GLG News by Toby Kolstad

Implications: On June 30, 2008, the STB ruled that CSX was charging excessively high rates to Dupont for several movements of chemical products and ordered the railroad to reduce them and pay reparations to Dupont . Several weeks ago, the STB ruled that UP had overcharged a Kansas Utility and ordered them to reduce their tariffs and to pay reparations. While it is possible that these cases might be the firsts of many shipper challenges to recent railroad freight rate increases,  neither case set effective limits for the railroad companies and it is doubtful that they will mean an end to the pricing power of the railroads.  

Analysis:

Although both cases involved rate rollbacks, the issues in each were very different. In the UP case, a freight tariff was involved and both parties agreed that there was market dominance and that the decision was to be based on whether the tariff was over 180% of UP’s variable cost for the movement. In the CSX case, the freight rates were well in excess of the variable cost of the railroad (280%-580%), but CSX argued that there was truck competition for the traffic at similar rates to theirs and therefore they did not have market dominance. The board rejected their arguments and held for the Dupont, but set the reasonable revenue to variable costs for these movements to be around 330% for CSX and ordered them to reduce their rates to reflect this ratio.

In the UP case, the arguments were much simpler and might have been adopted by any other shipper facing similar circumstances. In the CSX case however, the STB arguments and logic are less easily copied by other plaintiffs, although the speed and reduced cost of the hearing might encourage others to follow Dupont in challenging the railroads.

Implications: The Association of American Railroads (AAR) reported that the Midwest Floods “continued to negatively impact rail freight traffic” during last week, a statement easily verified by a quick check of the weekly carloads of the UP RR which showed at 10% drop in carload for the week ending June 21. However, the Eastern railroads which have very few if any lines in the area suffering from swollen rivers, namely CSX and NS, reported carload losses of 8% and 5% respectively. More importantly, a continuing trend in decreasing carloads began in early May and has brought the year over year traffic gains of 1.1% posted on May 3rd down to only 0.3% on June 21st.

Analysis:

During the first half of 2007, both grain and coal traffic segments were down compared to same period in 2006, -6% and -2% respectively. Much of the gains reported for these two commodities in 2008 were just a continuance of the traffic gains recorded in the second half of last year. As the year progresses,  the year over year comparisons for these traffic segments will be less rosy and it is most likely that the overall carload traffic total for the year will be lower than that recorded last year when carload traffic decreased 1.6% from 2006.. The same might even be true for the ton mile count, which is currently up almost 2% over last year, which was down almost the same amount for the year from 2006.

Coal accounts for 41% of all railroad carloads, so even a small increase in this traffic will far outweigh major changes in other traffic segments. Coal traffic is up 3.2% nationally, but coal production is up only 0.9% through June 12st. The railroads handle most of the exported coal, which is expected to be up by 50% by volume over last year and account for 160% of the increase in overall coal production in 2008. In other words, without the huge increase in export traffic, coal production would have been down this year. Foreign demand for US coal may not continue. Notwithstanding the weakening US dollar, supply disruptions in Australia, South Africa, and China played a key role in boosting the international purchases of US coal. Foreign suppliers will eventually recover and it is unlikely that US exports will continue to surge or even maintain the sales volumes being recorded today.

Grain is the second largest traffic segment, accounting for 7.5% of all US carloads. The 2008 harvest will probably be less than 2007, and with elevator stocks at record low levels, grain traffic in the 2008/2009 grain year that starts in September will almost certainly be less than the current year. Grain traffic for calendar year 2008  should exceed the amount handled in 2007, but not nearly as much as the 18% gains posted for the year thus far.

Except for carloads related to metals (ore, products, and scrap), almost all other railroad traffic segments are seeing carloads well be 2007 levels. This situation will continue until economic growth returns.

The railroads have been able to offset traffic losses for the past two years with freight rate increases and there is no reason to suspect that they will not be able to continue this practice. Coal and grain prices are at all time record levels and any increases in freight rates for these two commodities would be small compared to the change in basic price increases going to the producers. Rail profits may even rise slightly if rate increases are enough to offset the traffic losses. Next year may be another matter however.

Implications: The recent announcements of major cutbacks in US light vehicle production will definitely have a negative impact on both railroad traffic volumes and railroad profits. While this traffic only accounts for only 5% of all US carload shipments, its hefty margins contribute much more to the bottom line than other traffic segments. However, more serious problems relate to the potential decrease in grain traffic during the current grain year due to the weather and flooding problems in the Midwest. After the 1993 floods, grain traffic fell 30%, and this traffic segment accounts for 8% of US railcar loads.

Analysis:

So far this year, railcar loads of autos and autoparts were down 14% before the cutbacks in production were announced. Part of the problem was identified by the author of the “Sector Snap” article as being related to the change in the mix of automobiles and light trucks and SUVs. Multilevel autorack flatcars can handle more automobiles (15-18) than trucks and SUVs (12-15), so when more automobiles than SUVs are sold, fewer railroad carloads are needed to handle the traffic. This trend is expected to continue in the future, exacerbating the problems related to the announced production cutbacks.

A more serious problem for the railroads however, involves the potential for serious losses in the grain traffic during the second half of 2008 and most of 2009. If grain production suffers only half as much as it did in 1993, the railroads would still lose over 15% of their traffic since more of the crop would be used for domestic needs than exported, and the railroads transportation share of the domestic market is lower than the export market. Grain has been the one of the few traffic segments that have not shown decreases since the housing bust and financial crisis began, and the loss of this traffic will strain railroad profits since it is unlikely that they will be able to raise rates enough to cover this magnitude of a loss.

Implications: Overlooking the author’s tendency for hyperbole and his greatly distorted timeline of history, his conclusion that demand for new coal cars will soon return is right on target. He is also right in highlighting the current danger to those builders who might be exposed to fixed price contracts and escalating steel and specialty parts costs. However, he overlooks one crucial new element in the market for coal cars that Freightcar America (FCA) did not face the last time demand surged for its products: competition. In 2004, the last time buyers changed course and began ordering cars, FCA enjoyed an almost 100% market share. This time however, they will have to contend with a resurgent Trinity Industries (TRN).

Analysis:

Demand for coal cars surged in 2004 after being dormant for a few years due to overproduction in the late 1990s when coal sales were either flat or barely growing. The demand for cars during those years was due to railroad operating problems and slow train speeds, one of the main reasons demand for coal cars was so strong in recent years. As they did in 1999, the railroads improved their train speeds again in 2007/08 and made many of the cars built after 2004 surplus, causing the current downturn in orders even as coal traffic on the railroads surges once again.

Hopefully, the traffic will keep growing and demand for new aluminum cars will return to historic levels. Unfortunately for FCA, this time around they will have to contend with a more aggressive Trinity Industries in the coal car arena. Since the middle of last year, Trinity has increased their market share for this car type from around 20% to almost 50% through aggressive pricing, leasing, and new product designs.

Freightcar has kept control of one type of coal car however, and demand for it is soaring. In conjunction with Norfolk Southern Railroad a few years ago, FCA developed a hybrid stainless steel/aluminum car for the export coal traffic. Low utilization rates and the need to use open flame heaters to thaw frozen coal through the manually operated gates of the coal cars used in export traffic required special cars to replace the aging fleets at both NS and CSX. FCA’s hybrid cars was a success and is contributing to much of that company’s performance this year.

Implications: The in Forbes article about the large number of surplus railcars, the author incorrectly blames the railroad companies for stocking up on ethanol cars until the “ethanol bubble burst” and they realized they had built too many cars. In truth, railcar leasing companies ordered the cars after hearing requests and projections by ethanol companies about the need for more equipment to handle future production from new capacity that was either planned or already under construction. That new capacity is still coming online, albeit at a pace much slower than originally expected, and there may be a few thousand “surplus” cars until production catches up with car supply in 2009.  The ethanol phenomenon has mitigated some of the other problems faced by the railcar industry that can be more correctly blamed on the railroads.

Analysis:  When rail traffic surged in 2004, railroad companies found they did not have sufficient locomotive power to handle the increased number of carloads very efficiently. Railcars waited in terminals for power to arrive and trains ran slower due to low horsepower to ton ratios. With their cars taking longer to cycle back to loading stations, shippers ordered more new cars to add to the supply chain so that they could maintain production and satisfy their customers’ needs in a timely manner. Leasing companies were more than happy to build and lease these new railcars.   Three years and three thousand new locomotives later, the railroad train operation are once again running more efficiently and all of the new cars that were added to the fleet to meet the artificial demand caused by the slow trains are no longer necessary. Thousands of coal cars and grain covered hopper cars sit idle even as coal traffic is up 4% and grain traffic is up 18% in 2008 over the moderately depressed 2007 levels. If orders and deliveries of new cars remain low for the rest of this year and traffic keeps growing, the surplus cars should be back in service by early next year.   The surplus cars in some of the other fleets are less easily explained. The large number of surplus lumber flats can be attributed to both the collapse of the housing market and to a builder/lessor who refused to recognize the signs of impending trouble before it was too late. The large number of surplus intermodal cars is due to the improved train speeds, the decrease in imported containers, and to a major railroad buying cars for its own fleet and returning/storing cars that belonged to the national fleet owner and pool operator, TTX Corp.   If a recession occurs, it will delay the recovery of the railcar industry which now is unlikely to happen before late next year

Implications: IANA (Intermodal Association of North America) reported that the first quarter intermodal volume was down 2.4%, almost identical to the decline reported by the AAR several weeks ago. Not surprisingly, the decline in imports was cited as the main reason for the decline, although the losses were partially offset by tenth consecutive increase in domestic shipments. Although it was forecasted that imports should improve at a healthy pace once the current bout of economic weakness passes, no guess was made as to when that might occur.  Our guess is that railroads may be in for a long wait for that to happen.

Analysis:  The volume of railroad intermodal traffic can be shown to be statistically related to the inflation adjusted volume of retail sales (ex gasoline). No other factor needs to be tracked to determine when intermodal traffic will pick up. Retail sales have been hurt in recent months (years) by a number of economic factors, not the least of which is the rising cost of gasoline. Just a few years ago, the average consumer spent just 3.5% of their disposable income on gasoline; today that percentage has climbed to 5.5%. That increase represents over $200 billion dollars that is no longer available to consumers to purchase other stuff, an annual amount that makes the current one-time tax rebate look insignificant.   Energy costs are not expected to decrease and conservation efforts will take years before they have a measurable impact on the wallet of the average consumer. Imports may not decline significantly in the next few years, but it is unlikely that they will start to grow again anytime soon. Economists are projecting a long bout of sub-2% GDP growth for the US, at least into 2010. If intermodal shipments are to increase before then, railroads will have to improve the speed of their intermodal trains which currently average just under 30 mph and only 10 mph faster than their slow coal trains.   For railroads, that will mean slow to no growth in what was their fastest growing traffic segment. Intermodal revenue surpassed coal revenue a few years ago, but will likely fall below coal revenue this year. Unlike coal traffic where rates have increased almost 60% in the last few years, intermodal traffic is very competitive (highway carriers) and rates have been relatively stagnant and have not compensated for the loss in volume. Western carriers have been hurt more than their Eastern counterparts.   For car builders such as Greenbrier, it may be a few more years before orders start to come in for this intermodal equipment.

Implications: The Surface Transportation Board ruled that the freight rates that the Union Pacific Railroad unilaterally imposed upon Kansas City Power and Light in 2006 for the transportation of their Powder River Coal were in excess of the board’s guidelines for a carrier that had market dominance. Since the STB used an easily understood methodology in reaching this decision, this may be the first of many challenges to the railroad freight rate increases since 2006, often characterized as their newly discovered “pricing power”.

Analysis:  A common carrier can be deemed to have market dominance if there is no effective competition from other rail carriers or modes of transportation for the transportation to which a rate applies and for which it charges rates which are more than 180% its variable costs. In the case at hand, both the UP and KCPL agreed that there was no effective competition, but they disagreed on the percent of variable cost calculation. The UP’s computations of the latter were in the range of 155% to 164%, while the KCPL computed the railroad rates to be in the 207% to 229% region.   Railroads report their costs, revenues, and operating statistics to the STB each year in standardized formats that are used to compute the system-average variable unit costs for each carrier. In past rate case appeals, railroads and shippers were able to argue for modifications to the system average figures based on the operating characteristics of specific freight moves. In the UP/KCPL case however, the STB applied the system average unit costs and reiterated their intention of using average costs to simplify freight rate appeals.   The STB found that the UP’s rates were between 189% and 204% of their variable costs and ordered them the refund the excess freight revenue, with interests, to KCPL for shipments from the first quarter of 2006 to the first quarter of 2007.  Additional refunds will be required when the remaining data for 2007 and 2008 are supplied by the UP. Moreover, since the ruling will apply until 2015, the rates will either have to be reduced or the STB will be enforcing additional refunds.   The STB also used the new cost of capital methodology they recently published (April 15, 2008) to determine the unit variable cost. They estimated that this alone accounted for half of the overcharge amounts they computed for the five quarters between 2006 and 2007. If the old cost of capital procedures had been used, the rates would have been found to be between 185% and 193% of the variable unit costs.

Implications: Trade magazines are usually constrained to write only positive comments about the companies in the industries they cover, since subscriptions and ad revenues are more dependent on goodwill rather than good investigative reporting. In the article reviewed below however, the writer/editor finally fesses up, CSX was poorly managed in the past, and much of the blame belongs to the ex-Chairman/CEO, John Snow. The article goes on to heap the usual praise on the new management team assembled a few years ago by Michael Ward, probably trying to aide in their defense against the corporate raid being staged by the TCI fund.

Analysis: Ward and team have a new operating plan and it hopefully will be successful; results to date are inconclusive. While train speeds and terminal dwell times have dramatically improved, so have those on the other rail lines and CSX had more room for improvement than others. Also, traffic volumes are well below levels of a few years ago and one would expect the rail system to be more fluid. More telling of better operating management are the reductions in personal injuries and derailments; either transportation officers are more focused on their work or maintenance practices have been improved or both.   Most of the improvements to the bottom line have been achieved by raising prices, a nice strategy that has worked for the past few years and may still work for a few more quarters, but one which eventually must end. Hopefully, the extra money will allow good maintenance practices to be continued and good investments to be made to reduce costs and increase volumes in the future. Only time will tell on the latter, but better maintenance is already evident in their operating results.   The problems that resulted from the mergers that created CSX should not be so quickly dismissed. The string of poorly handled mergers that led to CSX points to an executive team that was more at home in dealing with regulators than at managing a railroad operation. The spider web of rail lines that is CSX is one of the most difficult systems to manage and one that would challenge even the best management team. Which leads one to question why a group of investors (TCI), who have no railroad management experience, could do any better than the current team of managers at CSX.   What TCI is offering investors sounds pretty similar to what past managements told the Interstate Commerce Commission and Surface Transportation Board they could achieve with one of the old CSX mergers. Great plans have a way of faltering on the rocks of reality, and unless you have a good skipper to handle the crisis, the wreck will be nasty. Ward may be overpaid, but he has shown himself, so far, to be a good skipper and should be entrusted to keep guiding the company.

Implications: CEO’s never like to go into lengthy explanations on the dynamics of their industry in explaining a dismal financial performance, but with year to date coal volumes up 4.6%, according to the most recent AAR report, blaming the economy for the problems besetting the company seems more like dodging the issue than helping shareholders understand the situation. The new president of FreightCar America cannot be blamed for how the company found itself in these waters, but a better explanation of the problems might have given shareholders more confidence in his ability to navigate the company in the future.

Analysis:  Two years ago, a combination of real and artificial demand, coupled with over optimistic speculation by freight car lessors resulted in windfall profits and volumes for this coal car builder. Back then, everyone knew the bubble would eventually burst and the high level of orders would disappear as surplus cars began to arrive in the market. It was hoped that the railroads would not be able to return to the train speeds they had achieved just a few years earlier, but such was not the case and many of the cars that had been built to compensate for the lengthy car cycles became unnecessary as train speeds improved and car cycles shortened. Which brings us to the current situation; there are still surplus cars even though car loadings have increased 4.6% over last year’s levels.   FreightCar has a good relationship with the Norfolk Southern Railroad (NS), having purchased the latter company’s repair shops in Roanoke, VA to expand their production capacity in 2005 in order to meet the surging demand for coal equipment. NS has recently given FreightCar more orders to replace its aging fleet of steel cars and this will significantly help the company through the tough times ahead.   Competition in the railcar market is heating up, with new entrants (National Steel with its first US plant in Alabama), re-energized contestants (Trinity with its new RDL car and its aggressive leasing), and too few orders to keep everyone satisfied. Unless all the new coal fired plants that have been advertised for years finally start to come online in 2009, it will be 2010 or later before the current surplus situation ends.  

Implications: During the last downturn in the railcar building industry, Greenbrier gained market share while cutting back production since the cars it produced were more popular that the car types manufactured by the other builders. This time around, just the opposite is true; there is almost no demand for the intermodal well cars, lumber flats, and boxcars that carried Greenbrier through the last recession, but there are still buyers for the coal, tank, and grain cars manufactured by the other railcar builders. In response to market conditions, Greenbrier closed its Canadian plant last year and began to solicit orders in other car types such as covered hoppers and tank cars. Manufacturing margins for these car types will be slim for a while as Greenbrier buys its way into these new markets. In the mean time, its plants are not operating at the levels that are necessary to earn a profit in this marketplace.

Analysis:  The multiyear contract with BNSF was recently renegotiated and orders for intermodal well cars were decreased in exchange for more orders for covered hopper and auto-carrying cars, according to reports issued by the company. Unfortunately, the long running intermodal line in Portland Oregon probably has higher profit margins than the new lines in Mexico that make covered hopper cars and the auto-carriers ordered by BNSF and overall production margins will probably slip in the future.   The company delivered almost 13,000 cars in North America in 2005, but it will be lucky to top 6,000 cars in 2008. Although Greenbrier closed one of the three plants that it was operating in 2005, it began a joint venture with another plant in Mexico and began sharing orders with that company in 2007, negating the capacity reduction that would have kept its remaining plants operating near capacity. With only 6000 cars to spread between three plants, profits from manufacturing will be severely depressed if not negative.   The market for Greenbrier’s old mainstays, intermodal and lumber flats will probably not return to healthy levels for at least two more years, and the markets that it is entering, tank and grain cars, already have at least three well established builders making it tough to grow market share and increase profit margins. Greenbrier has made significant moves to diversify its operations and has beefed up its roster of repair and refurbishment operations in recent years. These plants will hopefully carry the company through a tough time for its new car operations in the next few years.

Implications: Per the author(s) of this blog, 10Q Detective, the prospects of increasing demand for railroad coal cars is not good and therefore the chances of accelerating growth at Freightcar America is also poor. There is so much that is wrong with this article and how it analyses the demand for new coal cars that it is hard to see how they managed to get to the right conclusion that the future prospects for Freightcar America are less than positive; but they did. Notwithstanding the current trends in railroad coal traffic (up 4.3% for the year), demand for coal cars is going to be soft for the next few quarters. Since coal cars are the main product of FreightCar America, its railcar deliveries will be lower in 2008 than in 2007.  

Analysis:  It might be stated that some railroad traffic rises and falls with general economic activity, but it is also true that some traffic is acyclical, that is, it rises and falls due to other factors. Coal is one such traffic segment, as might be concluded by the fall in production in 2007 and the rise in output so far this year. Therefore, to infer that future coal production will rise or fall if the economy improves or declines and therefore the need for coal cars will increase or decrease would be wrong. Demand for electricity does track with general economic activity, but the use of coal to generate electricity is dependent on many other factors, not the least of which are the price of natural gas and the power of the environmentalist in influencing the choice of fuel by electric utilities. At the present time, it is still too early to say how coal production change in the future.   The second problem with the commentary is the assumption that the railroads need to make investments in coal cars in the future. For the past twenty five years, most of the railcars that have been added to the national coal car fleet were bought by leasing companies or electric utilities. Like today, the railroads did not have the capital resources to invest in both their physical plant and their rolling stock and they elected to allow other companies to supply cars to the national fleet. Leasing companies might be worried that the new found prosperity of the railroads might lead them to once again buy railcars for their own fleets, but car builders need not worry that there will not be enough capital to fund future acquisitions.   With so many erroneous assumptions, how did the author(s) end up with the right conclusion? To be brief, too many railcars were built in the past few years and the railroads have improved their operations enough to produce a large surplus of coal cars. The surplus will dampen demand for several months.  

Implications: For almost 100 years, or since 1921 to be precise, the railroad industry has been shedding excess capacity and abandoning lines and terminals. For most of that time, unfortunately, it was also losing traffic to other modes of transportation, primarily to the trucking industry. It was only recently that the railroads finally realized that they had abandoned too many lines and that excess capacity was no longer an issue. BNSF had to buy back a line they had sold that went from Seattle across the Cascade Range, and UP has been busy relaying some of the double track the SP had removed from the Sunset Route in the early 1990s. (The SP president was named the Railroad Man of the Year for that and similar feats.) With capacity tight, the railroads learned that they could charge more for their services and be somewhat indifferent to traffic losses as long as they were operating at or near capacity. Why would a company in such a situation be in any hurry to build more capacity?

Analysis:  Much of the congestion currently found on the railroad network is there by design. Rail lines were abandoned or relegated to local service in order to put more traffic onto designated corridors where operational efficiencies could be achieved. The Union Pacific’s yard at North Platte NE is so busy because traffic that used to move through Utah and Colorado was rerouted to the South Pass of the Rockies and across Nebraska where grades were lower and trains could run faster and with fewer locomotives and crews.   Much of the traffic growth in the West is due to the surge in coal traffic out of the Powder River Basin. The two main carriers in the West added track only after the traffic clearly warranted more capacity, but even those investments were gambles that the Green Lobby in the US would not be successful at curtailing the use of more coal in the future. Coal exports have partially offset some of the setbacks in recent months on the domestic scene, and rising natural gas prices have kept prices for coal at elevated levels. With high prices for coal and tight line haul capacities, the railroads have been able to raise freight rates almost 50% during the past few years.  

Implications: The decline in trailer and container shipments, especially those originating at West Coast ports, has resulted in a large surplus of railroad intermodal cars, specifically the doublestack well cars used to handle containerized imports. BNSF (NYSE:BNI) has been reported to have parked thousands of well cars around its system. Other railroads are reporting, however, that surplus quantities are no greater than might be expected at this time of year due to the seasonal nature of this traffic. Nevertheless, with traffic down significantly from last years’ levels (-4%), it’s hard to imagine how the seasonal railcar surplus looks normal.

Analysis:  A number of forces are affecting railcar demand: (1) traffic is down for most commodities, including intermodal containers; (2) excessive deliveries of new railcars in recent years are still being worked off; (3) train speeds are increasing and making cars built for the slow trains of the past few years redundant. Surplus quantities of all car types are plaguing both railcar builders and railcar lessors and will be a drag on new railcar demand for more than the coming year unless railroad traffic rebounds in all segments and train speeds decrease because of congestion once again. Since that is not likely to happen until we are well into 2009, it is unlikely that strong demand will return to the railcar sector for many months.   It should be noted that grain and coal shipments are up in 2008 and will continue to drive overall railroad carload totals up for the rest of the year. Railcars that handle these commodities were built in large quantities in recent years, more than could be justified by traffic demands. The resulting surpluses will have to be worked off before more are needed.

Implications: Mike Ward said that CSX would continue to enjoy double digit earnings growth for another few years, and he put an exclamation point to his forecast by boosting the share buyback program and increasing the dividend on these shares outstanding. His inspiring words however, might just have been an opening salvo against the investment funds who want to scale back CSX’s capital investment programs in order to reward their short term investments. It’s a shame that such bravado is necessary, but it would also be a pity if The Children's Investment Fund and 3G Capital Partners were allowed to loot the CSX treasury for their short term gain at the expense of other investors and perhaps the US taxpayers if they set up another Conrail type bailout in the future.

Analysis:  All the railroads have benefitted from the pricing power that a near capacity operation and a runaway inflation in commodity prices allow. From a rail shipper’s point of view, the pair of developments might be likened to the perfect storm. However, while railroads might be assured near capacity operations for the indefinite future, continued inflation in commodity prices is not as certain. Economic forces have a way of adjusting for distortions in prices over time, and it is not at all certain that the current trends can be maintained over the long time required to reach to 2010.   That said, there are other developments at CSX that might just possibly make the prediction more likely than the continuation of the economic trends of the past few years. After nearly 20 years of mega-mergers that began with the Chessie System and the Family Lines in the mid-1980s and ended with the combination of CSX and part of Conrail in the late 1990s, this railroad has only recently developed a cohesive management team and is only now really beginning to concentrate traffic on core line segments that are being given priority for capital upgrades. The strategy is by no means a certain route to success, but it is at least an attempt to rationalize the spider-web of rail lines that have been cobbled together through past mergers. Without the financial resources that have been accumulated in recent years through the pricing power developments, the capital upgrades planned for the future would not have been possible and the continuation of the subpar performance of this company with operating ratios around 80%  would have been the norm. Instead, operating ratios may begin to fall in future years not just because of increasing revenues, but also due to decreasing costs; at least that is the plan. CSX has a long way to go before it can aspire to the operating ratios in the low 70% range of its main competitor in the East, but at least it now has a plan to get there.    

Implications: Two years ago, the ethanol industry went into overdrive in expanding production facilities and ordering railroad tank cars to move the expected flood of new production. No one, however, looked at how the ethanol was to be handled at the customer end of the distribution network and that has produced a major problem for the new industry. Even with corn prices well above $5.00 per bushel, ethanol producers could make about $0.20/per gallon if they could get their product to the final customer, the US motorist. Unfortunately, there are only four terminals ready to handle unit trains of ethanol and the shipment of small carload lots is just too slow to move the expected production. Tank car lessors who ordered large numbers of railcars to move ethanol have been left holding the bag this time waiting for the gasoline distributors to get with the program.

Analysis:  In 2007, the industry produced around 6.5 billion gallons of ethanol, up from roughly 5 billion gallons in 2006. By the middle of 2007, the industry capacity was over 7 billion gallons and another 6 billion gallons was set to come online before the end of this year. To meet the demand for transportation, tank car builders and tank car lessors were added 12,000 ethanol cars to the national fleet last year and planned to add a similar number of new cars this year to handle the expanding production. Near the end of last year however, the growth in production slowed to a crawl and all reports since January hint that the total production for 2008 will be closer to 7 billion gallons than to the expected 9-10 billion gallon output previously expected. Last year there were dozens of tank cars looking for a home; this year, the number of surplus cars will reach into the hundreds and thousands as producers cut back because they cannot get their product to market.      Despite the record level of corn prices, it has been a buyers’ market for ethanol since last summer. Perhaps that is why the USDA has forecasted that farmers will plant fewer acres of corn in 2008 than they did in 2007. If that forecast comes true, ethanol product will probably cap out for a year or so until the distribution networks along the Atlantic and Pacific coasts are built to handle all the ethanol that is ready to flow from the Midwest. In the mean time, companies like Trinity Industries (TRN), GATX Corp (GTM), The Andersons (ANDE) who have made commitments for ethanol tank cars will have to grunt and bear it for a year or so more.

Implications: It’s hard to argue with success, and success is what the railroads are currently achieving after a decades -long battle for survival with their highway and barge competition. While all modes of transportation saw freight traffic soften in recent quarters, only the railroad companies have been able to maintain their profit growth. Praise is coming from all quarters and investors are being encouraged to join the likes of Warren Buffet in buying into the rail industry. The high P/E ratios are said to be justified by the prospects of double digit profit growth for several more years. Notwithstanding all the hype about productivity, the problem is, all of the recent growth in profits has been due to freight rate increases, and it must be questioned how many more years these annual increases can be maintained.

Analysis:

After the railroads were deregulated, sort of, by the 1980 Stagger’s Railroad Revitalization and Regulatory Reform Act, the major railroad companies aggressively reduced their rail networks, spinning off many branch lines and secondary main lines to new shortline and regional railroads that employed non-union crews. It might be argued that these actions induced the railroad unions to be more accommodating to the carriers’ request to reduce crew sizes on trains and switch engines, but whatever the reason, the railroads were allowed to eliminate cabooses and eventually reduce their train crews to just two members, an engineer and a conductor. By the mid-1990s, the railroad industry had achieved most of the productivity gains that are currently allowing them to perform so well. All that remained was to reduce the cutthroat competition that had so ravaged the industry during the years that the trucking companies were taking their high revenue traffic over the Interstate System and the inland barge companies were keeping much of their low rated bulk traffic at unprofitably low levels. The latter task was finished by year 2000.

In recent years, the productivity gains of the 1980s and 1990s and the reductions in competition achieved in the 1990s have enabled the railroads to impose near double digit annual freight rate increases and to take all of the additional revenue to their bottom lines. Success has been achieved; but how long will shippers take the continued rate increases? Increases in diesel fuel costs and increases in commodities prices have given some cover to past rate increases, and may continue to provide some justification and cover for future rate increases; but when will these inflationary trends end. It is unlikely that the inflationary pricing in all sectors will continue indefinitely, and once it ends, the railroads will probable resume their single digit growth rates. Maybe that is why Warren Buffet only buys BNSF when it is priced below $80/share.

Implications: The growth rate of the ethanol industry has slowed significantly in recent months as the price of corn pinched the profit margins of most firms and put some inefficient producers out of business.  With corn prices at $5.55/bu., reformulated gasoline (ethanol) prices must be above $2.00/gal just to break even, and prices last summer dipped as low as $1.50/gal. after a small surplus of ethanol developed. As uncertainties about costs, prices, and demand increase, producers are scaling back their plans for expansion.  Railcar lessors however, have already committed to buy, or have already taken delivery of enough railroad tank cars to move the previously projected production total of 10 million gallons 2008. Car surpluses are developing as lessees walk away from commitments, a rarely used and dangerous practice for most users in that industry.

Analysis:

Commitments by railcar lessees to take delivery and to begin payment on leases for railcars used to be almost as good as written contracts, and the latter were rarely broken. This was especially true among tank car lessees and lessors who populated a rather small community where reputations lasted for decades. With the boom in ethanol production, dozens of new players and companies have entered the rail car market and these newcomers are not playing by the traditional rules. Commitments by companies to lease new cars are being broken, and even lease contracts are being challenged as companies delay startups or cancel expansion projects.

Companies such as GATX Corp. (GTM), Trinity Industries (TRN), and The Andersons (ANDE) have made major commitments to this new industry and have built or have committed to build thousands of new tank cars. In late 2006, the existing capacity of the ethanol industry was 6 billion gallons per year and capacity expansions in excess of 7 billion gallons per year were expected to be installed by the end of 2008. To handle the increased production, there were 24,000 orders for ethanol tank cars backlogged for production in 2007 and 2008. Half of those cars have already been built, and already surpluses are arising as companies walk away from previous commitments. None of the builders and none of the leasing companies are saying that orders for new cars have been cancelled, but it would be wise if production schedules were at least extended beyond 2008 to let the industry production catch up. This would hurt the 2008 revenue and profits of the car builders (TRN, Union Tank, and American Railcar (ARII)), but it would give the market a chance to clean up the current surplus and it would keep production levels from plummeting in future years if a big a surplus arises after the 12,000 new ethanol cars are built this year.

In total, perhaps over 36,000 cars new ethanol cars will have been built between 2005 and the end of this year if current schedules are not reduced. Between 2005 and 2007, production increased from 4 billion to 6.4 billion gallons. It was recently thought that production in 2008 would be between 9 and 10 billion gallons. Based on production increases during the last quarter of 2007 it now appears that the output in 2008 will not even reach 9 billion gallons and will be lucky to exceed 8 billion gallons. That would mean a surplus of thousands of the tank cars and it would take years to absorb that fleet.

Implications: The two largest railroad carload traffic segments, Agricultural products and Coal, are once again flowing in record quantities after a disappointing performance in 2007. Grain traffic is up 17% for the first 8 weeks of the year and coal shipments are up 3.4% for the year following increases last week of 18.3% for grain and 4.8% for coal compared to the same week last year. Traffic segments related to construction and the domestic economy in general were all down, except for Chemicals which include ethanol (up 3.7% YTD). The largest segment by revenue, Intermodal, was also down for the year, -3%.

Analysis:  The gains in grain and coal traffic appear larger on a year-over-year basis in this softening economy than they should. Last year, both segments were down by significant margins during the first quarter when compared to the traffic levels in 2006. Grain was down almost 8% following a bad harvest in 2005, and utility companies were reducing their stockpiles in 2007 during the first quarter and coal traffic was down almost 4%. Nevertheless, the gains this year came at a fortuitous time and have more than offset the declines in most other railroad traffic segments. Moreover, the signs point to continued growth in both of these sectors in the coming months and years. Prices for all types of farm commodities are at record levels and farmers are planting every available acre to meet increasing foreign and domestic demand. Foreign demand for US coal should also keep production increasing in spite of the continued assault by the green forces in this country. Most importantly for both segments, the rising commodity prices should keep supporting railroad freight rate increases.   Overall, carload traffic is up 1.4% for the year, even though carloads in most business segments are down. Most worrisome for the rails is the continued decline in intermodal traffic. This business segment had been expected to be the engine of growth in the future and most of the cap-ex funds spent by the railroads in the past few years have been in this market. Last year, intermodal traffic was down 1.6% for the year, but traffic during the first 8 weeks of the year was even with 2006 volumes. The economic doldrums that seems to be gripping the US show no signs of ending soon and the railroads will have to be thankful for the resurgence in demand for their boring old bulk commodities.

Implications: Railroads, both large and small, have managed to keep raising freight rates each year, even as some of their traffic segments have suffered declines in loadings and ton miles. Although the data is still incomplete, it does not look as if the rate increases are to blame for these traffic losses. Moreover, opposition to the freight rate increases has not grown significantly and regulatory laws that have been promoted by groups such as CURE are not likely to be passed in the near future. If there is one factor that has been responsible for this situation it is the steady increase in commodity prices during the past few years, and rail freight rates should be able to keep rising as long as commodities keep getting more expensive.

Analysis:

Hardly a week passes without some news of inflating commodity prices. This week, crude oil has begun another run at $100 per barrel and iron ore prices were increased 65% in negotiations between China and CVRD. Last week, the rapid increases in grain prices were noted in the USA Today article by Sue Kirchhoff and John Waggoner. The price of corn has risen from around $2.50 to near $5/bu. and soybeans have increased from $7.50 to $13.26/bu. World prosperity is the main factor driving this round of demand-driven inflation, although some might correctly point to the use of food grains and oil seeds by the biofuels industry as the most visible factor driving grain prices up. Biofuels however, would not be in such demand if there was not the perception, if not the reality, of rising demand and limited supplies of crude oil. Daily crude oil production has not risen since the fall of 2006 and some industry experts are pointing to that time as the all time production peak for crude oil.

Prices for other commodities such as metallic ores are rising due as much to the consolidation of suppliers as to the increasing demand from China and the other developing countries. However, demand driven inflationary pressures last seen during the 1970s seem to be back and railroad freight rates will probably keep rising in concert with all the other basic commodity prices.

Implications: Carl Icahn’s purchase of a 9.5% stake in Greenbrier Cos. seems to imply that he intends to pursue a merger between American Railcar (ARII), in which he controls a majority of the stock, and Greenbrier, two railcar builders with complimentary design portfolios and railroad business interests. The two companies each lack what the other possesses and the merger might be a good strategic move in an industry plagued by cyclical swings. However, Greenbrier’s manufacturing output has declined for the past two years and looks to fall again in 2008.

Analysis:

American Railcar has three state-of-the-art manufacturing plants in Arkansas which produce specialty covered hopper and tank railcars. A leasing affiliate, American Railcar Leasing, is owned by Icahn but is no longer a part of ARII. Greenbrier owns an old manufacturing plant in Oregon where is produces most of the intermodal equipment purchased by the railroad industry. Trinity (TRN) used to have a major market share of the intermodal business but ceased to pursue orders for these cars in 2002 after its merger with Thrall Car Manufacturing; Freightcar America (RAIL) and American Railcar both have new designs for intermodal cars and appeared to be ready to take on Greenbrier. However, the market for these cars is very soft and is not likely to recover for at least two years, thanks to all the cars Greenbrier has built for BNSF recent years. BNSF has been acquiring its own intermodal cars and returning rental cars to TTX Corp. The latter company owns most of the intermodal cars in the national fleet and will have to work off their surplus before reentering the market for new equipment.

Greenbrier used to build boxcars and lumber flatcars, but the markets for these cars evaporated and they are not likely to re-appear anytime soon. Greenbrier has also built grain covered hopper cars in Mexico in recent years, including many for their own fleet, just as they did in the waning days of the housing market with centerbeam lumber flats. In this market, they compete with Trinity Industries (TRN) which is arguably the low cost producer of this car type.

Greenbrier’s earnings have been sustained with acquisitions in the railcar repair industry. The company is now a major player in that industry and has a huge fleet of managed railcars that they can direct to their own shops to keep production levels up. The size of the managed fleet is many times that of the owned fleet, and if the latter can be sold to reduce the debt load, it should not greatly affect the in-house diversions to company owned repair shops.  However, most of Greenbrier’s income is derived from just a few large companies that provide business to all of its different segments, and successfully unwinding this company to pay down debt and reduce overhead may provide a difficult task.