April's 2012 rail data looks like more than a little bit of history repeated. While the healths of the railroads and the economy have generally been pretty closely correlated, some of that linkage is breaking down. With coal demand plunging, but most other core industrial categories doing well, this may be a case where rails struggle to replace the high-margin coal revenue while the rest of the economy continues to grow.
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Another Weak Month
According to Rail Time Indicators, a publication of the Association of American Railroads, United States rail traffic dropped 5.5% from last year's level and 2% from March. Intermodal traffic was up 3.6% from last year, while the month-on-month performance saw 0.3% growth. Of the 20 major categories, 11 had positive carload traffic in April (versus 13 a year ago and 12 last month).
Once again, though, traffic trends were dominated by the volatile (but voluminous) coal and grain numbers. Coal traffic plunged more than 16% this month, while grain was even worse (down 17%). Scrub those out and the ex-coal/ex-grain traffic actually increased almost 7% for the month - a pretty good sign for the economy as a whole.
SEE: A Primer On The Railroad Sector
No Joy in the Coal Mines
Clearly the current trends in coal are having a big impact on the sector, as the combination of a warm winter, low natural gas prices and new environmental rules all combine to pressure coal demand. This is a serious matter for Norfolk Southern (NYSE:NSC), CSX (NYSE:CSX) and Berkshire Hathaway's (NYSE:BRK.A) Burlington Northern, as all of these companies get a substantial amount of their revenue (25%+) and operating income from hauling coal.
If there's good news, it's that most of the Eastern utilities that can switch to natural gas have already done so. Moreover, there's not as much natural gas-fired capacity in the Midwest, so those utilities will continue to need coal. If this happens to be an exceptionally warm summer and electricity demand spikes, those coal inventories might decline and demand could pick up. Nevertheless, this is going to be a lousy year for coal transport.
SEE: Understanding The Income Statement
There Are Some Alternatives
While coal is a major line item for Norfolk Southern, CSX and BNSF, it's not nearly as significant for Union Pacific (NYSE:UNP), and it's frankly a small part of the overall picture Canadian Pacific (NYSE:CP), Canadian National (NYSE:CNI), Kansas City Southern (NYSE:KSU) and Genesee & Wyoming (NYSE:GWR).
Kansas City Southern would seem to be an especially interesting railroad today. While it has some vulnerability to the grain sector, record corn plantings suggest that there should be heavy rail demand later in the year as that corn moves to silos and other customers. More to the point, it has good industrial exposure and should continue to benefit from the ongoing traffic recovery without that worrisome exposure to coal.
SEE: Earning Forecasts: A Primer
The Bottom Line
It's not too surprising, then, that Kansas City Southern, Canadian Pacific and Canadian National are all near 52-week highs and sporting double-digit enterprise multiples (though CN is technically at 9.9 times as of this writing).
By comparison, CSX would seem to be the cheapest of the major Class 1 comparables. While investors may be tempted to think CSX has been overly punished, a quick look at the earnings estimates suggests only moderate downward revisions so far (though the March quarter was actually pretty solid).
The good news for rail investors is that there wouldn't seem to be much room for coal traffic to get worse, while industrial demand has remained fairly strong. Though the health of Europe and China play directly into that lucrative intermodal growth, I wouldn't be in a hurry to flee this sector yet.
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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.
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