Unpacking Rail Earnings: How Volume Growth Fuels Merger Talks

Speaker 1 [0:00] All right, let’s go to the other great mode of domestic surface freight. We’ve got Bill Stevens who’s going to talk, break down all of the action in the rails. It is absolutely hot. Bill, welcome to Freightways Today again. How are you, sir?

Speaker 2 [0:16] I am well, Craig. Hi, hi, Julie. How are you both today?

Speaker 1 [0:19] Well, we know it’s exciting. You’re going to be down in Chattanooga next Tuesday. We have the Future of Rail Symposium that will be right here in Chattanooga. We got the CEOs of probably the hottest story in freight, Norfolk Southern and Union Pacific. Now, we are told they won’t talk about the merger itself, so it’s going to be in the room. I don’t know if, if, uh, uh, if what you’re expecting to hear from that conversation.

Speaker 2 [0:43] Well, um, our timing is perfect because on Monday they are going to file the supplemental information that the Surface Transportation Board asked for regarding the merger. So that is going to be question number one. What does this additional merger do that can—

Speaker 3 [1:00] or additional information do that can help get your merger across the finish line from a regulatory review perspective? Um, so we’ll, we’ll have a—

Speaker 2 [1:09] we’ll—

Speaker 3 [1:09] they’ll have a lot to say about the merger, I am sure.

Speaker 1 [1:12] So they will talk about it. I, I— that’s, that’s certainly refreshing. I think it’s what our audience wants. We’re going to give them what they want, right?

Speaker 2 [1:18] Yes.

Speaker 3 [1:18] Oh yes. Yeah, absolutely.

Speaker 1 [1:22] I had the chance to interview the head of the STB, the chair of the STB, Patrick Bucks, a couple of days ago related to the virtual symposium. Now, one of my opening questions was, tell me about what your thoughts on the merger was. And he immediately shut me down. He’s like, I can’t talk about that. But it is great. And we’ve got, you know, BN’s gonna be on CSX. We’ve got some of the Canadian railroads. It’s a jam-packed agenda. I’m super pumped about it, Bill.

Speaker 2 [1:52] It is. And we have some, some looks at autonomous trains as well, which is, you know, people say that’s going to be the future of growth in the industry. So it’ll be an interesting, interesting conference to look at. We have earnings reports came out last week and this week, uh, from— actually all this week, it’s been a long week, um, for, uh, 4 out of the, uh, 6 Class 1 railroads. Um, and really the results show what happens when you get a little bit of volume growth.

Speaker 3 [2:28] Um, you know, all of the railroads reported improved financial results. Uh, some had record revenue.

Speaker 2 [2:36] Um, if you look at this chart here, CSX’s volume was up 6%. UP up 2%, NS up 4%, and Canadian National up 5% with an asterisk because that is the way they prefer to count it based on revenue ton miles.

Speaker 3 [2:51] If you look at carloads, which makes it— equates it with the other railroads on that chart, uh, volume was relatively flat at 0.35% growth.

Speaker 2 [3:01] Um, but, uh, what, what’s important here too is these improving volume outlooks and financial outlooks have prompted 3 of the 4 railroads to raise their financial outlooks for the year and in some cases their volume growth outlooks. And intermodal has primarily been driving that, but it’s also broad-based across most of the merchandise carload sectors. Coal depends on the railroad. Norfolk Southern was up quite a bit.

Speaker 3 [3:38] Thanks to exports of metallurgical coal. Union Pacific was down due to high stockpiles at utility plants and also low natural gas prices. Their business is predominantly utility coal.

Speaker 2 [3:52] But, you know, you look at the intermodal figures, you know, CSX up 9%, UP was up 4%. But within that, their domestic intermodal set a 4th straight quarterly record for volume. And they had double-digit growth. Norfolk Southern intermodal was up 5%, and they’re seeing strong truck-to-rail conversions, they say, amid the high fuel prices. And the outlier here is CN. As we’ve talked about on Wednesdays, the intermodal market is different in Canada than it is in the US. And one thing that CN’s Chief Commercial Officer Janet Drysdale said on their earnings call this morning was that truck capacity is not as tight in Canada as it is in the US.

Speaker 3 [4:42] And that’s been a key factor in driving those domestic volumes up in the US.

Speaker 1 [4:48] The regulatory and immigration crackdown is really an American story. And Canada’s got its own situation with immigration issues, but they’re Their orientation on the Canadian truck drivers is quite different than the administration’s orientation. So it certainly makes sense that the Canadian railroads would not be as bullish on intermodal as what you see. Plus you’ve got the whole tariff overhang on this, Bill. Any thoughts there?

Speaker 2 [5:17] Yeah, that’s it exactly.

Speaker 3 [5:19] And CN said that the key here for them is to be adaptable amid ongoing trade tensions and disputes and tariffs that are levied one day and pulled back the next.

Speaker 2 [5:32] Um, and so never-ending story.

Speaker 3 [5:36] Exactly.

Speaker 2 [5:36] And, um, you know, they’ve talked about metals traffic is, is still moving, uh, across the border, um, despite the tariffs because the US can’t produce enough of, of aluminum, for example. Um, forest products traffic not doing well for CN.

Speaker 3 [5:53] Um, that’s partly due to tariffs, partly due to the low uh, you know, the slow housing starts in the US.

Speaker 2 [5:59] Um, but, uh, you know, when you look through, um, the railroad’s outlooks, um, for the various traffic segments, um, you know, they really see broad-based, um, positive outlooks.

Speaker 3 [6:14] Uh, at CSX, the only thing that was really, uh, negative was, uh, automotive and, and chemicals. And I think that might have more to do with the chemical plants that, that CSX serves.

Speaker 2 [6:26] Union Pacific, the only negative thing that they had on their second half volume outlook was, was coal. Um, everything else, uh, was—

Speaker 3 [6:35] they viewed in positive territory in their carload business, which is, you know, industrial products, uh, traffic, the ingredients that go into things.

Speaker 2 [6:44] Um, they believe that theirs is going to be above the rate of industrial production, which suggests market share gains versus truck. Norfolk Southern said industrial activity is a positive for them as well as global energy prices. And in the intermodal side, the truck market tightening is positive.

Speaker 3 [7:06] They were mixed on consumer demand, I think mostly because of the high fuel prices that are affecting everybody at the pump.

Speaker 2 [7:16] And coal, they were kind of neutral. CN was really positive on petroleum and chemicals traffic.

Speaker 3 [7:22] That’s a huge export story for them as well as internally with a new fuel facility in the Greater Toronto Area. Grain continues to be a bright spot for them.

Speaker 2 [7:34] They do believe that their domestic intermodal is gonna grow this year and then automotive traffic as well.

Speaker 3 [7:43] They’re down on intermodal, international intermodal, partly because they’ve been demarketing some of the lower margin traffic.

Speaker 1 [7:52] Hey Bill.

Speaker 2 [7:52] And then, yep.

Speaker 1 [7:53] Go ahead, sorry.

Speaker 2 [7:55] No, no. And then just forest products and fertilizers, they had a negative outlook on. CPKC, the other Canadian-based railroad, they report on Wednesday.

Speaker 3 [8:03] And then BNSF, which is a unit of Berkshire Hathaway, they will report alongside their parent company next month.

Speaker 1 [8:09] So this is a big change in direction. Earlier this year, we’ve covered it extensively. The railroads were pretty bearish on this year, or at least not constructive about this was going to be an off year. I think the industrial slowdown that we saw last year probably prepared them to think the worst. The change is that there’s a massive change in tone, just in terms of perception of the improvements in construction in this year that’s taking place across their business. Are they, do they believe this is really driven by higher demand? I know intermodal is a truck fungible story from a capacity standpoint, but what are they seeing on the demand side, particularly in the economic, the economy?

Speaker 2 [8:51] Norfolk Southern pointed to industrial development efforts and how new plants and plant expansions are coming online in a variety of sectors across their network. I believe they said it was double, uh, what it was last year. It’s a similar story at CSX. So they are seeing that industrial economy, uh, pick up and, and gain steam.

Speaker 3 [9:14] CSX also pointed to construction around data centers as driving, uh, some of their construction-related traffic increases as well. Um, and, um, Union Pacific had similar things to say about the industrial economy and manufacturing.

Speaker 2 [9:29] Um, so I think they were cautious, uh, earlier, earlier on this year because of, um, the length of the freight recession and saying, oh, we see the turnaround, you know, next year or the second half of the year, and then it just not playing out.

Speaker 1 [9:48] The industrial, the industrial economy was a dog last year. We see it in the freight data. It just was absolutely anemic, but it has come back since November, and that’s certainly given everyone— but I think Like many of the trucking companies in the first quarter when there was earnings reports, they were constructive, but still cautious. As we like to say in freight, nobody gets credit when you’re a public company for being wrong. In terms of if things are bad, you’re going to get spanked by the markets. If you are overconfident, and that’s why a lot of the public CEOs, particularly the seasoned ones, tend to be more conservative when they’re talking about market developments. It’s interesting, because We talked to a lot of those folks. They’re more bullish when they’re one-on-one than they tend to be with Wall Street when they’re talking about the market, because they have to be very careful to set themselves up for failure.

Speaker 3 [10:36] That’s it exactly. It’s way better to under-promise and over-deliver than the other way around.

Speaker 1 [10:41] The opposite, you get absolutely obliterated if you’re on the wrong side of that, if you’ve over-promised. As anybody who’s been public knows that that’s a dangerous thing. So Bill, I want to talk about the merger for a second, because it’s obviously the most important story. We have just a number of big announcements this week. You covered the whole story where CN was given— can you explain for those that aren’t real deep into the rail market, why is this a significant development?

Speaker 2 [11:10] Well, a couple of things. First, railroading is all about the map. It’s not the highway network. You can’t just go anywhere.

Speaker 3 [11:16] You can only go as far as your map gets you.

Speaker 2 [11:20] And there were 2 deals that Union Pacific and Canadian National worked out.

Speaker 3 [11:25] One is totally tied to the merger and the other never would have happened without merger discussions.

Speaker 2 [11:31] So the first is, and this is not dependent on the merger, Canadian National gets a haulage rights agreement between Memphis and the Mexican border at Eagle Pass, Texas, over Union Pacific. So in other words, Union Pacific will haul CN’s traffic from Memphis to Eagle Pass. That enables CN to be a better competitor against CPKC, which can offer single-line service between Canada, the US, and Mexico. This, uh, CN deal applies only to Canadian origins and destinations traffic moving to and from Mexico, um, but it’s a faster route and is, and is far superior to, uh, the existing offerings.

Speaker 3 [12:14] They currently hand off traffic to Union Pacific in Chicago, so they get a longer length of haul out of this.

Speaker 2 [12:21] In exchange, Union Pacific, uh, gets rights to run over CN’s Chicago bypass. Back in 2009, they, they bought a railroad called the EJ&E, which basically is, is kind of like a loop road around Chicago, doesn’t go through it.

Speaker 3 [12:39] And Chicago, of course, is congested, notoriously so at times.

Speaker 2 [12:44] And, and it’s inconsistent and long, uh, the transit times through Chicago.

Speaker 3 [12:50] CEO Jim Vena said at times when he was at CN, they could get a train faster from British Columbia to Chicago than it took to get from one side of town to the other.

Speaker 2 [13:00] That’s an extreme example, but you Union Pacific will get this much faster route through Chicago as a result of this. And they want to—

Speaker 3 [13:11] once they put the finishing details on this and reach a final agreement, it’s not contingent on the merger, and they want to start moving this traffic as soon as they can.

Speaker 2 [13:21] The part that’s related directly to the merger involves giving CN access to customers, uh, in basically in, in the Midwest.

Speaker 3 [13:33] There’s only a handful of them that under this merger, since there’s no overlap, would go from the option of having 2 Class 1 railroads serve them and have seen it just go to one. And it’s the same for customers that currently have the option of 3 railroads going down.

Speaker 1 [13:48] Was this just a way of, for those customers that have dependencies, to demonstrate to the STB that they’re trying to find ways to provide some competition?

Speaker 3 [13:57] Yes. And Union Pacific and Norfolk Southern were upfront about this when they filed their merger application. They knew that they were going to have to provide access to enhance competition in that overlapping area in the Midwest, which is primarily in Missouri.

Speaker 2 [14:15] And so CN will get access.

Speaker 1 [14:17] Is it chemicals? Like, what is the— what are the commodities that are impacted?

Speaker 2 [14:21] It’s a variety of carload shippers.

Speaker 3 [14:23] That specific question did get asked on CN’s earnings call today, and they didn’t really answer it.

Speaker 2 [14:29] Um, it’s—

Speaker 3 [14:30] it— but we’re, we’re talking 5, 5 shippers who see their option go from 2 to 1, and it, it’s 2 dozen perhaps who see their options go from 3 to 2, and most of those are in the St. Louis area. Um, so it’s a range of carload commodities and ag, given, you know, the location in Missouri. Um, and, and, um, CN will, uh, get at trackage rights over Union Pacific, which would have, uh, basically 2 parallel routes across Missouri. CN will use one, and they gain access to the Kansas City market for the first time, uh, on their own tracks or with their own trains, controlling their own destiny. And they get to use Union Pacific’s, uh, yard, uh, that is really not used very much today, Neff Yard in Kansas City.

Speaker 2 [15:21] So in exchange for all this, CN said, hey, this solves our competitive concerns about the merger. We get growth opportunities out of it, and as a result, we will not oppose the merger.

Speaker 1 [15:37] Well, Bill, I’m so excited to see you next week. We have the National Model Railroad Association’s convention, their annual convention will be here in Chattanooga. So for those that are interested in model railroads or in trains, it’s the perfect week to be here in Chattanooga to talk about that. And so So much is happening in the railroads. We have the right people coming to the virtual event. It’s a bang-up lineup, by the way.