Tuesday, September 4, 2007

Railroads

OK, I've been promising a post on US railroads for three weeks. Here it is.

The US is running out of transportation capacity. Most of you who live on the coasts already know about this in your daily lives, but it is occurring in freight as well. There's a lot of reasons why:
-Most importantly, the change in the automobile from a family vehicle to a personal one.
-Movement of the population from the heartland to the coasts
-Continued economic and population growth

"America runs by truck" as the slogan goes, but trucks are slowing down. According to the stats I could find, they have fallen by about 5% in the last few years. In the past this would have been rectified by building more roads. This is no longer possible: skyrocketing costs, eco-opposition, and the near end of eminent domain have closed this out. As far as freight expansion of the airlines - don't even ask.

Rail is the one mode that still has significant excess capacity. I know - you are going to tell me about the rail traffic jams of a few years ago. Those are history. The fact is that the US railroad business was very poorly run after the mergers of the 90s. Even on the long-haul western RRs, speeds were less than 25 mph. This has now changed. Speeds are up; dwell times are down. Remember, trackage is the limiting factor in US RR capacity. An increase from 25 to 35 is 40%.

This has gone along with a general improvement in RR management and Boards. I believe that this is the reason Buffet, Chris Hohn, Ican and such have gone in. The change is industry-wide - even pathetic losers like Amtrak are doing better. The most important result of this is that they are using their duopolies (two RRs in the east; two in the west) for shareholder return, not competition for growth.

Along with the improvements in mgnt. and capacity, commodity trends have favored RRs. Two of their biggest customers are agriculturals and coal. Both of these have had increases in volume, with more to come. The growth in ethanol has led to high revenue tank cars being substituted for hoppers. Intermodal (trailer piggybacks) will also rise with increasing road congestion.

But the biggest trend will be in an increase in RR margins because of operating leverage. Remember, this is a very high fixed cost industry. For example, BNI's operating margin (net) has gone from about 15% to 22% in the last few years. It's hard to disentangle operating margin from pricing power - to a certain extent they feed on each other since a duopoly can reduce unneeded capacity.

OK, what to buy? Realistically, you can probably buy the whole ector. I chose one western (BNI) and one eastern (CSX). A buy-side analyst I read and respect claims NSC as the cheapest, but I deferred. Of course the risk in BNI is that you wake up one morning and find Buffet has reduced his position. I judge this to be unlikely since the position is getting too large to exit. There is no RR ETF.

This position is unhedged. I expect to keep it for a very long time, and I don't want to bet that the stock market goes down over the next five years.

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