Growth Is the Logical Path Ahead for Rails

Overview:

• Investors are awaiting the next leg of earnings growth post-precision scheduled railroading (PSR).
• Managements steer investors towards carload growth, but we see persistent service and ease-of-business deficiencies.
• Regulatory and reshoring tailwinds are positive but linked to service.
• Failure to grow organically could prompt rails to press for mergers, but established regulations are a major obstacle.
• Cyclical near-term catalysts prevail, but gaining confidence in the secular growth thesis requires:
  • shippers see service and tech/artificial intelligence (AI) gains,
  • reshoring upside or
  • favorable merger rule shifts.

The TD Cowen Insight

Investors await the next leg of Class I rail earnings growth as the PSR story moves towards the rear-view mirror. This report explores the factors at play that can drive the future success of the railroads. We believe the Class I's need change; if they cannot show volume growth, the group may be at risk to de-rate lower or be forced to look at merging.

Our Thesis

While PSR gains are not completely in the rear-view mirror, rails are likely to need another story to maintain the investor interest the group has enjoyed over the last two decades. Management teams steer investors toward a return to carloadings growth despite long term trends of declines and loss of share to truck. This focus arises because the Class I railroads have underpenetrated their total addressable market (TAM) for over a decade with carload growth lagging Gross Domestic Product (GDP). At the root of share loss has been an inconsistent service offering, which rectifying is intended to drive growth.

Our survey data validates that the shipper experience with the railroads is deficient. A persistently tenuous correlation between metrics and the shipper experience (lamented for decades) does not bode well for the conversion thesis if not addressed. We believe increasing freight visibility, ease of business, operational flexibility and service quality will be paramount to the Class I's ability to stay relevant in public markets. We view the levers of growth as largely in control of the railroads.

Since 2000, U.S. Class I rail multiples have increased approximately five turns despite declining volumes (versus approximately three turns for S&P) due primarily to pricing in excess of inflation and implementing PSR and other productivity initiatives that led operating margins to increase by 20 points. If Class I's cannot show growth, the group may be at risk of de-rating lower.

Mergers have entered the conversation again recently as sources of growth are questioned. Establishing a transcontinental railroad would reduce interchange complexities and offer cost synergies. However, achieving this is a tall order from a regulatory perspective. Current regulatory precedent for the Surface Transportation Board (STB) to approve a merger is prohibitive and would require a change in current rules and/or the railroads to agree to forms of increased competition such as full reciprocal switching. While investors should keep an eye on any rule changes/shifting precedents, we believe it is too early to lean on mergers as a growth lever for rail earnings. Focusing on organic growth is both a higher probability and more durable path to growth.

What is Proprietary?

We analyzed 20-plus years of rail history, conducted a proprietary TD Cowen rail shipper survey and spoke with industry participants. We also examined industrial end markets, technological initiatives and Off-the-Road (OTR) trends to better understand the positioning of the Class carriers.

Financial & Industry Model Implications

We believe there is a risk to carloading growth over the long term if service and growth are not prioritized by the Class I rails and their managements. While the near to medium term offers more idiosyncratic opportunities that may enable another investment cycle to playout, we see potential downside risks to longer-term carloadings growth.

What to Watch

Service metrics

Rail service deteriorated sharply during COVID when layoffs were met with an inflection in freight. Each of the U.S. Class Is saw high-double-digit deteriorations in avg speed peak to trough, with the Eastern rails seeing the worst declines. Rail service metrics have shown improvements, but shippers need service consistency to make long term changes to their supply chains. We continue to monitor service metrics the rails publish and believe consistent steady improvements will be imperative.

Shipper perception (TD Cowen proprietary surveys)

Despite service showing improvements, there is a gap between published railroad service metrics and shipper sentiment on rail service. Rail shippers have consistently (since we began digitally tracking our survey in '16) wanted to put more freight onto the railroads, though poor service metrics have dissuaded them.

Regulatory changes

Rail mergers have entered the conversation again recently as sources of growth are examined. If the rails fail to prove they can grow with a concerted effort made by the industry, they may be forced to press the merger issue or else face multiple contraction. We acknowledge that this is a tall order given regulatory obstacles. There is still a remaining seat left on the STB and we expect it to be filled shortly, which will give Republican nominees a 3-2 board advantage.

Technology adoption

Lack of shipment visibility is a key pain point for shippers. Regulatory changes at the FRA could also enable the industry to fully take advantage of some overlap between labor and technology. We expect artificial intelligence (AI) will be a key theme for railroads as the technology evolves; areas for focus will likely be in

• quoting bids,
• optimized scheduling,
• safety improvements, predictive maintenance, and
• corporate back office costs. While the Class I's have not explicitly outlined the opportunities from AI, we expect this to be an emerging theme in 2026.

Gains made by autonomous trucks:

Autonomous trucking has always been on the proverbial radar screen for rail operators but never taken that seriously as it was viewed as being "7-10 years away" 7-10 years ago. While it has not arrived in the ubiquitous fashion envisioned, we are starting to see the beginnings of a driver out model for some operators. We do not see autonomy being a headwind to short- to near-term growth, but note it bears watching for the longer term.