Rails Beyond Coal – The Dawning of the Domestic Intermodal Age

AB HATCH abh18@mindspring.com

155 W68th St Suite 1117 NYC 10023

www.abhatchconsulting.co / MillerTabak

Green vs Black? The RR Renaissance & “the end of the coal age”

Wisconsin RR Day/Eau Claire

October, 2012

Economic malaise Rising capital

requirements Regulation Maritime trade flows Utility Coal

Rail Assessment

Opportunities Threats

Strengths

Pricing Volume Growth Service levels /

productivity Modal shift Consolidation?

Strong secular growth Favorable market

structure Supply constraints Solid barriers to entry Limited alternatives

Challenges Capital intensity Capacity bottlenecks Port congestion Service/productivity Reliability vs. trucks

Future Growth Potential

5 Secular stories (in order)….• 1-Intermodal – International and now Domestic• 2 –Shale/Oil – Problem and solution? • 3-Chemicals/Re-Industrialization• 4 - Grain – the world’s breadbasket• 5 - Coal? Exports – “legs”?• Other Rail Opportunities exist but in smaller

scale: The Manifest/Carload “Problem” (hub&spoke) vs. point-to-point “Unitization”/Industrial products/MSW (garbage) /perishables/others

UNCERTAIN Paper Ethanol

Rail Intermediate term volume prospects

ABOVE GDP

BELOW GDP Auto Parts (?) Domestic Coal (-?)

ABOVE GDP Intermodal – Domestic (+

+) Intermodal – International Shale/oil Agricultural products Export Coal

Chemicals!

GDP-GROWTH Autos (+?) Lumber (+?) Aggregates Metals (+?)

Railway Innovation focused on growth -

Intermodal is Emphasized

• CP – larger trains• CN – alliances, routing protocols – the scheduled railroad!• BNSF – Logistics Parks, JBHT&Domestic Intermodal, grain

“Shuttles”; • NS – PPPs, JVs and “Corridors”• KCS – little engine that can – Mexico, Lazaro, Houston…• CSX – MSW, RailEx, Trop Train, etc….Nat’l Gateway• UP- Doublestacks, exploiting the carload franchise; the PRB• All: Short line cooperation, Operating Plans,

communications/IT/PTC, Disintermediation, operating excellence….

Near Term

• Q1 – EPS +30% despite: coal, grain, economy- beats Street expectations

• Q2 – up ~20/20 RRs again beat expectations, reiterate Goals/Targets

• H2 outlook perhaps a bit more muted• End of coal decline? But not grain? Where

are we in recovery? Pricing?• Cash flow – still “balanced” use? Capex

will still be supportive of growth segments

Current Issues

• Rails in the Recovery – or in another slowdown? Is 2012 “just another” 2011?

• What’s true? RR (cyclical) traffic or business headlines?• End of the Coal Age?• Capex – Strategic or Tactical plans prevail? $13B!• PTC• After the Rereg Fight what? STB? TSW?• Govt role –partner? Or preoccupied &broke?• The Green mantle – two-edged sword….• PE &Infrastructure – and activist? – funds: back for

good? CP….• New “Golden Age”? Service

Underlying Themes or “Givens’

• Green is here to stay• Oil Prices will remain high (price points at $65,

$45, $25/bl)• Governments spending will be problematic• Infrastructure will be challenged • Trade will be dynamic but remain strong• Near-sourcing and in-sourcing remain themes• Trucking Productivity has peaked• Driver shortages are a secular/demographic

issue exacerbated by govt regs (CSA/HoS)

Carbon Footprint– from cocktail chatter to decision point

• 2003 – 221/F500 report on carbon; 409/F500 in ’09

• Green supply chains enforcement by Wal-Mart (from $2B transport spend to $4B+ by ’11); GE, P&G, etc….advantage intermodal

• Anticipating future EPA regs (12/23/11) and emissions law – advantage cheap & plentiful Natural Gas

• Rails – Double-edged Sword – green developments hurt coal, help intermodal & shale

• One major result is:

Coal in Trouble

• Domestic in secular decline due to regs/legislation, accelerated by weather, economy and, especially NG price

• Exports tied to global economy (ie; China); competition – and infrastructure access

• What was once “stable” and base business is the most uncertain

• Solution: invest elsewhere….

Every picture distorts a story?

Exports to the rescue?

Shale

• Frac Sand, brine & water, pipe and aggregates inbound

• In cases of Oil, “Rolling Pipelines” out….• Hess – 286 cars, 9 trainsets now, 27 in a few

years (followed by Phillips 66, others)• Pipeline companies developing rail terminals in

ND• Tar Sands and pipelines• Chemical Industry – secondary impact• Industrial Development – tertiary impact

Estimated Delta In RR Revenues/Prologistics Group

Approx Annual Carloads

Approx Rev/Car

Change In Rev

2008 2011

Coal 8,320,000

7,120,000 $1,700 ($2,040,000,000)

Oil 6,000

92,000 $3,700 $318,200,000

Sand 160,000

360,000 $3,500 $700,000,000

Total 8,486,000

7,572,000 ($1,021,800,000)

15

Shale Plays

Why move crude by rail?

• Moving a barrel by rail can cost $7 to $14, compared with $2 to $5 by pipe, depending on destination. But that price difference pales in comparison to a $15 to $30 premium for reaching the right markets

• Producers are working shale everywhere and rail transload terminals are a cost-effective, very quick way to start moving crude to market

• Flexibility to serve all markets using existing N.A. rail infrastructure. Existing rail routes have capacity to reach East and West Coast markets in the U.S. that may not have sufficient pipeline capacity.

• Isolation of commodity to provide a “pure barrel” to the destination

• Speed to market – 12 months to build a unit train rail terminal

• Comparatively low entry level capital requirements

• Source: Watco

What, me worry?

• Coal – its price not community

• Quick then suddenly – 10% hit?

• Activists – what's next?

• Compensation: shale (+++)?

• Compensation: chemicals?

• Compensation: export coal?

• Compensation: domestic intermodal?

Revenue SharePercent of Total Revenue for Major US Railroads

Source: AAR analysis of 10-K reports for BNSF, CSX, KCS, NS & UP

* 2012 estimated based on first half of year

Intermodal Growth DriversDomestic and International

• Globalization

• Trade

• Railroad Cost Advantages

• Fuel prices

• Carbon footprint

• Share Recovery From

Highway

• Infrastructure deficit & taxes

• Truckload Issues; regulatory

issues, driver issues

US Railroad Intermodal TrafficTOFC-COFC Units

Source: AAR analysis of 10-K reports for BNSF, CSX, KCS, NS & UP

* 2012 estimated based on first 35 weeks of year

Recessions

Millions

Modal Shift Projection

Current Truck Market

Current Rail Intermodal Market

Projected Market Shift

TRANSLOADING REACHING NEW HIGHS

Source TTX, IANS, Piers

Ron Sucik RSE Consulting

International Intermodal

• Still game in the old vet

• Even with near-sourcing

• Even with changing flows (which may disadvantage rail)

• Retail still tied to Asia

• MLB still tied to rail service

• Growth of 1-2.5X GDP

Intermodal Issues 2012+

• International: trade flows, retail sales, exports & balance – UNP’s vision vs NRF, TTX

• Panama Canal? On time? How much? Etc….• Emerging Developments – Rupert, Lazaro, Miami• Domestic – development of “Corridors” & “Gateways”,

etc• Domestic – bimodal partners, shipper developments• Domestic – service & pricing?• Q1/12 – up 5.9% (domestic +9%, int’l +3%, IMC+11%)!• “There’s somethin’ happening here….”

Re-industrialization?

• Near-Sourcing: Mexico, CA

• Gas effect round two:

• CHEMICAL INDUSTRY

• Fertilizers

• Steel/Autos/White Goods etc

• Northeast, etc back “in play”

Growth is Expensive

• Huge Capex - $50B in the last 5 years in the US – through the Great Recession!

• AND: Comeback of the share repo/DPS?• EPS beat the Street consistently, yet:

– Uneven returns in the Modern Age– Recent improving trend line– Misunderstanding Intermodal profitability 2004-8– Threats to ROIC threaten capacity– Street begins to call for capex reduction?– Suppliers 2012 looks solid – can they hold on till true

recovery?

Rail Capex in 2011/12/13?

• Record $12B last year• Record $13B this year – many rails

pegging at 17-18% of revenues (rising by double digits)

• Corridor developments, NG, terminals, locos, cars, shale buildouts, etc

• PPPs – in decline?• Still emerging as DPS plays, buying in

shares

Railroad Capital ExpendituresClass I Railroads

$0

$2

$4

$6

$8

$10

$12

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

Billions

Source: Railroad Facts & Analysis of Class I Railroads, AAR

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 07 08 09 10

Cost of Capital Return on Investment

Source: Surface Transportation Board Note: Cost of equity estimation method changed by Board effective 2006 and 2008.

ROI is everything

• Rails must retain price (@”rail-inflation plus” levels, or +3-5% YOY)

• Productivity – through capex, IT, scheduling, service

• Must remain de-regulated (even if not directly an intermodal issue)

Simple Math

• Rates

• Returns

• Capital Expenditures

• Capacity

• Service

ARE ALL CONNECTED!

Virtuous Circle (’03-07) or Disinvestment?

Election 2012

• Republicans pro-coal

• Dems pro-gas

• Labor not a near term issue

• Tea-Party and Infrastructure

• PPPs?

• $- no matter who wins, who can pay?

www.abhatchconsulting.comABH Consulting/www.abhatchconsulting.com

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

www.railtrends.com

CP

• OY. 2nd (3rd) Proxy Fight since 1954• Not a takeover• HH track record vs recent CP (OR, weather,

M&A, growth)• HH goal 65% OR by 2015• CP goal 70-72% in three years (YE’11 83.1%;

C1 avg 71%)• (as example) CSX goal 65% OR 2015• CP’s new management team yet to be

revealed….

Positive Train Control (PTC)• “Unfunded Mandate” – part of 2008 safety bill• Overseer is FRA – who puts cost/benefit ratio at 22:1• Rails have put cost of installation and maintenance at $10B – and

rising (UP, CSX have increased 2011 capex based in PTC)• Possible benefits in capacity, velocity, fuel consumption as well as

safety; many of those captured by other technological advances• Covers all rail interaction with passengers and TIH as of 2008; short

lines exempted• Technology proven only in limited scope (BN/Wabtec: ”ETMS”)• Initiated after Chatsworth accident – obvious public benefits• Contrarian viewpoints exist – the new “Digital Railway”• Efforts to reduce footprint, extend deadline….

New Transport Bill

• Rumor! Tue – too little/too late (or “calamity averted barely and not for long”)

• Tiger 3 20% RR decline ($104mm)

• PTC deadline to be extended from 2015 to 2020? Not yet….

• No TSW change

• No Freight Plan

• Govt’s declining role (in infrastructure!)

Warren’s $44B “all-in” bet

• Advantages of going private? (capex cycle) – will we see now?

• Influence in DC - “Robber Baron” vs. “Sage”

• Bets not (just) on economy – rereg, coal, western intermodal

• Bought on the cheap! – How does the investment look today, folks?