n the transportation business, the primary concern has been fuel costs for the past two years. This situation has changed. With a renewed focus on volume strength (level of material shipped around the country) in this depleting macroeconomic environment, many of the same rails that saw buying momentum from the 2008 commodity spike are being absolutely "de-railed" by renewed concerns amid collapsing volumes. While the major railroad companies have been able to beat expectations for the year, is there any reason to be optimistic going forward? Every week, the Association of American Railroads (AAR) releases updated volume trends in the form of a weekly carload report. While many of the readings have been sporadic (to say the least), the overall theme is of disappointment. Most recently, on December 11th, the AAR announced that carload freight was down 8.5 percent from the same week in 2007, with intermodal shipments bucking the downward trend at 9.8 percent in the red. This comes somewhat as a surprise from companies that were, for the most part, bullish on the future of volumes from just under a month ago. Clearly, the global slowdown is putting downward pressure on carloads… but let’s not panic; to this date, shipments are only down 1.5 percent from last year’s period. Warren Buffett’s Big Bet With new positions from Berkshire Hathaway revealed on Monday, December 15th, the stock that has gotten a large share of Warren Buffet’s attention continues to be in the rails with Burlington Northern (BNI). Last week, Buffett used the weakness as an opportunity to add an extra 2.2 million shares through fresh put option contracts. After this most recent spree, Berkshire owns about 20% of Burlington, on top of strong positions in competing rails Union Pacific (UNP) and Norfolk Southern (NSC). Perhaps the stock market guru senses a future opportunity that other investors are simply not accounting for to this date. Is the Volume Crash Over-Hyped? With the shares of leading railroad firms trading at multi-year lows, it would seem that these companies have been unjustifiably brought down by a commodity crash and intensifying production fears. Will pricing power continue into 2009? And how about crude oil? Will the commodity bubble burst actually dismiss the once-needed efficiencies of transportation by rail? Perhaps a slowing domestic atmosphere will simply rob rails of their traditional carload capacity optimization? There are many unanswered questions floating around in the heads of traders looking at the railroad industry, but perhaps the sell-frenzy is overdone and things really aren’t as bad as we make them out to be. rails_summerhil_yonge_tall_01 Here are a few points that could lead to better than expected numbers: The Federal Reserve Target Rate Cut: As the U.S. Federal Reserve cut its federal funds rate target from 0 to 25 basis points, we may actually see a benefit in the railroad arena. This recent government action has definitely shown the Fed's interest in keeping our economy stimulated. With any rate cut, our economic environment is stimulated into a flurry of activity… including increased demand for shipments worldwide. It may sound like a bit of a stretch to link a rate cut with boosted demand for rails, but this is something that does in fact fit with the global theme. Don’t overlook the government’s ability to boost demand, albeit somewhat artificial, and help the rails out of a pinch. Long-term Transportation Consolidation: I am ranking the entire rail industry as the conviction buy of 2009. Why? As other forms of transportation start to melt away into deficits and negative returns, I feel that it is the railroads that will receive major increases from the consolidation. Sure, railroad transportation may not be the newest idea in town, but it is reliable, energy efficient and improving constantly. You just don’t see many hybrid FedEx trucks driving around. From the third quarter releases: CSX (CSX) grew fuel efficiency by 3% in the quarter, Union Pacific boosted velocity speeds by more than 2 mph to 23.7 mph, Burlington Northern grew fuel efficiency by 2.2% quarterly, Norfolk Southern saw 9% improvement in transit times for their coal division and Canadian National (CNI) saw train speed up 12% with switching productivity up 6% during the quarter. This efficiency-building is a theme that you don’t see in the trucking industry, the air-freight industry or even shipping. As other forms of transportation collapse, railroads may see increased workload from the sole fact that they are the best way to move things around. Unrealized Fuel Tailwinds: Let’s not forget that crude oil was significantly higher in the third quarter. The same pessimism that we are seeing toward the industry now existed one quarter ago in the form of fuel surcharges. The major domestic railroads saw fuel costs increase anywhere from 55-60% in the third quarter… and this did put a ton of pressure on their pricing power. Regardless, most of the hedging in the industry is on a per-contract basis where deals are negotiated. Railroads should see a significant benefit in their figures from lower fuel costs overall, and this may easily translate into more favorable outlook and earnings. Previous Guidance Bullish: There are still plenty of strong points in the rails despite current headwinds from a volume slowdown. Turning to the third quarter earnings reports, many of the rails were actually raising their forward-looking guidance last quarter. Some, such as industry-leader Union Pacific, even admitted that volumes would be “soft.” However, this really didn’t detract from much of the profit-seeing as guidance was typically raised across the board in a similar environment. Has volume actually deteriorated enough since then to merit share collapses in the rails of more than 30% on average since the last quarter’s surprising success? Obviously, things aren’t pretty in the transportation stocks as a whole. But the market tends to take news and over-react… the news that we see right now still suggests decent numbers from the railroads. Recently, Merrill Lynch downgraded their rating for the major railroad, cutting most companies to neutral or sell ratings. In addition, in late November UBS analyst Rick Paterson claimed that anyone who feels volumes are “OK” is “in fantasy land.” He even went so far as to say “get the knives out.” Understandably, a lot of people shrugged off the railroads when they traded at a premium of anywhere from 20% to 35% of current values now in mid-December. I believe there is enough conviction to place bets on the rails down here with P/Es ranging from 8x to 13x. The best names going forward, in my opinion, will be Union Pacific (P/E: 11x), Burlington Northern (P/E: 13x) and CSX (P/E: 9.5x) on growth initiatives and exposure to the Powder River Basin for maximized coal transportation. In an industry that typically beats on negative sentiment with stable revenue streams and plenty of contract-negotiating power, there may be a considerable amount of upside in the rails. -Jim Regan