventory levels at the domestic 'Big Three' auto manufacturers, Fitch
expects North American auto production will be flat or slightly down in 2005
versus 2004, depressing railroad revenues in that area. Among the top four
U.S. class I railroads, Norfolk Southern has the most exposure to the
domestic auto industry, with 13% of its operating revenue in the first three
quarters of 2004 generated by auto shipments. Union Pacific, at 10%, has the
second highest exposure.
Although the railroads have been adding capacity in 2004 to improve
operational efficiency and customer service, Fitch expects capacity will
continue to remain fairly tight relative to demand in 2005. The railroads
have learned from their past mistakes and are now taking a measured approach
to capacity growth, adding just enough capacity to improve their operational
integrity. In particular, they are being especially careful to avoid the
possibility that overcapacity will occur if U.S. economic growth suddenly
slows or reverses. They are also keenly aware of the revenue benefits from
limitations on capacity and, in some cases, are showing a willingness to
turn away business that does not meet their profit objectives. Thus, the
relatively favorable supply-demand relationship will continue and should
provide some pricing power to the railroads in 2005.
Fuel Prices
Though fuel surcharges have been responsible for a portion of the overall
increases in revenue per carload seen in 2004, tight supply of capacity
relative to demand has allowed the railroads to increase their spot rates
and to negotiate more favorable pricing terms when contracts are renewed. It
is unclear how much of the 2004 price increase has been due to surcharges,
as most railroads will not disclose that information for competitive
reasons. However, in their 2005 planning, the major carriers are looking at
opportunities to further increase their rates, as well as to incorporate
fuel surcharges into many of the contracts that have not had them in the
past.
As with all parts of the transportation sector, oil prices will continue to
be a concern of the railroads in 2005. Oil prices are generally forecasted
to remain relatively high in 2005, which will continue to negatively impact
operating costs, as diesel fuel accounts for roughly 12% of the average
class I railroad's operating expenses. However, three of the top four class
I railroads have significant portions of their expected 2005 fuel
requirements hedged, the exception being Union Pacific. Combined with fuel
surcharges, hedging should significantly mitigate the pressure of high fuel
prices in 2005. However, the biggest concern of high oil prices is not the
effect that diesel fuel costs have on operating expenses but, rather, the
potentially negative consequences that sustained high prices could have on
the U.S. economy. Should high oil prices begin to slow growth in the economy
beyond what is currently forecasted, the railroads are concerned that
transportation demand will wane and revenues will suffer.
High fuel prices do have some positive effects in that they magnify the cost
differential between railroads and trucks, as trains are relatively more
fuel efficient than trucks. The railroads generally view the trucking
industry as their primary competition, and as fuel prices remain relatively
high in 2005, the railroads' competitive position will be strengthened. In
some ways, this can be viewed as a 'natural hedge' against high fuel costs.
It is likely, in fact, that the trucking industry will contribute directly
to higher rail revenue as it finds intermodal trains an increasingly cost
effective way to move trailers and containers over long distances.
Pension Issues
One of the biggest issues facing a number of U.S. 'old-line' industries is
the significant level of underfunding in many defined benefit pension plans.
Although the major U.S.-based class I railroads maintain defined benefit
pension plans for non-operational employees, the majority of railroad
employees are covered by the federal Railroad Retirement Plan. As such,
although several of the largest U.S. railroads have defined benefit plans
that are significantly underfunded, the size of the plans and required
contributions are relatively small. Although it is likely that the railroads
will make contributions to their defined benefit pension plans in 2005,
Fitch does not expect that the amounts contributed will be enough to
significantly constrain free cash flow generation.
Rail Capacity and Financial Outlook
With solid economic growth in the U.S., 2004 has been a banner year for U.S.
railroad industry volumes and revenues. Following a drop in demand that
began during the most recent recession, business began picking up for the
rail industry in the latter part of 2003. By early 2004, with the economic
recovery in full swing, growth in manufacturing output and increased import
and export volumes supported demand for rail transportation at record
levels. Demand was also high for other railroad staples such as coal,
chemicals, and agricultural products. Adding to railroad demand was a
shortage of truck drivers that led to capacity constraints in the trucking
industry. Through the end of the third quarter of 2004, year-to-date
operating revenues at the top four class I railroad companies were up 8.3%
from the same period in 2003. Collectively, the same four companies posted a
5.9% increase in transported carloads and, importantly, a 3.0% increase in
revenue per carload.
Against this backdrop of increased demand was a relatively constrained
supply of rail capacity. During the recession, the railroads cut back on
spending and non-essential investments in track and equipment. They also
took steps to reduce employee headcount. However, subsequent to these
cut-backs, the relatively brisk recovery in the U.S. economy, combined with
the trucking shortage, meant that rail demand quickly exceeded available
capacity. Although this supply-demand scenario helped boost railroad
revenues, the sudden increase in demand also quickly revealed the weaknesses
in railroads' networks. While revenues were up, profitability was challenged
as some major rail carriers, most notably Union Pacific and CSX, saw the
fluidity of their networks decline. Average train velocities at these
carriers fell, and their cars spent increasing amounts of time parked in
rail yards. The percentage of on-time departures and arrivals was down
sharply, while labor costs were pressured as increasing numbers of standby
crews were needed to operate trains when scheduled crews were out of
position.
Reacting to this decline in performance, the major railroads have begun
focusing on correcting operational problems and are taking steps to add
capacity where necessary to improve the flow of their networks. They are
growing capacity through a combination of adding locomotives and rail cars,
hiring train and engineer employees, and reworking their networks to improve
operational fluidity. Union Pacific is in the process of adding over 700
locomotives to its system and hiring 5,400 train and engineer employees. CSX
is also adding a significant number of locomotives and employees and has
launched an initiative it calls the 'ONE Plan' that aims to improve network
flow and available capacity by optimizing car routings. The railroads' focus
on improving network efficiency should begin to yield results in 2005.
Although the additional capacity will result in some higher costs,
particularly in the areas of labor and equipment leases, and may also drive
marginally higher levels of capital spending, these increases should be
offset by savings related to better network utilization. This should
translate into lower costs per carload and improved operating margins.
As the railroads' financial position has begun to improve, returning cash to
shareholders has become a key priority. As share prices have risen, this has
generally been accomplished through dividend increases, rather than share
repurchases. Currently, BNSF is the only U.S.-based class I railroad with a
share repurchase program in place. However, three of the four class I
railroads have significantly increased their quarterly dividend payouts
since early 2003.
Between the first quarter of 2003 and the third quarter of 2004, Norfolk
Southern increased its quarterly dividend by 43%, BNSF by 42%, and Union
Pacific by 30%. However, CSX kept its quarterly dividend constant. Over the
past 12 months, Union Pacific used $291 million in cash for dividend
payments, while cash used for dividends was $224 million at BNSF, $133
million at Norfolk Southern, and $86 million at CSX. Fitch expects that
higher levels of predividend free cash flow will lead the railroads to
consider further dividend increases or share repurchases in 2005. However,
with relatively high stock prices, the railroads are likely to favor
increasing their dividends over repurchasing shares.
Contacts:
Fitch Ratings
Stephen A. Brown, 312-368-3139
William T. Warlick, 312-368-3141