Rail Renaissance: Returns, Capital & Capacity

AB HATCH [email protected]

155 W68th St Suite 1117 NYC 10023 www.abhatchconsulting.com

REF11/La Quinta!

March 2011

Rail Assessment          

Strengths Strong secular growth Favorable market structure Supply constraints Solid barriers to entry Limited alternatives Opportunities Pricing Volume Growth Service levels / productivity Modal shift Consolidation?

   

Challenges Capital intensity Capacity bottlenecks Port congestion Reliability vs. trucks

   

Threats Economic malaise Rising capital requirements Regulation Maritime trade flows

2010 – Recovery is not just an Eminem song

 Rails (all modes) surprised by the volume strength  2010 & Q4 results exceed street expectations  2011 – guidance increased and confidence raised  Capex numbers

way

free cash flows up – so are overall

Future Growth Potential

   Oil, Carbon, Infrastructure & Efficiency Intermodal – International

and

Domestic Grain – the world’s breadbasket   Coal? Exports The Manifest/Carload “Problem”  MSW (garbage), perishables, others  Point-to-point vs. Hub & Spoke (or Southwest vs. United)

Intermodal Growth Drivers Domestic

and

International



Globalization



Trade



Railroad Cost Advantages



Share Recovery From Highway



Truckload Issues

U.S. Railroad Intermodal Traffic

(millions) 14 12 10 8 6

2010 through 36 weeks = + 14.6%

4 2 0 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 U.S. Railroad TOFC/COFC Units Source: Association of American Railroads’

Weekly Railroad Traffic

Domestic Intermodal

      The real growth opportunity is the age-old goal of taking trucks off of the highway Driving down the LOH (requires very tight service standards) Corridor development (see NS’ “Crescent”); truck partnerships (see JBHunt) Fuel price, carbon footprint, infrastructre shortages and congestion, driver shortages (CSA 2010) Trailer (TOFC/”Piggyback”) the gateway drug” for containerization Opportunities in unitized carload as well

CS: Future Corridor Volumes Compared to Current Corridor Capacity (Cambridge/AAR) - 2007 2035 without improvements Below capacity Near capacity At capacity Above capacity

Carbon Footprint – from cocktail chatter to decision point

 2003 – 221/F500 report on carbon; 409/F500 in ’09  Green supply chains enforcement by Wal-Mart (from $2B transport spend to $4B+ by ’11); GE, P&G, etc….

 Anticipating future EPA regs and emissions law

S0 -What

is

the growth rate?

     Great studies done – in 2007 Is there a “Great Re-set”? (paper, autos, retail, coal) Or do we look past 2035 and simply add a few “lost” years? (the emerging consensus save for the coal question) AAR new assumptions suggest coal is flat from DOT projections while the rest reaches 2025 targets despite Great Recession impact (ie;

future intermodal/carload growth is higher than recent studies…)

Will the government policy help to increase modal share by 10%?

Rail Intermediate term volume prospects ABOVE GDP  

ABOVE GDP



Intermodal (++) – Domestic



Intermodal - International Agricultural products Export Coal



Ethanol BELOW GDP



Paper



Auto Parts (?)

 

GDP-GROWTH



Autos



Lumber Chemicals (+?) Aggregates



Metals UNCERTAIN



Domestic Coal

Growth is Expensive

  Huge Capex - $40B in the last 5 years in the US –

through the Great Recession!

2011 +20% (wide range) – recovery, tax rules

 AND: Comeback of the share repo/DPS?

 EPS beat the Street consistently, yet:  Uneven returns in the Modern Age  Recent improving trend line  Threats to ROIC threaten capacity

Rail Rates Began to Rise

12% 10% 8% 6% 4% 2% 0% -2% -4% -6% -8% -10% -12% % Change in Avg. Inflation-Adjusted Rail Rates*

First meaningful increases since 1980, with much of it tied to higher fuel costs

'90 '92 '94 '96 '98 '00

*Revenue per ton-mile Source: AAR

'02 '04 '06 '08

Railroad Rates- the old story

Class I Railroads, Revenue Per Ton-Mile –

another (related) New Paradigm

Cents

3 2 1 0 7 6 5 4 Constant $: Down 54% since 1981 Current $: Up 5% since 1981 '81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09

Source:

Railroad Facts,

AAR

Finally, Railroads Making Decent Money...

Net Income $9 $8 $7 $6 $5 $4 $3 $2 $1 $0 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09

Source: AAR

RR CoC vs. ROIC – RR Stocks have done well but… they still trade at a discount to all stocks 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09p Cost of Capital Return on Investment Source: Surface Transportation Board 2009p Cost of Capital is AAR filing, not decided by STB Note: Cost of equity estimation method changed by Board effective 2006 and 2008.

Tax Incentives to Leverage Capacity Expansion

   

Just ONE example of a “future consideration” 25% tax credit (for rails or shippers) for projects that expand rail capacity Expense other infrastructure capital expenditures Leverage private investment

Rail Capacity and Capex

          Rail Capacity is extremely fungible Heavier/faster track, double track., sidings; Larger cars (avg size: ’80 79tons; ‘90 88.2 ’08 110.5) Unitization, shuttle trains Denser systems (2001 8.9mm RTMs/mi; ’08 11.6) IT – planning, signaling, communications (PTC?) Unitization Equipment in storage (down to the dregs) T&E employees System Velocity

RRs Still Making Record Re-Investments

Net Income $9 $8 $7 $6 $5 $4 $3 $2 $1 $0 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 RR Spending Per Mile $250,000 $225,000 $200,000 $175,000 $150,000 $125,000 $100,000 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09

Source: AAR

Class I Railroad Capital Spending vs. Net Income (Current Dollars) $12 $10 $8 Capital Spending $6 $4 $2 $0 Net Income -$2 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source: Association of American Railroads

Railroad Capital Expenditures

Class I Railroads Billions

$12 $10 $8 $6 $4 $2 $0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source:

Railroad Facts

&

Analysis of Class I Railroads,

AAR

Positive Train Control (PTC)

       “Unfunded Mandate” – part of 2008 safety bill Overseer is FRA – who puts cost/benefit ratio at 22:1 Rails have put cost of installation and maintenance at $10B –

and rising

Possible benefits in capacity, velocity, fuel consumption as well as safety; many of those captured by other technological advances Covers all rail interaction with passengers and TIH as of 2008; short lines exempted Technology proven only in limited scope (BN/Wabtec: ”ETMS”) Initiated after Chatsworth accident – obvious public benefits –

some political support brewing?

Railroad Capital Spending

($ billions, constant 2009 dollars) $11 $10 $9 $8 $7 $6 $5 $4 $3 $2 $1 $0 Roadway and Structures Equipment 1980 1984 1988 1992 1996

Data are for Class I railroads. Source: AAR

2000 2004 2008

The Staggers Act: An American Success Story

Productivity decline due mainly to fuel price volatility.

(Index 1981 = 100) 300 270 240 210 180 150 120 90 60 30 0 Staggers Act Passed Oct. 1980 Productivity Price Volume Revenue

Railroad Employee Productivity

Class I Railroads, Ton-Miles Per Freight Service Employee

Millions

12 10 8 6 4 2 0 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source:

Railroad Facts

, AAR

Rail Service Cycles

 Is the recent improvement in the metrics sustainable? Systemic?  Is it a product of huge capex injection and IT?

 Or, is it merely a product of lower volumes/less stress on the network…

Capacity Constraints

 ROIC and ReReg  The revival of passenger railroading (the vast majority of which is on freight network)  HSR (and HrSR)  TIH/NIH issues   TSA and secuirity NIMBY – see the CN and its tortured purchase of the EJ&E; efforts on MSW

Current Issues

        Rails in the Recovery (and beyond) What’s true?

RR traffic or business headlines?

After the Rereg Fight what? STB? TSW? HSR?

Govt role –partner? Or preoccupied &broke?

The Green mantle – two-edged sword….

PE &Infrastructure funds – back for good?

Panama Canal?

New “Golden Age”?

Service

Service will be the Key to the Next Cycle  Service at all time highs  $40B spend in last 5 years (service ought to be better!)  Putting increased traffic back on at current velocity means: Higher asset utilization, more market share gains, greater operating leverage (perfect circle affects all stakeholders)  Implications for equipment fleets

Street influence on RRs – and Why that affects ALL stakeholders

  

Battle for cash Management’s reactions to pressures Investors, competitors, regulators, politicians, labor – oh, yes, and customers

  

Rare Industry: Short term decisions (current economic outlook)/long term consequences (40+ year life of a locomotive)

Remember 2004! (?) – rails unprepared for volume; embargoes

Which “bucket” (Capex, share repo, DPS) will they place their chips?

Simple Math

 Rates  Returns  Capital Expenditures  Capacity  Service

ARE ALL CONNECTED!

Virtuous Circle (’03-07) or Disinvestment?

RR/Investor Issues Summary 3Rs3Cs

 Recovery?

 The Re-Set  Re-Regulation  Capital Needs  Capital Cooperation  Cash Flow

Developing website

 www.abhatchconsulting.com



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Survey 

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2011 November 1-2

ABH Consulting Anthony B. Hatch

155 W. 68th Street New York, NY 10023 (212) 595-0457 [email protected]

Warren’s $44B “all-in” bet

 Advantages of going private? (capex cycle)  Influence in DC  “Robber Baron” vs. “Sage”  Bets not (just) on economy – rereg, coal, western intermodal  Bought on the cheap! “

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