The Resurgence of Railroads | Capital Group

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The Resurgence of Railroads

By Matt Wilson
Capital Group Equity Analyst

Few images are more iconic than that of a freight train speeding along the tracks from one end of the country to the other. It’s a scene etched in American history, alongside stagecoaches and saloons. But it’s also very much a picture of today. Far from being a relic of a bygone era, the freight rail industry is undergoing a powerful renaissance. After years of operating in the shadow of the trucking industry, improved performance and dependability have made the freight rail sector a growing force in the U.S. commercial transportation system. Though railroads face near-term challenges, the long-range outlook is very promising.

Railroads endured a punishing contraction in the 1960s and 70s as the expansion of the interstate highway system allowed trucking companies to seize significant market share. Trains were slow, costly and prone to frequent breakdowns. Just one disabled train could bottleneck the entire system, delaying shipments for scores of customers. But thanks to deregulation in 1980 and a new generation of forward-thinking management teams, railroad companies have spent much of the past three decades reinventing themselves. Faster locomotives, more-efficient use of track space and better labor relations have improved the industry’s image and made cargo shippers much more willing to use trains.

Railroads are also benefiting from problems bedeviling the rival trucking industry. Though truckers have been helped by the sharp drop in gasoline prices, their industry is grappling with a severe shortage of drivers willing to work the long-distance routes that compete most directly against railroads. The average salary for a long-haul trucker is $46,000 a year, or a mere $7 an hour when away from home because of the 70-hour weeks that cross-country trips require. Trucking companies are being forced to raise pay — one just boosted it 26% — and pass the added costs to customers. Not surprisingly, employee turnover tops 90%, meaning companies must constantly recruit new drivers. That’s becoming increasingly difficult as aging baby boomers retire. The average driver is 55 years old, and finding younger replacements is tough given the grueling lifestyle and modest compensation. By one estimate, there is a current shortage of 30,000 drivers, which is expected to worsen to nearly 240,000 within seven years.

Railroads have built-in advantages that bode well for the long term.

One of the most attractive attributes of railroads is that they don’t face many of the risks common to other industries. For example, in an increasingly globalized world, railroads have no foreign competition. Likewise, the huge cost of laying and maintaining tracks deters domestic rivals from encroaching on one anothers’ turf. Rail companies also face little threat from new technology, whose disruptive effects have upended other industries. Finally, railroads have neither product cycles that lead to sharp earnings volatility nor retail-oriented brand names that are vulnerable to shifting consumer sentiment.

Certainly, the railroad industry faces challenges, especially in the short term. After several years of strong results, volume growth has recently weakened significantly, with key sectors such as coal and shale oil declining on a year-to-year basis. That’s partly due to comparisons with a robust period last year, when the freight business was snapping back from a frigid winter that brought the East Coast to a standstill. The weakness in rails is likely to be temporary given that aggregate volumes have declined only six times in the past quarter-century and then bounced back sharply. Also, railroads have a diverse customer base, preventing one end market from weighing excessively on the overall business.

Longer-term, railroads always contend with two issues: the need for large capital expenditures (capex) and the threat of government regulation. Rail is one of the most capital-intensive industries, with nearly one-fifth of revenue going toward capex, as operators maintain rail networks that stretch for tens of thousands of miles. The privately funded rail industry spends nearly $30 billion on capex, a considerable sum given that federal and state governments devote only $100 billion combined to the entire U.S. highway system. While highways are underfunded and suffering from crumbling infrastructure, the U.S. freight rail network is at its strongest point in more than a century. Even so, significantly more investment is needed to alleviate growing congestion along heavily trafficked rail lines.

Rail providers also face the ever-present risk of regulation, especially given recent concerns about train safety and environmental issues. The derailments of several trains hauling crude oil have prompted federal regulators to require costly improvements, including the installation of electronically controlled brakes to prevent speeding trains from jumping the tracks. Railroads could also be affected by any rules that restrict the use of coal as an electricity source, as the coal industry is a profitable rail customer.

After many years of decline, railroads are slowly gaining market share.

Still, the positives of the rail industry greatly outweigh the challenges. For one thing, shippers are using railroads for ever-shorter routes. Though trains have long been cheaper and more fuel-efficient than trucks, manufacturers once shunned rail for jobs of fewer than 1,000 miles. But with improved reliability and faster delivery times, they now turn to trains for trips of half that distance. Such heightened demand has translated into increased pricing power, especially as rail lines become more congested. Price hikes by trucking companies are also giving railroads more leeway to boost revenues. Rail companies should raise prices between 4% to 5% this year.

There are other reasons for optimism. Rail companies are experiencing strong growth in the so-called intermodal sector, in which freight-filled truck containers are loaded onto trains and shipped long distances. Furthermore, it’s unlikely that the regulatory environment will change materially. State and federal regulators understand that railroads’ huge capital expenditures boost employment, spur local economies and reduce the number of trucks on their roads. The appeal of railroads should only grow as concerns about climate change intensify. Trains use only one-fourth the fuel of trucks, burnishing the image as an environmentally friendlier mode of transport. Also, Congress is growing more concerned about truck safety and limiting the number of hours drivers can spend on the road.

After years of losing market share to trucks, railroads have slowly begun to reclaim it. Despite the advantages that trains hold in long-haul routes, trucks now capture eight times as much freight revenue. I expect the balance to slowly shift as railroads target the trucking industry’s most profitable routes. That should help rail companies achieve steady and durable growth well into the future.

The views expressed herein are those of the author and do not necessarily reflect the views of everyone at Capital Group Private Client Services. The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable, are subject to change at any time and should not be construed as advice. There is no guarantee that any projection, forecast or opinion will be realized. Past results are no guarantee of future results. This material is provided for informational purposes only and does not take into account your particular investment objectives, financial situation or needs. You should discuss your individual circumstances with an Investment Counselor.