Factors That Could Hinder The Railroad Industry Upturn

There is no doubt that the new tax law has been a big positive for railroads and should be instrumental in driving growth for the industry. The new tax law apart, other factors like a buoyant U.S. economy and intermodal growth act as major tailwinds for this key sector.

These positives notwithstanding, there are a few factors that raise concerns for railroads. Let’s dig deep on the subject.

Sluggish Automotive Production – A Key Challenge

Weakness in the automotive sector has been hurting railroads for quite some time, with domestic production declining substantially. The scenario was not vastly different in the final quarter of 2017 as well. Results of major railroad operators like Union Pacific Corporation (NYSE:UNP) (UNP) and Norfolk Southern Corporation (NYSE:NSC) (NSC) were hurt by soft automotive volumes.

What’s worse is that the situation is unlikely to improve in the current year.

Union Pacific on its fourth-quarter conference call said that light vehicle sales for full-year 2018 are projected at 16.9 million units, reflecting a 2% decline from the 2017 levels. Norfolk Southern, meanwhile, said that it expects automotive volume to lag vehicle production in the United States.

These disappointing commentaries on the automotive sector do not bode well for railroads. As a significant portion of revenues is accounted for by this key sector, weakness pertaining to automotive production in the United States is a major headwind for railroads.

Service Issues

CSX Corporation (NASDAQ:CSX) (CSX) was plagued by service disruptions last year, which severely dented its operations. However, the railroad took measures to combat the issue. The Precision Scheduled Railroading system, implemented by the company's former CEO, E. Hunter Harrison, seems to be paying off. The system generated efficiency-related savings to the tune of $460 million in 2017.

However, service issues now seem to be hurting Canadian railroad operator, Canadian National Railway Company (CNI). In fact, the company has been facing a number of challenges related to network congestion for the past few months, which have hurt its operational performance. Further, oilfield service major, Halliburton Company (NYSE:HAL)'s (HAL) statement issued in February 2018 that Canadian National’s service delays have been affecting its bottom line, underlines the gravity of this situation.

Additionally, rival Canadian Pacific Railway Limited’s (CP) commentary about its increasing network fluidity highlights the fact that these operational issues might affect Canadian National’s customer base and adversely impact its growth prospects, unless resolved quickly.

Canadian National announced a change at its helm, in March 2018, in order to primarily address the service issues. The new CEO (interim) has apologized to its customers for the service woes. He has promised an improvement on the service front. However, in the event of management change failing to yield the desired results, the stock would be hurt further.

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

NAFTA

NAFTA refers to the trade pact inked in 1994 between the United States, Canada and Mexico in a bid to secure better terms for domestic workers. NAFTA has basically done away with almost all tariffs among the three nations. However, President Trump has in fact threatened to withdraw from the agreement, if the negotiations, which are currently in progress, fail to yield the desired results. He believes that it is a bad deal, not in favor of American workers.

The uncertainty over the North American Free Trade Agreement (NAFTA) continues to hurt railroads, especially the ones like Kansas City Southern (NYSE:KSU) (KSU). A significant portion of Kansas City Southern’s revenues come from U.S.-Mexico shipment. In fact, many railroads including Kansas City Southern are not in favor of the U.S. scrapping NAFTA. They believe that such a move might put pressure on supply chains, jobs and consumers apart from having adverse political implications.

However, the President has stuck to his guns and imposed a deadline of May 1 pertaining to the NAFTA negations. Beyond that date, there will be imposition of steel and aluminum tariffs on Mexico and Canada.

Railroads would be hoping for a favorable resolution to the issue as an unfavorable development on this key issue might dampen their prospects severely.

Other Headwinds

President Trump’s plans to shift focus to traditional energy businesses such as coal is aimed at benefiting the coal industry and therefore railroads. This is because the fortunes of railroads are tied to coal.

However, even if the Obama-era Clean Power Plan (CPP) is repealed, as wished by the Environmental Protection Agency (EPA), coal revenues might not pick up. In the current year, the EIA predicts coal production to be 736 million short tons (MMst), down 5% year over year.

Moreover, many are not in favor of repealing the CPP due to fears of environmental hazards among others. Furthermore, the process of repealing CPP is time-consuming. With uncertainty regarding CPP’S fate, a major overhang on railroad shares would remain until there is clarity on this key issue.
Even if legislative and regulatory measures hindering the coal industry come into effect more vigorously, the commodity’s long-term competitive position has materially been weakened by the abundant and largely cheap natural gas supplies. In other words, railroads will benefit from some incremental improvements in coal shipments, but the long-term trend is in the opposite direction.

Check out our latest Railroad Industry Outlook for more news on the current state of affairs in this market from an earnings perspective, and how the trend looks ahead for this important sector at the moment.