NRC members and friends,
Please find below a special report on freight rail industry capital expenditures, produced by Tony Hatch. Tony is President of ABH Consulting, a long-time speaker at the annual NRC Conference, and is considered by many to be the premier financial analyst of the freight rail industry.
The report was sponsored by the NRC and is being made available to NRC members as one of the many benefits of membership in the NRC.
We hope you find the analysis useful and revealing.
National Railroad Construction & Maintenance Association (NRC)
500 New Jersey Ave NW, Suite 400
Washington, DC 20001
Tony Hatch Special Report on Freight Railroad Industry Capital Investment
Subject: Railroad Capital Expenditures (CapEx) remain crucial to the "Rail Renaissance"
Railroad Capital Expenditures since the Staggers Act ($Billions; 2013E)
Source: AAR/abh consulting
Summary: Capital spending is a function of available funds, best self-generated, and a spending plan split between regulatory requirements and expectations of future returns on the investment. For rails, CapEx has been the easy-to-follow guide to the recovery of the industry (the "railroad renaissance") from under-spending due to poor ROI, to catch-up, to investment in future growth justified by improving returns and prospects. By any measure, rails are a capital intensive industry, but the returns on that massive investment are approaching positive levels, enough to justify further spending. Rails today generate enough capital to allow for a "balanced (with dividends and buybacks) policy" for free cash flow. Any change in this cycle, however, aside from the phase out of the PTC spend, would suggest a narrowing of opportunities in the face of regulatory issues, service execution failures, etc. Overall, however, rails have learned through trial and error over the post-Staggers period to increasingly spend "strategically" rather than "tactically," which is a good thing given the very long lives of the assets. Rail CapEx of over $13B this year (2013) suggests another record year, as would the estimated total spend of $24.5B.
Staggers leads to the first CapEx revival (1980s)
Before the Staggers Act and railroad deregulation, capital expenditures were sporadic at best - given the poor returns that railways generated, cash was in fact siphoned from them into other portions of the conglomerates that the railway holding companies had become, in the investment fashion of the times. Many of the other business units sprung naturally from the rail portfolio (underlying mineral assets, real estate, fiber optics along right-a-ways, etc), some not (Whitman Chocolates, etc) but all were perceived as having better return potential, hence a higher call on the cash flow. Staggers changed all of that, allowing a return to health of the industry. CapEx increased in the years just prior to and then immediately after the 1980 passage of Staggers, which also coincided with (and drove) a "purification" process, as conglomerates fell out of fashion in favor or "pure plays". One aspect of Staggers was the allowed creation of the modern short line industry, whereby low density lines were sold or spun off (to new locally based entrepreneurs with lower cost structures) with the effect of reducing Class One mileage to the longer haul main-line core network, which absorbed a higher percentage of the increasing CapEx dollar.
CapEx increased in order to:
- Bring the decayed networks back up to a normal level ("catch up")
- Increase safety standards (safety is a corporate citizen's primary responsibility of course, but under FELA it is also very good business)
- Retain what business they could versus onslaught of the subsidized and deregulated trucking industry
- Chase a small but increasing amount of new business opportunities (automotive, new coal PRB, the nascent double-stack intermodal sector)
1990s - Consolidation and the first stirring of the renaissance
As railroads reduced expense, primarily, but not limited to, manpower, they began to show signs (or sow seeds?) of the revival that would later be called the "renaissance", as intermodal intervention spread from international to domestic (the JBHunt deal, etc), Mexican opportunities began to be developed, etc. But by far the major driver of the next jump up in CapEx was the consolidation of the era - UP+CNW+SP; ATSF+BNSF, CN+IC+WC; the split of CRR into NS and CSX....each of those created CapEx need and opportunity, from new jointly served market opportunities, to new route development, to IT spend, to massive need for network rehabilitation (SP). Many if not most of the mergers were neither on time (in terms of normalized not to mention accretive operations) nor on budget (in terms of stated in ICC or STB documents) which led to massive upset for shippers, regulators, investors. One response was to spend. And indeed, after the conclusion of the merger issues, the resulting euphoria bred an "if we build it they will come" attitude...just in time for the end-of-the-century recession.
21st century - the maturation of the Railroad Renaissance and of Strategic CapEx
- The modern rail era brings with it a revived, growth hungry industry, recapturing market share of value added goods while participating fully in globalization - and in the near-sourcing/Mexican opportunity.
- At present it is undergoing a rapid, once in a lifetime shift form utility coal as the backbone to the new energy era, with shale development, crude-by-rail and "game-changed" chemical/(re-)industrial developing growth segments.
- The rails reacted to the recession at the turn of the century by cutting CapEx under severe investor pressure. When the volume boom, across cyclical and less cyclical sectors alike, began in about 2003, several rails were forced to embargo traffic due to capacity constraints, leading to massive customer and political upset and the revival of the re-regulatory movement in Congress. On the other hand, the obvious crossing of the supply/demand threshold led to the rails gaining pricing power (including surcharging for volatile fuel) for the first time in modern history.
- The resulting rail boom led to growth in CapEx and the newfound "luxury" of thinking of CapEx in strategic terms (replacing ties on time every 30 years) rather than tactically; previous boom/bust periods have been deeply stressful to the supplier and contractor industries.
- Deferred maintenance is simply too expensive and doesn't fit with strategic plans; note the CSX experience of 2002-2008.
- PTC - multi-billion government mandated safety initiative - Originally estimated at $13.2B after the 2008 passage of the Safety Act, with a 20:1 cost/benefit ratio as ascribed by the FRA; for US operations only, with billions yet to spend and a likely deadline slip due to "interoperability" issues.
- The growth boom in new segments (domestic intermodal) and regions (North Dakota, Mexico) and new car types (tankers, auto racks) and IT (beyond PTC) has led to new spend in new regions, etc - for example the low density granger network in North Dakota now being built out - by rails and by energy companies - to handle massive unit trans of CBR (crude-by- rail).
- Political and shipper reasons to "learn the lessons of 2003-04" - politically, the rails cannot afford any other "service meltdowns" such as 1995-99, or 2003-05, that caused massive press and government scrutiny and shipper anger. The STB was forced to set up annual service plan reviews, etc - and the re-reg bill got out of the Senate Commerce Committee in 2009 - the closest call yet.
- Investor patience as ROI grows, rails earn Cost of Capital (CoC) for the first time as an industry in 2012. Clearly the growth-to-come is well understood by the Street, as is the need to keep the network in fine order, and the increasing service demands of domestic intermodal, etc. However, calls for alternative use of free cash flow - dividends and, particularly, stock buybacks - continue. Railroads' "balanced plans" retain the advantage - as long as ROI keeps increasing, and isn't capped (by regulation, by execution failure, etc).
- Buffett buys BNSF, adds very patient capital to the competitive mix - does BNSF have a long term strategic advantage by being held by patient capital? Or will other rails continue to also act similarly, giving the whole network a modal advantage?
- Highest ever service standards (domestic intermodal, etc) lead to development of service related CapEx (sidings, terminals, etc). Running intermodal services between 1000 miles down to 550 miles (roughly a day's drive) requires a level of precision heretofore unseen, as does an on-time network with short haul intermodal, long haul, passenger trains, bulks, merchandise, etc.... Slow orders, derailments, accidents, etc simply must be avoided. The benefits, in terms of productivity and market share, are, of course, enormous and obvious.
- Passenger growth - the recent re-embracing of passenger rails, whether High Speed Rail or - more likely - High(er) Speed Rail - means more competition for network capacity, more scrutiny, and given the speed differences, more operating plan complexity.
Breakdown of Capital Spend - 2011 (the last year with full data)
The AAR breaks down 2011 expense in a variety of interesting ways - for example, of the $57.8B in rail spend in 2011,
- 65% ($37.5B) went in to running the railroad (crews, fuel, etc);
- 15% ($8.7B) went to "maintain the network" and
- 20% ($11.6B went to "grow and modernize the network".
Most importantly are two major categories - the cost to maintain the network ($8.7B in 2011) and the cost to grow and modernize the network ($11.6B in 2011). Note that the figures exclude depreciation, and the definition of "growth CapEx" as used here by the AAR is different from the way railways show this in investor presentations (when it literally is just new terminals, etc).
The cost to maintain the network ($8.7B in 2011) is broken down into:
- $2.6B wages
- $0.7B benefits
- $0.6B payroll taxes
- $0.6B other
- $2.1B Materials & Supplies (rail, ties, car parts, etc);
- $1.9B Purchased Services (outsourced track and rolling stock repair and maintenance); and
- $200mm Rentals (of big track machines, etc).
Within "grow and modernize" ($11.6B) are two basic categories:
- $8.0B Track & Property
Within Track & Property ($8.0B):
- $2.6B rail new & used
- $1.6B ties (15.4mm installed in 2011)
- $700mm signals
- $400mm bridges
- $200mm land; and
- $1.5B "other"
Within Equipment ($3.6B):
- $1.6B locomotives
- $1.0B freight cars - remember that over 50% of the overall fleet and growing are owned by shippers or financial companies and thus not counted here!;
- $400mm highway equipment; and
- $300mm "other"
2013 looks to be another record year for rail capital expenditures, just....
CapEx, as stated at meetings such as the NRC Conference and based on statements coming from the earnings conference calls or press releases (etc), it appears that 2013 CapEx will slightly exceed 2012's record levels, helped by BNSF's whopping $4.1B plan. The rails look to be spending about 18% of revenues, down from about 18.7% in '12 (JoC) - but enormous compared to the average industrial company's 3%. Weather, PTC, loco spending, coal outlooks, etc all have made 2012/13 a difficult two year period for comparisons. Several Class Ones (UNP, CSX, CP) have either announced a reduction in CapEx or a reduction in CapEx as a % of revenues from 17-18% to 16-17%.
The debate over CapEx - what is too much? (And how do you measure it?) What is adequate CapEx? What is basic maintenance? How does one best measure capacity, in fact, in such a fungible world? Those all may be "artistic" rather than "scientific" questions - we can guess that the slow build back to peak (2006) volumes and the desire to never recreate the issues of 2004 mean that we are about 20% or so short of capacity on the rail system at present, with bottlenecks and slack areas, and targeted growth build-outs. So what should the rails be spending? It should be noted that the historical measurement of CapEx/revenues has been somewhat out of date for a while - when volume growth was equal to (or exceeded) revenues, it was a decent proxy for "work"; with pricing (and fuel surcharging) power since ~2003, volume is well below half of the revenue growth and thus is an imperfect proxy for workload (neither price nor fuel surcharges wear out track). Several carriers (CSX, UNP) are saying they are downshifting CapEx targets from 17-18% of revenues to 16-17% - but with revenues expected to grow in the high single digits or higher on a secular basis, is that really a downshift? Another way to look at this is % of depreciation, - the 6 publicly traded major rails average 213% (ranging from a high of 272% at KSU to a low of 114% at CNI - source: The Blanchard Co.) but that becomes an issue when you consider the long lives of the assets (and hence the call by many investors for using a return on replacement as opposed to ROIC in regulatory matters). Using CapEx/cash flow reveals an average of 73% (in a tough year) still allowing for a balanced program - the wide range ran from 86% at CP (80% at KSU) 57% at CNI and 60% at UNP (source: Ibid.). A new measurement needs to be formulated.
However measured, the nature of CapEx has always been tricky with rail investors, many of whom have a preference for direct shareholder payout (i.e., dividends or share buybacks). After all, using the traditional measurement, rails have averaged about 15% of revenues in the modern era, and that compares to about 3% for the "average" industrial company. And freight rail ROI has trailed CoC in that same post-Staggers period. Over time, the improving returns, benefits from strategic purchases of rolling stock, and the unfolding "railroad renaissance" have taught patience to a generation of rail shareholders, who have allowed management to invest these vast sums (in 30-year plus assets) and make the difference between the one privately held carrier (BNSF) and the pack of publicly held carriers fairly narrow. The net result is vast improvement in safety and in service as measured by the AAR "metrics", and thus vastly improved financial returns and economic opportunity.
Can that last forever? Are there enough growth projects? Should one shrink CapEx and harvest cash? Is UNP's $100mm or so decline in YOY CapEx a strategic shift, or the timing nature of some projects? In fact, one of the most amusing questions in the CP Q4 earnings call was about when CP would initiate a share repurchase program, juts months into the new restructuring agenda. But, CP aside, the opportunities to improve returns through spending on the railway network are still compelling. After all, with revenues still growing in the high single digits (despite the secular impacts of coal and grain) and expected to grow even more as the economy improves, housing recovers and the investments in intermodal, chemicals, CBR, etc, pay off, at this point we see no reason to fear a change in rail management's balanced policy towards cash flow. As long as ROI remains huge and unobstructed by regulation (or execution failure) the industry will continue to invest in both maintenance and growth. Should anything change, CapEx would be an early victim, hurting service and capacity at a time when government spending on infrastructure is poor and the outlook problematic.
CapEx notes by Class I carrier:
- CSX announced a slight increase to a record $2.3B (+100mm) and a reduction of 100-200bps to 16-17% of revenues. PTC was 14% of that ($325mm with "$800mm to go"); 54% was infrastructure.
- UNP announced a $3.6B plan, down slightly (the warm weather in 2012 moved some projects forward, further distorting the YOY picture). $1.675B in "infrastructure", $670mm in "capacity", $610mm for "locos & equipment" ; $195mm for IT and $450mm for PTC - UP spend of $3.15B for 2013 ex-PTC would represent a slight increase over 2012.
- NSC reduced CapEx by $241mm, some of it timing, to $2B. $831mm will be for "Roadway Improvements", $203mm for Terminals, $84mm for Growth Projects and PPPs, $57mm for IT and $229mm for PTC.
- KSU kept CapEx for this year at 18% of expected revenues (23% including pull-forwards and leases etc).
- CNI increased planned CapEx $100mm to $1.9B - $1B on track/infrastructure, $700mm on "growth" and $200mm on rolling stock etc.
- CP, going through a slimming program, announced that CapEx would be held at about $1B for the next few years - leading to what ought to be pent-up demand for service and capacity projects (see CNI).
- BNSF on the other hand increased its CapEx program by $450mm to $4.1B - $2.3B "to improve its core network", $1B on rolling stock and growth CapEx will focus on the Bakken Shale in Intermodal sectors....for the first time there is real rail spend in the Bakken, joining E&P and pipeline companies - a positive signal the CBR market will have longevity.
Anthony B. Hatch
155 W68th suite 1117 NYC, NY 10023
212.595.0457/ 917.520.7101 M
National Railroad Construction & Maintenance Association (NRC) - www.nrcma.org