The rate of profit growth major U.S. railroads can wring out of weak volume increases appears to be shrinking.
The total profit of the Class I carriers, excluding privately held BNSF, was about $2.2 billion in the second quarter, up 12.5 percent year-over-year. That’s still enviable for most industries, but the major Class I’s may be reaching the limits to year-over-year profit growth. The earnings of the four U.S. carriers in the second quarter jumped 26 percent year-over-year to $1.8 billion, twice the rate of profit growth of the most recent quarter.
Whether the railroads are nearing the limits of profit growth depends largely on how much coal traffic recovers, and how the broader economy fares. Coal volume, which historically accounts for 40 percent of total railcar volume, is down nearly 10 percent this year, according to the Association of American Railroads.
Utilities are burning less coal this year because of the warmer-than-normal winter and because more power plants are switching from the nation’s largest power source to natural gas amid more stringent federal regulations on emissions. Although coal volume likely will wane in coming years, the worst of the recent drop in coal loads appears to be over.
“With much higher temperatures across our utility network and with some mitigation in natural gas prices recently, we’re beginning to see some customers add trains sets and increase orders of coal,” Don Seale, Norfolk Southern Railway’s chief marketing officer, told investors on July 25. “In fact, over the last month, the estimated average stockpiles in our utility network have declined by 14 percent.”
Railroad executives, while expressing concern that the U.S. economy will slow in the second half, agree a double-dip recession isn’t on the horizon. If volume growth doesn’t surge but climbs steadily along with the rest of the economy, railroads have two main paths to consider. Bowing to expectations from Wall Street, railroads could ramp up their pricing power even more to squeeze higher profit out of volume. Or, they could keep to their annual single-digit increases in pricing and resign themselves to lower profit growth.
In either case, the carriers are unlikely to slow their capital investment in 2013. The carriers, after all, didn’t pull back on spending on their networks during the recession. And, with the Department of Transportation forecasting an 88 percent jump in freight rail demand by 2035, carriers have plenty of reasons not to let up on network improvements. The carriers this year plan to spend a record $13 billion on network improvements ranging from extended sidings to new terminals, after investing $12 billion in 2011.
Those improvements have produced efficiencies, improving profit margins, but they haven’t been enough to combat flat volume growth. Total traffic hauled by the four carriers in the second quarter was flat year-over-year, compared with a 1 percent uptick in the first quarter. Similarly, revenue was virtually flat in the last two quarters compared to a year earlier.
Intermodal business, however, is a glaring exception. Intermodal traffic among the four Class I carriers rose 6.1 percent year-over-year in the second quarter, after expanding 5.6 percent in the first. Domestic intermodal growth appears to be outpacing international intermodal gains, but that could change depending on the health of the peak shipping season. U.S. containerized imports expanded 2.9 percent in the second quarter from the same period in 2011, but Journal of Commerce Economist Mario Moreno expects brisk shipments in the fall to push annual growth to 4.1 percent.
“The international business has strengthened a little more than what we expected in our earlier outlook, and our domestic business, in terms of highway conversions, is also coming very strong,” Eric Butler, Union Pacific Railroad’s executive vice president of marketing and sales, told investors on July 19.
Intermodal revenue expanded 9 percent year-over-year in the second quarter, following a 14 percent jump in the first. Revenue per intermodal unit, a measure of pricing, ticked up about 3.8 percent year-over-year in the second quarter, compared with a 9.1 percent rise in the first.
A similar scenario played out in year-over-year increases when carload and intermodal unit business are factored together. Total revenue per railcar and intermodal unit inched up 1.6 percent year-over-year in the second quarter, compared with a 7 percent increase in the first.
Rail analyst (and JOC columnist) Ted Prince said the declines aren’t a sign of carriers easing pricing. Instead, they result from lower fuel surcharges brought on by lower diesel prices. A drop in more profitable coal loads also helped pull down revenue per carload. He described the earnings results as “maintaining the status quo” with “measured growth in the boundaries.”
Still, that several analysts questioned whether carriers have eased pricing gains, which carriers denied, suggests there is Street pressure to drive up profit growth even if volume is flat and the top commodity type is weak. That should make for some interesting contract negotiations between shippers and carriers.