rail renaissance: returns, capital & capacity ab hatch abh18@mindspring.comabh18@mindspring.com...

Rail Renaissance: Returns, Capital & Capacity

AB HATCH abh18@mindspring.com

The Transportation Conference

Toronto September 2008 ::

Railroads at historic tipping point

The Railroad Renaissance is here – will it last? Capacity issues across all modes Volume increasing – right? Share, rates, service levels (yes) – and returns increasing But pushback (shipper/regulator/union) also increasing! A secular, not a cyclical story – right? Capacity and infrastructure – and competitor - issues remain Fully reflected in the market? Or is this just another cyclical

slowdown? NET/NET- The industry is poised to go up – or down –

based on decisions made here & now

Railroad PerformanceClass I Railroads

0

50

100

150

200

250

300

64 68 72 76 80 84 88 92 96 00 04

Index 1981 = 100

Source: Railroad Facts, AAR (Based on a design by R. Gallamore)

Productivity

Volume

Revenue

Price

Street influence on RRs – and Why that affects ALL stakeholders

Battle for cash

Management’s reactions to pressures

Investors, competitors, regulators,

politicians, labor – oh, yes, and customers

Short term decisions/long term

consequences

Which “bucket” will they place their chips?

Show Me the Money

Share Price is the Indicator – over time!

Cash (Flow) is King

High ROIC = High Stock Price

And Vice Versa

Key is the phrase “through a cycle”

Old Model: Disinvestment

New Model: TBD (But CP gives us a clue)

Simple Math

RatesReturnsCapital ExpendituresCapacityService

ARE ALL CONNECTED!

Virtuous Circle (’03-07) or Disinvestment?

Sources of capital

FCF – booming at most carriers (capex vs. ROIC)

Governments – states, PAs, Feds, PPPs Governments – Canada as contrast Traditional Street sources & Banks Institutional investors Hedge funds Private Equity/Infrastructure Funds (still?)

New Sources of Capital – Threat or Opportunity?

Fortress-RailAmerica/FEC (etc)

Infrastructure Funds (Toll Roads)

Hedge Funds & “Activists” (TCI)

PPPs – Heartland, Nat’l Gateway, CREATE

Share repos

C-1 Buyouts (DM&E)

JVs – Meridian, Patriot corridors

Threats to the Renaissance

Cyclical vs. secular argument New Congress –impacting labor & shippers Mandated Reviews – STB, Canada Rereg – the MAD answer Execution: service Execution: merger Hedge funds? Liquidity?

Railroad Daily Stock PricesJanuary 2, 2008 through September 16, 2008

50

75

100

125

150

175

1/2 1/16 1/30 2/13 2/27 3/12 3/26 4/9 4/23 5/7 5/21 6/4 6/18 7/2 7/16 7/30 8/13 8/27 9/10

S&P500 Simple Average of BNI, CSX, NSC & UNP

Index Jan 2, 2008 = 100

Sources: Yahoo Finance (adjusted for dividends and splits)

Railroad Daily Stock PricesSeptember 2, 2008 through September 16, 2008

80

85

90

95

100

105

110

9/2 9/3 9/4 9/5 9/6 9/7 9/8 9/9 9/10 9/11 9/12 9/13 9/14 9/15 9/16

S&P500 Simple Average of BNI, CSX, NSC & UNP

Index Sept. 2, 2008 = 100

Source: Yahoo Finance (adjusted for dividends and splits)

S&P 500 and RailroadsMonthly Data January 1980 – April 2007

Index Jan. 1980 = 100

Sources: MSN and CSI, Inc.

0

200

400

600

800

1000

1200

1400

Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05

S&P500 Railroads

Railroad Return on EquityClass I Railroads

0%

2%

4%

6%

8%

10%

12%

14%

91 93 95 97 99 01 03 05 07

Source: Railroad Facts, AAR

n.m.n.m. = not meaningful (negative value)

RR CoC vs. ROIC – RR Stocks have done well but… they still trade at a discount to all stocks

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07p

Cost of Capital Return on Investment

Source: Surface Transportation Board, 2007p based on AAR filing and Railroad Schedule 250s Note: Cost of equity estimation method changed by Board effective 2006.

Railroad Intermodal Revenue Growth Over 5% - Long Live the New King!-

19901995

20002005

.

$0

$2

$4

$6

$8

$10

$12

$14

Billion

s

Source: Carload Waybill Statistics (includes non-Class I railroads)

Coal Intermodal

17%18%

19%20%21%

22%23%24%

25%26%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Coal Intermodal

*Data for BNSF, CSX, KCS, NS, and UP Source: Railroad financial reports

Intermodal and Coal as a % of Revenue*

Intermodal is the Top Source of U.S. Freight Rail Revenue

U.S. Railroad Intermodal Traffic(millions)

0

2

4

6

8

10

12

14

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

U.S. Railroad TOFC/COFC Units

Source: Association of American Railroads’ Weekly Railroad Traffic

U.S. Railroad Intermodal TrafficTrailers vs. Containers (millions)

0

1

2

3

4

5

6

7

8

9

10

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

U.S. Railroad TOFC Units U.S. Railroad COFC Units

Source: Association of American Railroads’ Railroad Facts

Intermodal Growth DriversDomestic and International

Globalization

Trade

Railroad Cost

Advantages

Share Recovery

From Highway

Truckload Issues

0 10 20 30 40

2035p

2002

Future Demand for Freight Transportation Will Continue to Grow

p – U.S. DOT projection

Billions of Tons of Freight Transported in the U.S.

Intermodal’s Enduring Questions

Lots of moving parts

The improved ROIC of RR Intermodal ’03-’06 is the

essence of the Railroad Renaissance

Long term volume growth rate of 5-7%

Long term pricing growth rate 3-4%

True International drives the train

Will “True” Domestic join the party?

Truckload Issues

TL surplus – “perfect (ugh) storm” in the short term

Driver shortages – permanent?

Tight capacity – a secular issue

Q4/Q1 capacity and rates a temporary/cyclical issue (isn’t it??)

Transload increase to absorb some capacity?

Stubbornly high fuel prices – growing price gap to intermodal

Insurance costs

Traffic congestion

Net: better switch than fight?

Coal and Ag – Bulk Comeback

New growth mode? Emissions and environmental issues Oil prices and coal Politics and coal; and grain/rereg Ethanol Exports Feed

New operating plans

Cooperative alliances

Working with customers

Technology

Massive equipment and infrastructure investment

Additional employees

What Are Railroads Doing to Increase Capacity?

150,000

152,000

154,000

156,000

158,000

160,000

162,000

164,000

166,000

168,000

170,000

2001 2002 2003 2004 2005 2006 2007 2008

Total Class I Employment: Jan. 2001-Mar. 2008

Rail Employment is Up for the First Time in Decades

Source: Surface Transportation Board

Railroad Capital ExpendituresClass I Railroads – and so far 2008 looks to be a paradigm shift!

$0

$2

$4

$6

$8

$10

80 82 84 86 88 90 92 94 96 98 00 02 04 06

Billions

Source: Railroad Facts, AAR

RRs and Investment

Is growth affordable? Capex up 10% in ’07? One rail cuts, 2 increase capex during ’07 What will 2008 look like? (long term growth v

short term weakness) Is additional capacity necessary? Desirable? Can the intermodal model extend to carload? Wall Street’s constrictive role (“fighting the last

war”) – is it changing? Is this disconnect between the Renaissance and

the Street the opportunity of a lifetime?

% Growth in Trains Per Day From 2005 to 2035 by Primary Rail Corridor

Future Corridor Volumes Compared to Current Corridor Capacity

2035 without improvements

Below capacity

Near capacity

At capacity

Above capacity

Future Train Volumes Compared to Future Train Capacity

2035 with improvements

Below capacity

Near capacity

At capacity

Above capacity

-$1$0$1$2$3$4$5$6$7$8$9

'80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06

Source: Association of American Railroads

Net Income

Capital Spending

Class I Railroad Capital Spending vs. Net Income

(Current Dollars)

25% tax credit for projects that expand rail capacity

Expense other infrastructure capital expenditures

Leverage private investment

Tax Incentives to Leverage Capacity Expansion

Railroad Rates- the old story Class I Railroads, Revenue Per Ton-Mile – another (related) New Paradigm

01234567

'81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07

Cents

Source: Railroad Facts, AAR

Current $: Down 1% since 1980

Constant $: Down 54% since 1980

Railroad Employee ProductivityClass I Railroads, Ton-Miles Per Freight Service Employee

0

2

4

6

8

10

12

80 82 84 86 88 90 92 94 96 98 00 02 04 06

Source: Railroad Facts, AAR

Millions

Rail Service Cycles

Is the recent improvement in the metrics

sustainable? Systemic?

Is it a product of huge capex injection

and IT?

Or, is it merely a product of lower

volumes/less stress on the network…

Rail Regulatory Risk

Biggest Uncertainty Entering ’08Safety Bill“Competition” Bill (“M-A-D”)Cost of Capital RevisionMandated STB, CTA “Reviews”AAR/RAC/ASLRRA have great “D” but

hard to score on defense

ABH ConsultingAnthony B. Hatch155 W. 68th StreetNew York, NY 10023(212) 595-0457ABH18@mindspring.com