Investors are scaling back their profit forecasts for several of the major U.S.-based railroads ahead of the release of their third quarter earnings next month, after the carriers saw sluggish growth in volume and higher fuel prices in the period.
The railroads are still darlings in the investor and hedge fund community, as the carriers have consistently delivered profit quarter after quarter even when volume growth waned. But even the industry’s much-envied operating ratios can’t completely stem a slowing economy and high diesel prices.
The reduced expectations were reflected in Norfolk Southern Railway’s warning on Sept. 19 that its third quarter earnings would be at least 23 percent lower than the averaged expectations of analysts. The railroad, which reports its earnings on Oct. 23, blamed weak coal traffic and merchandise shipments, and reduced fuel surcharges.
Sluggish coal shipments aren’t a new story, with carriers having felt crunch in one of their largest and most profitable lines of business since late 2011. A warm winter exacerbated utilities’ broader shift toward natural gas-powered electricity generation amid tightening federal regulations on emissions. U.S. coal traffic was down 9.3 percent in the first 38 weeks of the year compared to the same period a year ago, according to the Association of American Railroads.
NS coal volume was down 13 percent year-over-year in the third quarter, according to a BB&T research note. Softening demand for coal exports to Europe and Asia also hurt traffic. A 6.6 percent year-over-year increase in intermodal volume in the third quarter helped NS offset the weak coal volume and a 1.2 percent dip in merchandice shipments.
“With fuel prices up significantly during the quarter, we expect (NS), which has more (fuel surcharge) exposure than any other Class I rail, to recoup some of those losses in" the fourth quarter, BB&T said.
NS isn’t alone in losing a bit of its shine ahead of third quarter earnings results, with UBS reducing its ratings from "buy" to ‘neutral” for not only that railroad but also CSX Transportation and Union Pacific Railroad. The global financial services company downgraded the rating for Kansas City Southern Railway from "neutral" to "sell." Credit Suisse, however, increased its earnings outlook for KCS, a sign of how the the investing community is far from uniform in its forecast for the rail industry. BNSF Railway, owned by Warren Buffett’s Berkshire Hathaway, isn’t publicly traded.
Stifel Nicolaus, an investment research firm, reduced its third quarter and fourth quarter earnings estimates for CSX, largely because the of “escalating diesel fuel prices experienced during the quarter and to a lesser extent from sluggish volumes.” The firm, which maintained its "buy" rating for the railroad, said it expects diesel prices will continue to affect CSX’s fourth quarter earnings because of “the roughly 60-day lag time in fuel surcharge recovery.” Unlike its major rival NS, CSX isn’t expected to downgrade its third quarter profit guidance, Stifel Nicolaus said.
The research firm also cited sluggish economic growth and delayed fuel surcharge recovery for why it downgraded its third quarter and fourth quarter profit estimates for UP. The firm maintained its "hold" rating and pointed to further Mexican volume growth through UP’s connection to the KCS’s cross-border network. Analyst John Larkin added that UP is also poised to gain more crude shipments through its terminal in St. James, La., and higher profit through the repricing of legacy contracts.
“The company has roughly 5 percent of its freight revenue, or an estimated $1 billion in revenue, up for negotiation in the next few years; we also note that the company repriced and retained 90 percent of the legacy contracts that came up earlier in 2012, which was roughly $1 billion worth of revenue that was repriced,” Larkin wrote in a Sept. 27 research note.
Considering their track record of delivering profit, the major U.S. railroads will likely continue to do so in the third quarter. The major question is whether expanding intermodal and domestic energy-related shipments will be enough to offset sluggish coal and grain traffic, and higher fuel prices. The second quarter earnings of the major U.S. railroads suggested that they might be nearing their profit ceiling, as total profit, excluding BNSF, was up 12.5 percent year-over-year, a half of the earnings growth seen in the period in 2011.
As other U.S. companies see their profit margins shrink amid a global economic slowdown, the railroad’s industry double-digit growth, or even high single-digits gains, as may be the case for the third quarter, is still enviable.