November 16, 2018
With BNSF having reported, and with me back in the country, for the rails we can put Q3/18 to bed. It was a decent enough performance, financially – but of course that’s not what will be remembered….it will be the webcasts and conference calls and the increased adoption of “PSR principles”…. And the debate about who/what/where and especially when one can expect results….Hunter is LHAO somewhere, excitement reigns, and veterans are wondering: “Is this anyway to run a railroad?”
First: RailTrends is sold out. Apologies to those who have had their plans affected, etc – this was a surprise to me, too. Remember, I have nothing to do with the economics and management (pricing/attendance/P&L) of the program – that’s “Progressive Railroading”/TradePress….there is a waitlist and I know of a bunch who have gotten in off of that list, so give them a call. I hope to see you there – we have the whole spectrum of rails and PSR represented, from top CEOs in on all ends of that spectrum, from initiator (CN) to veteran (CSX) to rookie (UP), to short-line pre-blockers and impacted neighbors (KSU) etc. etc. The agenda is attached. So - Hope to see you there and I apologize for any inconvenience…..
Second, I discuss some of the CBR excitement, below and attached; and feature my “Rail Questions of 2019” for the upcoming annual Journal of Commerce 2019 Preview issue at the bottom…..
RRs Q3/18 - News (& Opinion) over numbers: Even more than current financial results the quarter was one of the spread of the PSR revolution, like the Red Tide in the 1920s. NS produced a Canadian (OK, Michael Farrell is actually a Texan, but one who had worked at both CP and CN) to be their PSR/Clean Sheet magician - and fill a newly created post of SVP –Transportation under COO Mike Wheeler. The Canadian rails were confused, and the investment community noted that he has been on the NS property for a year! There was a huge and emerging split evident on the webcasts between short termism and what I would call prudent strategic investment – the coming decisions on 2019 capex (and the defense of debate that follows) will be very instructive. Service recovery looked fair – sequentially but one certainty cannot call an inflection point yet, especially with more PSR upheavals to come. Pricing remained strong – a potential emerging political issue for 2019 unless service improves.
BNSF results: more questions than answers – I just wish we knew more! The highlights are revenues up 16%, pre-tax income up 10% (which by implication puts their fictional EPS growth at the very bottom of the rail listings) and OR up 210bps to 65.2% - also close to the bottom of the leaderboard. To be sure, their Q3/18 had some excellent points – big growth in Ag and Industrial Products – and some perplexing ones (Consumer Products AKA “Intermodal Plus” revenues up 12% but volumes up only 1%?!?). They are in the midst of their every-decade or so arbitration fight with JB Hunt, their primary IM partner – and this time its big ($100mm or so?). Obviously that has to be resolved (and explained?) – as does the UPS Teamster negotiations which may incent that parcel shipper, the (or one of the) largest rail shippers, to move more business back to their Teamster drivers (which would be a case of the IBT pushing driver jobs at the expense of their own IBT union rail jobs!). Even in the past when they were public they were tight-lipped about this process; now fuggedaboutit!
Buybacks at a peak? Well, not so fast: It’s also interesting that Berkshire has joined (or rejoined) the Big Buyback World ($1B not really being that big, as compared to, say, Union Pacific’s $20B plan, or their own ~$104B cash hoard. In fact, that fractional share of the cash stash argues strongly against the consensus opinion that Buffett’s buyback decision “points to a dearth of attractive deals” (FT). And finally – there’s the impending retirement of BNSF Executive Chairman Matt Rose – still only 58. What does that imply about BNSF, ORs, competitive envy (PSR), Berkshire interference (despite pledges of non-involvement, etc)? the answer is, of course, that I don’t know….maybe we’ll all learn more when Matt and I have our “Fireside Chat” at MARS (Midwest Association of Rail Shippers) in Chicagoland in January
So, overall Railroads Q3/18 Results were pretty fair financially - certainly overall versus expectations. For example, 6/7 beat consensus, and the “average” EPS increase of 38% (about 1/3 being the tax gift) compares to the overall market’s ~25% YOY growth rate (S&P 500). Margins were flattish, of course – and still worse at CN (and, as stated, at BNSF – though they remain better than UP’s). Of course CSX takes the Blue Ribbon for improvement (and the second best OR, 670bps below its arch-rival). The Canadian’s adjusted EPS growth was half of that of their American friends, but only CSX was in their league in terms of Operating Ratio. Service only improved in spots – while things looked better sequentially (and in reported QTD), it remains a problem. Capex will solve some of that problem and we saw increases at CP and CN and defense of a strong plan at NS, though still low-balling at UNP and CSX.
The demand side was strong (but signs of slowing by the end of the quarter and into the webcast period). Sand officially rolled over, CBR’s boomlet has duration concerns, the plastics boom, long predicted (and, to be fair, by me via outside consultancy work) has yet to fully materialize (and exports are barely up before the tariffs kick in). There were lots of expressed “peak earnings?” fears. Truck tonnage was up just under 3% for September (compared to the +7% YTD levels). Auto sales were down 4% in the Q (but down 7% in September alone). Industrial companies issued warnings (CAT, Deere, GE, etc). Tariff fears and the post-early shipping hangover were also the talk of the day, though Chinese imports to the US were still up 13% in October (last of the early-bird specials?). Coal’s dead-cat has stopped bouncing (in fact, with Westmoreland into Chapter 11 and wind/solar cheaper than coal, more plants will be coming out of the network in 2019 after this big year). So that leaves intermodal (opportunity delayed or missed) and the revival of CBR (below). At the bottom are slides on 9-month traffic changes, YTD intermodal and an excellent AAR slide illustrating the dynamic changes in demand that rails have to deal wit on a constant basis these days, it seems….
Crude-by-Rail (CBR) – does this market have legs? Recent events have been supportive of that concepts, mostly (delays on pipelines on both sides of the border though oil prices don’t seem to suggest any supply worry). Attached are two presentations on the general subject. Note that the AAR and the RSI (Railway Supply Institute) represent two quite different constituencies – as you know: the former the railways (and really the big RRs) and the latter the combination (not always complementary) of rail car OEMs and owners – and that group split between financial/leasing companies and shippers. Obviously these guys have differing views on “new cars” – whether they are existing owners, manufacturers, shippers of CBR etc, and the rails who provide the “hook & haul” common carrier obliged service…. Attached are two presentations on the general subject. Note that the AAR and the RSI represent two quite different constituencies – as you know: the former the railways (and really the big RRs) and the latter the combination (not always complementary) of rail car OEMs and owners – and that group split between financial/leasing companies and shippers. Obviously these guys have differing views on “new cars” – whether they are existing owners, manufacturers, shippers of CBR etc, and the rails who provide the “hook & haul” common carrier obliged service….
Note that FTR’s Dick Kloster, who contributed richly to the discussion below (along with “anonymous sources” but this is not “fake news”, just opinion) will discuss this in depth at RailTrends(and I will report in depth afterwards)….Key assumptions must be made (by other “experts”) to determine the length of this opportunity – the longer, the more capacity becomes economical….
Political will (in all three NAFTA 2.0 countries, actually) – one example: The government of Alberta potentially entering the market (how very Canadian!) for CBR!
Other rail reaction – for example – will CP follow BNSF’s lead? And will UP see this as perhaps a huge market share opportunity (by accepting 117Rs)?
BNSF roils the markets! Contrary to rumor, however, BNSF has not banned the 117R (retrofitted) cars but they are pricing them at a higher rate than the 117J (new-build) cars. They are using the interchange rules, and the pricing (and terms/conditions) carrot/stick, to enforce the equipment change (and surcharges are, apparently, legal). Yet, adding to the confusion, they are doing so on “new business” only (after pushback) but as contracts roll, more “new business” will come under the new guidelines. BNSF has stated it will not do any more contracts for unit train service of non-117Jcars. Thus if a shipper wants the economics of a unit train service to move crude it needs 117J cars, and, of course, the cost of shipping via a manifest train versus unit train is significant. Time of delivery can easily double and cost per cars can be 2-3x the car transportation cost in a unit train. UP has similar tariff regulations effectively preventing non 117J cars in unit trains. Even though the 117R and CPC 1232’s are still legal, the rails, mainly BNSF (though others might follow), are using freight pricing tools to incent the use of 117J’s – via higher rates on 117R’s in crude, discounts on the ethanol side, etc. Two months ago BNSF announced that all “new” CBR business would “have” to move in 117J’s. All of the Js are “spoken for” presently. However, they cannot legally restrict the use of 117R in crude service because they are legal cars, just “influence” shipper behaviors….NOTE: the 117s are important for Bakken light/sweet CBR – I was told repeatedly that it “was not a factor” for Alberta oil sands heavy crude, which is stable (and needs heating coils etc).
So – is there a CBR/rail car bottleneck, and is it due to railway actions? Yes….DOT 117 are now the law of the land but CPC 1232’s can still be used in crude service until May 2023, then only 117’s afterward. There are two ways to get a 117, a new car which is recorded as a DOT 117J or a retrofitted car, called a 117R (R for retrofit). Most of the retrofits that have happened, or are planned, are former CPC 1232’s because cost is <$10k per car (the 1232’s are already 286k grl and jacked car, so the car owner avoids the $25k+ expense of going from 263 to 286 and avoids the $30k+ expense of jacketing a car… jacketing means wrapping the tank in a 1” thermo-blanket and then enclosing it in a “jacket” 11 gauge steel, i.e. think of a gigantic hot dog wrapper. There is a possible emerging issue regarding the lining of some of the 117Rs – fiberglass – which may be good for some services (ethanol) and may not be good for others (CBR).
Are there any DOT-117J cars currently in use hauling other products where the rails may be willing to haul it in a standard car, and the owner of those cars may be willing to transact with crude shippers to downgrade their fleet for a price? There are some 117J in ethanol (and some in other flammable service) service that I suppose could be sub-leased into CBR for a while and than the ethanol could move in a 117R, 1232 or even a 111. Cargill did this with their fleet, for a while. I don’t know about today….ethanol is moving well again. Mostly however companies are having to rely on building new cars for additional car supply. Note that the safety difference is pretty large between the old (111) and the new (all 117s) cars, but not really between the 117R and the 117J….
Build rates and potential? What everyone seems to want to know is the current build-rate for DOT-117J cars by month? What is the maximum production capacity? If it’s not running at 100% capacity, why not? New tank cars orders have been <11,000 cars the last two quarters – not a lot (this year new tanks in this service will be down YOY). Based on where the oil price spreads are, it would seem crude shippers would be pretty desperate to alleviate this bottleneck. Nameplate car production capacity is ~100K cars – but that’s “nameplate”; in reality, labor shortage etc might make that more like ~80K?, Even so, there IS capacity to build – the question is one of demand (not market, that exists – for now – but fleet owner demand). So, the market needs to find a fleet buyer (and, historically, the leasing industry has been guilty of chasing the latest trend (see ethanol/CBR/sand/plastic pellets etc etc). The builders will build whatever they are given orders for, obviously. The issue is the bump in CBR car demand is seen as another bubble and leasing companies aren’t going to build cars unless they get enough upfront terms to cover the eventual fall in future rents… a tall order that require ~7 yr. terms and healthy initial lease rates… but with netbacks for crude >$30 bbl there is so much profit available the some shippers are taking on cars….
Getting closer? It’s been said that the current lease rate is $1500-1750/car and at $2K it becomes economical for the big leasing companies to place orders. A CEO of one of the largest fleets summarized the conundrum best: “Yes shippers are willing to pay over $1,000 per month for 3 or 5 years. But the cars cost about $140,000 and there is a high probability of a pipeline being installed within the next 3-5 years so then what do owners do with all the 117J cars?” Cenovus, they of the 100K bl/day rail order, stated tin their Q3 release hat the “end may be in sight for pipeline bottlenecks”….Says a regional railway that connects with CP and CN etc: “The issue we have with the Bakken is the large amount of pipeline capacity that has been added into the Midwest and East. Also, a lot of the refiners in the Midwest are switching their refineries to process heavy crude because it’s cheaper. BP at Whiting, IN is a prime example of this switch. A refinery on us (Marathon-Robinson, IL) is just starting this conversion and will bring its oil in by pipe” Despite this, several lessors are buying for today’s demand, according to the leasing company head: “Tank car build capacity (without changing manufacturing processes) is ‘sold out’ into 2020. I believe all lines are operating, and some additional lines are being opened. GBRX will have four tank car lines producing in 2019 up from 2 in 2018.” So much for consensus opinion, though directionally there is agreement here.
For the Journal of Commerce Annual Review/Preview:
What are the big questions (for rail) going into 2019?
The question posed by the JoC for this year’s review is a good – but an impossible one to definitively answer. For railways, clearly demand will be strong in 2019, even against “tough comparisons”. But remember, demand-planning isn’t the rails’ (or anyone’s, really) strong suit. But assuming we see the anticipated growth (intermodal, CBR, Ag, Steel, etc) - can they, to paraphrase the largest railroad’s slogan, “handle it”? The short answer is yes – even in a year of disappointing service metrics, the rails handled the volume in 2018 – just not as quickly nor as efficiently as they had a few years before, or that their customers (and shareholders) would have liked to see. Looking at one critical component, domestic intermodal, the rails have (YTD) achieved a 6-7% growth rate, with domestic container business up 5%+. But is that good enough, in this best-of-all-worlds truck competitive market? Or will we look back on 2018 as a year of missed opportunity?
The rails have dramatically attempted to address these issues through restructuring (CSX, clearly on the upswing) or plans to do so (essentially every other US rail). The two Canadian originators of Precision Scheduled Railroading (PSR) have been spending the capital required to maintain growth in a post-PSR revolution model. How the US, particularly UP and NS, responds to these PSR-influenced changes will be on every shippers’ minds as we enter the new year; I suspect that the combination of new operating plans, management (again, and shareholder) attention, and capex will yield good results on the service (velocity, dwell side). But then there is the macro-drama – from market fears of “peak earnings” to lapping the tax cut to trade wars (impacting about half of the rail business – and the better half at that) to who knows what will be tweeted next?
For the long term the rails have the financial wherewithal and their enduring network advantage to prevail over the turbulence; their actions suggest they are addressing them, the rest is….harder to analyze….
Anthony B. Hatch