Why US Railroads' Operating Ratios Are Safe From Freight Woes

The soft freight scenario in the United States is a major headwind to railroad operators as a bulk of its revenues is derived from freight. The dismal scenario with respect to rail freight traffic in the United States is highlighted by the Association of American Railroads’ (“AAR”) data.

Notably, AAR refers to the industry trade group representing mainly the major freight railroads of Canada, Mexico and the United States. Per AAR, U.S. rail traffic (including carloads and intermodal units) has declined 3.7% this year through Sep 14.

The slowdown in global trade due to the Sino-U.S. trade tensions apart from inclement weather has hurt volumes this year. In fact, according to the latest Cass Freight Shipments Index report, North American freight shipments declined for nine consecutive months starting December 2018. What is worse is that the sluggish freight scenario is expected to continue throughout 2019, thereby hurting volumes.

As evidence, CSX Corporation (NASDAQ:CSX) had trimmed its full-year 2019 revenue guidance in July as it anticipates shipping volumes for its industrial customers to remain weak as a result of the trade overhang. Moreover, in August, Union Pacific (NYSE:UNP) trimmed its volume growth outlook for the second half of the year citing the trade spat.

Despite soft U.S. rail volumes due to the economic sluggishness, railroads in the country are witnessing improvement with respect to operating ratio (operating expenses as a percentage of revenues), a key measure of profitability for stocks in the railroad industry. The lesser the operating ratio the better, as it implies that more cash is available to a company to reward its shareholders through dividends/buybacks. A lower value of operating ratio is, in fact, a pat on the back for management of a railroad operator.

Let’s delve deep to unearth the reasons for operating ratio improvement despite revenue weakness.

Adoption of precision scheduled railroading model Cuts Cost

In a bid to counter lackluster revenues, most railroad operators in the country are looking to cut costs. In line with that objective,Class I railroads like Union Pacific , Norfolk Southern (NYSE:NSC) and Kansas City Southern (NYSE:KSU) adopted the precision scheduled railroading (PSR) model, which aims to improve efficiencies by streamlining operations.

The plan is also of paramount importance as railroads strive toward promoting safety and enhancing productivity. In fact, as a result of improving efficiencies due to PSR adoption the total number of employees at the U.S. operations of Class I railroads reached the lowest level in August 2019 since January 2012.

Cost Cuts Buoy Operating Ratios

With railroads striving to improve operational efficiencies to counter declining rail volumes, operating ratios are improving. In fact, operating ratio improved 2.2 points to 61.6% in the first half of 2019 at Union Pacific.

Similarly, this key metric improved in the first half of 2019 to 64.8% from 66.9% a year ago at Norfolk Southern due to efforts to improve efficiencies. Also, CSX’s operating ratio improved in the first half of the year courtesy of its cost-reduction efforts. Norfolk Southern and CSX carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Bullish Operating Ratio Forecasts

What is more encouraging is that railroads anticipate this key metric to improve further due to their optimization efforts. For instance, Union Pacific expects 2019 operating ratio to be below 61%. The metric is expected to be below 60% by 2020 and 55% in the long term.

Norfolk Southern predicts operating ratio to improve at least 100 basis points in 2019 compared with 65.4% achieved in 2018. Additionally, the company aims for a full-year operating ratio of 60% by 2021. At Kansas City Southern, adjusted operating ratio was pegged at 63.7% in second-quarter 2019. The company expects the metric at the lower end of the 60-61% range by 2021.

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