CHICAGO -- The major U.S. railroads have continued to hold the line with strong pricing despite weak rail freight volumes that reflect the problems in the country's housing and automotive sectors and light consumer spending.
The question among analysts and investors is: How much longer can they hold out in such a weak environment?
"Economics 101 tells us that when demand is weak, prices come down," said Donald Broughton, an analyst at AG Edwards. "That hasn't happened yet, but at some point someone may blink and lower their prices.
"The analyst who can correctly guess when that point will come — well, that's a career-making move."
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But some analysts and investors say that as long as the weak freight environment is not too prolonged, the railroads should be able to keep their freight rates at robust levels, helped in part by old contracts that will face price hikes when renewed, plus their relatively low cost compared with trucking companies.
"As long as we don't see an unprecedented slump lasting 18 months, I think the railroads can ride this weak patch out," said Tony Hatch, a railroad analyst at New York-based ABH Consulting.
According to data from the Association of American Railroads, the number of carloadings on U.S. railroads was down 3.3 percent in the second quarter of 2007 compared with the same period in 2006. For the first six months of the year, carloadings were down 4.1 percent.
But that decline has not translated into poor results for the railroads. No. 1 U.S. railroad Union Pacific Corp. and Norfolk Southern Corp. both reported higher net income for the second quarter, and CSX Corp. reported higher earnings before one-time items.
Only Burlington Northern Santa Fe Corp. reported lower profits for the quarter, but that was due to high fuel costs and not pricing weakness. Like the other railroads, BNSF reported higher revenue for the quarter thanks to its pricing.
BNSF's "sustained pricing power is a positive sign for the railroads," Morgan Stanley analyst William Greene wrote in a research note.
BNSF Chief Executive Officer Matt Rose said the railroad's pricing should remain strong into 2008, but price hikes could "decelerate" if freight volumes remained soft. The other railroads also say they aim to maintain strong pricing moving forward -- though as Norfolk Southern CEO Wick Moorman put it, the economy is the "wild card" for just how much his railroad will be able to raise prices.
BAD OLD DAYS
The railroads didn't always have their current pricing power. Following deregulation in 1980, the railroads spent two decades downsizing, merging and resolving their financial difficulties. Under a new generation of managers in recent years, the rails have seen their business grow, thanks in particular to stronger demand for coal and soaring imports of consumer goods into the United States.
The new officials in charge have also made the railroads more efficient and maintained a pricing discipline that these companies never had before.
"This is a different railroad now; we don't chase business the way we used to" CSX CEO Michael Ward said.
Although volumes have weakened since late 2006, that pricing discipline has so far not wavered.
Michael Santelli, senior director of Allegiant Asset Management's $420 million mid-cap value fund, which holds a small position in Union Pacific, said the contracts the rails have coming up for renewal should help them stick to that policy.
"The railroads still have some way to go to renegotiate all of their old contracts, so there is still pricing power there," he said.
The railroads also have a fuel advantage over their main competitors in the trucking sector. Although trucks tend to move goods faster than trains, they tend to burn three times as much fuel to do so. So rail freight is cheaper, though often slower.
"As fuel prices do not look like they are going to fall dramatically any time soon, I think the railroads can maintain pricing power," said Shawn Campbell, a principal of Chattanooga, Tennessee-based Campbell Asset Management, which manages assets of around $100 million and follows Union Pacific.
That combination of business that is yet to be priced, plus the relative savings compared with the trucking industry, should enable the railroads to hold firm on their freight rates. And as long as volumes pick up again before too long, the railroads should be able to use that growing business to further increase rates.
"No one expects (the weak volumes) to continue forever," ABH's Hatch said. "Once things improve again, I think the railroads are looking at a pretty thick silver lining."
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