U.S. rails skid into bear market on triple whammy cargo slump

U.S. railroads, Wall Street favorites for much of the past decade, are slumping into a bear market amid a three-way squeeze from plunging coal, crude-oil and grain shipments.

An index of the four largest publicly traded U.S. carriers has dropped 20 percent from its peak in November, paced by Kansas City Southern, as the companies struggle to offset the loss of volumes. They haven’t tumbled this much since 2011.

Those difficulties are likely to drag on, leading to the first annual industrywide earnings decline since 2009, as low natural gas prices sap coal demand, U.S. oil drilling slows and harvests return to normal after a record crop. That threatens to crimp a rally that made the group one of the top performers in the Standard & Poor’s 500 Index.

“It’s going to be a tough year,” David Vernon, a Sanford C. Bernstein & Co. analyst, said in a telephone interview after publishing a note last week whose title predicted second-quarter profit reports that would be “Dark and Full of Terrors.”

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Earnings per share for the largest U.S. railroads — the other three are Union Pacific, CSX and Norfolk Southern — will fall 0.6 percent in 2015, based on analysts’ estimates compiled by Bloomberg. Last year, they gained 19 percent. Analysts predict revenue will drop 2.8 percent this year after jumping 6.7 percent in 2014.

The dwindling volumes for coal, oil and grain are magnified in contrast with last year’s surges. Petroleum carloads, chiefly crude, are down 0.6 after 2014’s 13 percent increase. The other commodities are down even more; Union Pacific’s grain and coal declines are 10 percent and 17 percent, respectively.

Coal’s retreat is especially worrisome for investors because it’s the industry’s largest commodity, and the weakening demand may be permanent. Environmental regulation has squeezed the fuel, which many utilities can easily replace with cleaner- burning natural gas. Coal accounted for 18 percent of cargo for both Union Pacific and CSX.

“This group has had the whammy of coal and the whammy of grain,” said Michael Barr, a buy-side analyst with Neuberger Berman Group, which owns stock in the four major U.S. railroads. “It makes these reported numbers look really bad.”

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The S&P 500 Railroads Index’s gain in the 10 years through 2014 beat the broader S&P 500 by more than sixfold. Profits were driven by productivity as companies invested to refurbish networks following deregulation. Pricing gains were outsized as old contracts were renegotiated based on improved service.

Efficiency gains will be harder to achieve in coming years after most of the rails have increased their operating margins to more than 30 percent. Core pricing has increased, but not as fast as the past pace.

Not all investors are so pessimistic.

The railroads are only in a temporary rough patch, said Paul Taylor, chief investment officer for BMO Asset Management in Toronto, which owns rail stocks. Rails continue to take business from trucks and have pricing power, which drives earnings over the long term, he said.

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“Maybe the easy money has been made, but we don’t think this is over or long in the tooth,” Taylor said. “When the economy does well, the rails do well.”

Excluding coal and grain, shipments are tracking economic growth, Neuberger Berman’s Barr said. Railroads have posted a 4.1 percent increase in intermodal traffic, which is mostly consumer goods, in the second quarter so far this year. The industry tallies include BNSF Railway, now owned by Warren Buffett’s Berkshire Hathaway Inc.

The rails will regain their footing and investors will jump back in as valuations prove to be cheap, said John Larkin, an analyst at Stifel Financial Corp. Even with declines in coal and grain, Union Pacific is expected to post earnings growth of 4.7 percent this year, based on the average of 29 analysts’ estimates. Earnings in 2016 are expected to jump 14 percent.

“The railroads have had a great run over the last 10 to 12 years,” Larkin said. “Some people say the good days are over, but we argue that railroads’ returns can be better than the overall market.”

— Lauren Thomas contributed.