Unstoppable?

With all due respect to Denzel Washington and Chris Pine, the railroad stocks may be the things that are unstoppable and not just the exaggerated Hollywood freight train story.

The run the railroad stocks have had over the last decade is a real event and not just based on one. Indeed, railroad stocks have outperformed the market in nine out of the last 10 years. If the rail stocks finish this year ahead of the broader market, it will be more than just another notch in the railroad’s proverbial belts; it will be a decade of complete outperformance. As we exit the year and look into 2011, we must examine the position the industry is in and any events that could derail this runaway train.

Through the first nine months of 2010, rail volumes have continued their recovery, with total carloadings climbing 12.5%. Every commodity group has posted gains, with notable strength shown in metallic ores & minerals (up nearly 50%), motor vehicles & equipment (up 34%) and intermodal units (up 16%). The rails have been benefitting from a gradual recovery in the economy as well as continued truckload conversions. While we are unlikely to eclipse 2007 levels on an annual basis, thus far our top week in 2010 was a mere 7.5% from the peak weekly numbers posted in week 39 of 2007. We are far from claiming the economy is booming, but it appears that we have come a long way since the panic-stricken days of late 2008 and early 2009.

With the economy slowly rebounding the rail industry is continuing its pricing gains, with most Class I’s posting 3-6.6% core pricing improvement in the third quarter. Core pricing gains are expected to continue over the next year as the rails benefit from improving economic conditions and tight supply in the truck market. While most Class I’s will only commit to being able to price above “rail inflation,” their customers have been more vocal about what to expect. Indeed, when polled in our proprietary Dahlman Rose 3Q Railroad Shipper Survey, railroad the customers noted that they expect prices to increase 4.2% over the next 6-12 months.

Collectively, the Class I’s have proven more than capable at handling the increases in volumes as they have spent all of 2010 moving employees off furloughs and taking locomotives and cars out of storage. This has enabled many companies in the industry to post record operating ratios. Although many have broken the 70% mark, longer-term goals are targeting the 65% range for several carriers in the group. The railroads continue to spend high amounts for their capital expenditures and continue to pay dividends in the 1.3-2.2% range. That said, the group is generating ample free cash flows that should allow them to maintain strong balance sheets and support their shares via share repurchase programs.

When removing the rose colored glasses, we find some potential obstacles for the railroads as we ring in the New Year. The economic recovery will obviously have an impact on the railroads and the amount of carloadings they handle in the coming year. Aside from this easy observation, we note that coal could play a larger role going forward. Utility stockpiles are off from record highs in November of 2009 but uncertainty remains with natural gas prices trading at just $4.37 p/ncf. Additionally there are numerous potential hurdles on the environmental front that could cause problems for coal production going forward.

If the rails can avoid being overregulated from the government and the economy can maintain its recovery, it is hard to imagine investors not continuing to have interest in the railroad sector. Indeed, many railroads will be poised to grow earnings at a double-digit pace and continue to increase their dividends in the coming years. Although many may not consider this recipe “unstoppable,” it still seems like a successful investment strategy to us.