Investors ignore the risk of the railways
Today's Financial News - Posted January 27, 2009
The railroad industry is getting plenty of attention from investors, but for all the wrong reasons. Falling fuel prices will help, but not nearly enough to overcome plummeting demand.
By Andrew Snyder, TodaysFinancialNews.com
Baltimore – (TFN): It has been an interesting earnings season. During the first week, when Alcoa (NYSE:AA) issued its horrid figures, volatility reigned. Last week, the market remained fairly steady. The relative calm has given investors an opportunity to re-think their strategies and adjust their portfolios.
Now that nearly 100 companies reported their most recent results, we have a better look at where things are headed. So far, over half of the reports have exceeded analyst expectations. That helps to explain why, in the face of tens of thousands of fresh layoffs, the equities market has managed to tack on moderate gains over the last few trading days.
But as we all know, past performance is not an indication of future performance. Too many investors are looking at 2008’s final quarter as the bottom of the recession. The economic data we have received over the last two days prove the situation is only getting worse.
For example:
· We heard of over 40,000 job cuts in the last 24 hours. Many economists believe we will see three million jobs eliminated this year. That figure is on top of the 2.6 million we lost last year.
· According to the S&P Case-Shiller Home Price Index, home prices fell by over 18% over the past year. It can easily be considered a freefall.
· Retail sales are expected to post the first annual drop in history, with an expected decline of 0.5% in 2009 from last year’s figures.
I could go on and on about the dismal data Wall Street seems to have turned a deaf ear to. But my job is to let you know about trading opportunities and strategies. That means you need to take this data, dissect it and turn it into a profitable trade.
Trade the news
Right now, that trade will come from the railroad industry. Later today, Norfolk Southern (NYSE:NSC) will announce its fourth-quarter results. Street estimates believe the company will post a profit of $1.18 per share, up from just $1.02 a year ago.
When Union Pacific (NYSE:UNP) beat expectations last week, its share price jumped by about 10%. There is a strong chance Norfolk could mirror the action today.
But investors are so worked up over falling oil prices and the benefit it will have on the rail industry, that they cannot see the industry is collapsing under the weight of a falling economy.
Demand for rail transport is failing at a dangerous rate. In December, carloadings (bulk grain, chemicals, and large items) dropped 14.2, while intermodal (containers and trailers) demand fell by 13.7% from the same period last year. These are unprecedented declines, which have forced the nation’s rail carriers to park over 105,000 of their rail cars. That is nearly 20% of the nation’s total fleet.
There are signs the situation could get worse. On January 7, Peabody Energy (NYSE:BTU) announced it would cut coal production in the Powder River Basin as demand waned. This is a major hit to the rail industry, which depends on coal for about 40% of its shipping demand.
Even with all of this bad news, which continues to get worse, investors are following the lead of Warren Buffet, who owns about 22% of Burlington Northern and portions of the other two mentioned above. The Berkshire Hathaway (NYSE:BRK.B) CEO recently bought 4.4 million shares of the company for an average price of $62.54.
In the long-term, Buffet may be right. Railroads have a strong business model with huge barriers to entry and limited competition. But the industry is hugely dependent on the economy. If the nation’s productivity is declining, the rails have less and less goods to transport.
Don’t fall for it
All of this talk about celebrating lower fuel prices is hogwash. Fuel is a variable cost for the industry. As demand plummets, its marginal impact will have less and less of an effect on the company’s bottom line. What investors need to be aware of is the huge fixed costs of operating a rail system.
When Burlington Northern or Norfolk Southern put over 100,000 cars into storage, they still have to pay for those cars. And even though they are using their tracks less, they still have to pay to maintain those tracks. And they still have to pay their employees. Trains may have less cars, but they have the same fixed costs.
Let’s face it, railroads are volume-based businesses. When volume falls dramatically, the industry will suffer. That means traders with a bearish sentiment have an opportunity.
Really, there are many opportunities. You can short the three major rail carriers, but they rarely make large, volatile moves. You can make sizeable profits by purchasing put options. Today is the day to be buying. Or you can take a short position on the companies that depend on the rail industry.
One company that absolutely hates to hear that railcars are being stored in huge quantities is Trinity Industries (NYSE:TRN). It manufactures and sells many of those railcars that are no longer getting used. You can bet demand for its products are plummeting. Shares have dropped from $40 to $13 in the last six months. But with revenues declining, there is plenty of more room to fall. Single-digit prices are right around the corner.
Really, it does not matter which company you choose. Pick one of them, take a short position and you should be sitting on profits over the next three to four months. As usual, the more you risk, the more you stand to make.
This is an easy call. Many investors are looking at one small aspect of the industries profit stream. Unfortunately, there are many more factors affecting the industry. Take advantage of their mistakes.
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January 28th, 2009 at 12:41 pm
Mr. Snyder’s analysis is right on the money for future earnings of the railroads. As fuel prices decline so will revenues as the railroads fuel surcharges are lowered. Surface Transportation Board requires RR’s to lower these surcharges when fuel prices drop. Besides, the truckers will eat away at intermodal traffic if railroads are not competively priced (note: trucking companies are not seeing these large percentage declines in traffic).
Also be aware that rail freight traffic for many products like lumber and auto parts is down 40% or more and may not recover for quite a while as the housing and auto industries are in long term depression. One bright spot for railroad’s cost structure is that much of their locomotive and car fleets are leased and the maintenance contracted out, so these costs can be quickly eliminated from the balance sheet.