A Solid Report Card for Railroads
Just 20 years ago, North America boasted a number of large freight railroads. Today, thanks to a wave of consolidation, that group has shrunk dramatically to just a half-dozen. The remaining players are the two Western U.S. railroads, Burlington Northern Santa Fe (BNI) and Union Pacific (UNP); two Eastern U.S. railroads, CSX Corp. (BBB/Stable/A-2) and Norfolk Southern (NSC); and two Canadian railroads. Canadian National Railway (CNI) and Canadian Pacific Railway (CP).
Based on the dollar value of freight hauled, railroads (including intermodal operations) account for less than 10% of the total amount spent on transportation in the U.S. Trucks still see the bulk of this spending, with an estimated 85% share. Pipelines, air freight, and water transport each receive a very small percentage of total transportation spending. Based on tonnage shipped, railroads have a significantly higher percentage of the total.
The Big Six railroads have much in common. All have a well-diversified revenue mix and a large and nonconcentrated customer base. They all benefit from participation in an industry that Standard & Poor's views as having strong business risk fundamentals because of its limited cyclicality, effective barriers to entry, and good access to capital, including low-cost equipment financing. The latter is especially important given the industry's capital-intensive nature.
Despite their similarities, the railroads differ from each other in certain respects. Perhaps the biggest difference is geographic coverage, a factor that was initially established for some railroads more than 150 years ago, augmented by mergers. Coverage affects revenue mix, competition from other modes of transportation, length of haul, operating terrain, and track congestion, all of which influence operating efficiency and, ultimately, financial performance. A railroad's merger history and management's business strategies and financial policies and goals also influence financial results and help determine credit quality.
Burlington Northern and Union Pacific each operate railroad systems consisting of approximately 32,000 miles of track. They primarily operate in the Western, Midwestern, and Southwestern states in the U.S. and serve major U.S. ports on the West Coast and the Gulf Coast. Both have access to markets in Mexico and Canada through agreements with other railroads.
CSX and Norfolk Southern each operate about 21,000 miles of track. Both primarily function in the Eastern U.S. and certain states in the Midwest and serve various ocean, river, and lake ports in their territories. They also have access to markets in Mexico and Canada through agreements with other railroads.
The two Canadian railroads, Canadian National and Canadian Pacific, operate about 19,000 and 14,000 miles of track, respectively, across Canada and portions of the U.S. Canadian National connects both Western and Eastern Canada with Chicago and operates a line between Chicago and New Orleans. Canadian Pacific also connects its transcontinental line to Chicago with a line running from Western Canada.
The Western railroads have an edge over their Eastern counterparts in some ways. They generally have a longer average length of haul and face less congestion, both of which are positives for operating efficiency. However, they also face more challenging terrain on certain routes. In addition, while the longer average length of haul translates into better operating efficiency, it also means that the Western railroads have a greater exposure to escalating fuel prices (although this is diminishing as a factor with the successful surcharge programs the railroads have implemented in recent years).
Although each railroad carries a diversified combination of products, there are differences among the railroads in terms of the relative importance of specific commodity groups. For example, in the U.S., Burlington Northern and Union Pacific operate in the farm belt, so agricultural revenues account for a relatively larger percentage of their revenues than for the Eastern railroads. Similarly, Norfolk Southern's location has helped make it the largest transporter of steel in the U.S.
Each railroad competes both with the other large railroad operating in its territory and with trucking companies. Depending upon their operating area, railroads may also face competition from river barges, especially for chemical, petroleum, and grain products. Given the Eastern railroads' shorter average length of haul, competitive pressures from trucking tend to be slightly higher for them than for the Western railroads.
In response to operational problems after the mergers of the late 1990s, U.S. regulators imposed a 15-month moratorium on large U.S. railroad mergers in early 2000 and stiffened the requirements for approvals. Some industry observers have speculated that one more major round of mergers is likely, with each Eastern railroad linking up with one of the Western railroads in the U.S., essentially creating two transcontinental railroads. The potential for Canada's two transcontinental railways to merge is limited, due to competition concerns.
The financial profile of most of the railroads has improved over the past few years. This reflects stronger industry fundamentals over the period as well as cost cutting and efficiency improvement and yield initiatives implemented by most railroads. Credit protection measures for Union Pacific, CSX, and Norfolk Southern also benefited from management's focus on debt reduction in recent years. Debt for all railroads is underreported on the balance sheet because of the use of off-balance-sheet financing activities, including the extensive use of operating leases at all railroads and the use of accounts-receivable sales programs at some.
At A-, Canadian National is now the highest rated railroad among the group, reflecting its relatively stronger financial profile and materially higher operating margins. Burlington Northern and Norfolk Southern are rated BBB+, while Canadian Pacific, CSX, and Union Pacific are all rated BBB. All six companies have stable outlooks, indicating that Standard & Poor's does not expect the ratings on these companies to change over the next two years.
Here are S&P's current outlooks for each company:
Standard & Poor's expects Burlington Northern's credit protection measures to improve over the next two years, but not enough to warrant an upgrade. If the company were to use free cash flow to repay debt instead of rewarding shareholders, the outlook could be revised to positive. An outlook change to negative is considered less likely, although that view depends upon management's commitment to maintaining the current credit profile of the company, with no deterioration stemming from share repurchases or other shareholder-friendly activities.
Canadian National should continue to generate solid earnings and cash flow. However, Standard & Poor's believes upside rating potential is limited by the company's leverage position. If the company were to experience a significant deterioration in margins or a large increase in debt leverage (as could be caused by a sizable debt-financed acquisition), the outlook could be revised to negative.
Standard & Poor's believes that materially improved margins at Canadian Pacific could lead to a positive outlook, provided there is no significant growth in underfunded postretirement obligations.
Current ratings incorporate an expectation of improved operating performance and maintenance of the existing capital structure. Should the railroad strengthen these measures beyond current expectations, the outlook could be revised to positive. Conversely, failure to achieve the expected improvement could lead to a negative outlook.
Standard & Poor's expects financial measures to improve over the next two years but not enough to warrant a positive outlook or upgrade. An outlook change to negative is considered less likely, given the company's efficiently run network and management's commitment to moderate financial policies.
If the company is successful in restoring service to acceptable levels and begins to generate better financial results, the outlook would likely be revised to positive. An outlook change to negative is considered less likely, given expected benefits from restructuring and investment activities and management's commitment to improving operating performance.