By Andrew West, CFA The transportation industry's performance has strengthened significantly since the U.S. economic recovery began to pick up steam in the third quarter of 2003. We expect shipping demand to rise as consumer spending and industrial production increases.
Indeed, shares of trucking companies have outperformed the market so far this year. Year-to-date through Aug. 20, the S&P Trucking index, which includes Landstar System (LSTR
; buy; $52) and Yellow Roadway (YELL); accumulate; $42), has risen 10.2%, vs. a 1.2% loss for the S&P 500-stock index. The S&P Railroad index, which includes Burlington Northern Santa Fe (BNI
; buy; $36), has fallen 3.8% so far this year but more recently has gained ground.
ROADBLOCKS AHEAD? Despite the favorable demand environment, we think that challenges exist for the commercial transportation industry. Companies are dealing with capacity constraints, unusually high fuel prices, tighter labor markets, rising labor costs, and occasional labor unrest.
In the trucking area, we believe that new regulations of truck drivers' hours of service, which includes increasing the number of resting hours, will decrease productivity industrywide and increase labor costs per mile. On July 16, the U.S. Court of Appeals for the District of Columbia Circuit vacated the new hours-of-service rules, based on the court's view that the Federal Motor Carrier Safety Administration hadn't considered the rules' impact on drivers' health. The FMCSA subsequently announced that the new rules would remain in force during the 45 days it has been given to review the court's decision and decide how to respond.
Plus, a shortage of qualified drivers is hampering truckers' ability to expand services. And higher diesel-fuel prices are primarily a problem for truckload carriers because fuel costs absorb a greater portion of their revenues.
LESS CAPACITY. However, we believe that industry consolidation over the past few years has left remaining participants in a position to take advantage of increased demand. We expect the stronger carriers to regain pricing power for the first time in several years, making higher prices and improved yields likely this year, which should offset higher costs. In our view, enough capacity has been removed from the market to alter the supply/demand equation in favor of trucking companies.
Less-than-truckload (LTL) traffic generally follows trends in factory shipments of both durable and nondurable goods, which collectively approximate retail sales. Based on our economic forecast, we see LTL truck revenues rising about 9% in 2004 after an estimated 7% rise in 2003.
In 2004, we expect shipment volumes to improve as lean retail inventory levels meet improving demand from the accelerating economy. The estimated inventory-to-sales ratio was 1.30 in May 2004 -- a historical low in a 12-year downtrend.
LTL carriers' profitability in 2004 should benefit from higher volumes attributable to improved manufacturing and retail activity, likely price hikes, and improved asset utilization. For 2004, we expect the group to report a significantly higher operating profit margin of 6.1%.
RAIL REBOUND. For railroad operators, we project a 4.5% increase in ton-miles for aggregate rail traffic for 2004. With the U.S. and global economies strengthening and the dollar staying relatively weak, we expect improved metals and chemicals shipments, a rebound in coal demand, strong grain and coke exports, and continuing strength in intermodal shipping. Weakness is expected to continue in motor vehicle shipments due to the expected cooling of vehicle sales.
As the railroad industry's largest traffic source, coal accounts for about 40% of tonnage and 20% of revenues. Through July 24, 2004, U.S. Class 1 coal carloadings rose 3%, as power producers reacted to increasing electricity demand. We believe that below-average coal inventory levels, combined with economic growth and high prices for coal substitutes oil and natural gas, will drive increasing coal demand and shipping volumes in 2004.
We believe railroad rates will rise about 2.7% in 2004, on average, in line with our inflation expectations, on continuing flow-through of fuel surcharges and as rails gradually raise rates to reflect strengthening demand.
Rail profits have been variable in the past couple of years. We project a 22% profit improvement in 2004, driven by higher volumes and higher rates, which should allow for fixed cost leverage, improving efficiencies, and disciplined cost controls, offset by higher compensation and benefits costs.
TRAFFIC TROUBLE. Despite the recent gains, the industry's return on investment continues to lag behind its cost of capital. Nonetheless, we think the railroad industry has moved closer to acceptable profitability as its cost of invested capital has fallen to 10%, from about 17% in 1981.
One challenge is the recent decline in the speed and quality of rail service. Average miles per hour have slowed down fairly significantly for railroad operators because of heavier traffic. The companies that have been affected most by this are Union Pacific (UNP
; hold; $57) and CSX (CSX
; hold; $31).
Among the trucking stocks that we cover, we favor truckers Landstar and Yellow. Among the railroad companies, we like Burlington Northern.
Note: Andrew West has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. (SPSI). An affiliate of SPSI received non-investment banking compensation from Landstar, Yellow, Burlington Northern, Union Pacific, and CSX during the past 12 months. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com Analyst West follows trucking and railroad companies for Standard & Poor's Equity Research