Railroad freight rate increases are only reason for increased profits and share buybacks

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.