It’s not just falling fuel prices that are driving railroad profits

Implications: On September 10, an analyst at USB thought that the two major western railroads would do well in the second half of 2008, the day before CSX upgraded its earnings estimates for its third quarter from around $3.55 to $3.70.  USB had also upgraded Norfolk Southern to a BUY on September 10. Most analysts think falling fuel prices will give the railroads a short term boost in earnings due to the time lag between when fuel is purchased and when the fuel surcharges are recalculated. Since railroads hedge their fuel purchases, this may or may not be the reason profits at all four railroads will rise and continue to rise in the near future.

Analysis:

Railroad hedging activities may keep their fuel prices higher than the spot prices until the fuel price indices trigger a reduction in surcharge amounts. Most railroads have employed hedging strategies as a means of protection against rapidly rising fuel costs, and these strategies may work against them in the short term as fuel costs fall.

 

The reason that the railroads have enjoyed rising profits in recent years relates more to increased freight rates than anything else. Traffic volumes have been relatively static since 2006, but through aggressive rate increases the railroads have managed to achieve increasing revenue levels and increasing profit margins. Any jump in profits in the next several months will almost certainly be due to rate increases.

 

Non-fuel expenses have increased for most carriers as material and labor costs have risen; only CSX has been able to hold non-fuel unit costs relatively constant. Their actions have augmented the increased profits that their rising freight rates have affected. With the elevated capital expenditures in recent years however, all of the major railroads should see unit cost reductions when traffic builds in the next economic recovery. While the effect on the bottom line from these improvements will be smaller than the current freight rate increases, they should keep railroad profits increasing at a handsome (even if not double digit) rate when the traffic will no longer tolerate the annual freight rate increases the railroads have been imposing on their shippers.

 

However, the major reason operational efficiencies should improve in the future is the fact that there have been no major mergers in the last ten years. This is the first time in many decades that there have been no major railroad mergers; and there are no prospects of any additional merger activity in the future. Railroad managers will continue to improve their operations and capital expenditures will be more related to improving efficiencies and capacities than to stitching together different railroad systems.