By: Grant LacKamp
After decades of expansion, economic globalization is in retreat. Trade frictions arising under nationalistic-minded governments accelerated throughout COVID. More and more companies are looking to locate production as near as practicable to their final customers. America still has one of the biggest markets and economies in the world. If you want to increase exposure to the infrastructure of our economy, which industry stands to benefit?
Earlier, we wrote about nearshoring. In a partial reversal of offshoring, nearshoring moves operations to the closest country with a qualified workforce and lower cost of living, minus the time and culture differences. For many U.S. companies, this means moving production from China to Mexico. Other companies are bringing operations back home entirely. Underpinning this repatriation are the arteries crisscrossing North America for more than one hundred years; railroads.
The re-industrializing of North America will necessitate more mobilization throughout the region. Consider the following:
- Timber/Housing – We are in the middle of a significant nationwide housing shortage, evidenced by home price spikes through the pandemic. The solution is to build more homes, requiring more lumber and other base materials, nearly all of which move by rail.
- Natural Resources – Expanding green energy capacity calls for more electric cars, wind turbines, and solar panels. These applications require massive volumes of copper, nickel, and aluminum, all of which move by rail.
- Oil, Gas, Liquid Natural Gas, and Coal – Despite growth in investments and social consensus, we remain years away from having a fully sustainable grid driven solely by green energy. To bridge that gap, we need more traditional fossil fuels. Some of these liquids move by pipelines, but a sizeable and growing portion still moves by rail.
- Automobiles – Auto transportation is the most profitable business for railroads. As the auto business continues to recover its snarled supply chains, railroads carry primary distribution responsibility for getting cars closer to their final owner. We expect to see more auto components produced in Mexico, where manufacturing is robust and labor is cheaper. The most efficient way to transport items to and from Mexico is by rail.
- Intermodal – The COVID-19 pandemic sent e-commerce demand into overdrive. Underpinning growing e-commerce is an immense transportation network of railroads which is claiming a large piece of the business.
- Chemicals – Recent announcements from Intel and Taiwan Semiconductor regarding new semiconductor fabrication facilities reflect planned increases for chemicals to meet plant construction and chip production. Sponsors hope these are the first of many, and the chemicals needed for both phases travel by rail.
- Grains – Before sanctions, Russia was by far the world’s largest exporter of wheat and other agricultural products. Even after the war’s conclusion, sanctions surrounding grains will carry on for years, meaning the movement of more U.S./Canadian wheat for export to fill the gap. All of which will travel by rail.
While all these items primarily move by rail, they arrive at their ultimate destination by truck. To make this transition, railroads built massive networks of intermodal facilities where goods are unloaded by cranes and transported by truck for delivery over the ‘last mile.’ With this seamlessness, railroads became a much more integrated piece of the transportation network.
Rails have become the most efficient form of long-distance transportation over the last hundred years. They move goods in a very cost-effective and extraordinarily environmentally friendly way. According to the American Association of Railroads,
- U.S. freight railroads can, on average, move one ton of freight more than 480 miles on a gallon of fuel.
- One train can carry the freight of hundreds of trucks and are 3-4 times more fuel-efficient than trucks.
Yet, according to the US DOT, railroads move only 28% of freight in the U.S. vs. nearly 40% by truck. As Environmental, Social, and Governance (ESG) concern grow more extensive, we believe railroads will be one of the largest beneficiaries of growth that nobody is currently discussing.
Railroad’s efficiency derives from advances in service models and technology. The Precision Scheduled Railroading (PSR) service model helps optimize train movements across networks, placing focus more on moving railroad cars on a predetermined schedule instead of waiting to build long trains. For rail customers this means more consistent, predictable, and reliable service. For railroads that adopted PSR, it means fewer resources and capital required to move freight.
Smart sensors along tracks alert railroads to the location of units needing repair. Minimizing costs led to a 44% reduction in average rail rates and raised productivity. Railroads now move almost twice the amount of freight for nearly the same price paid in 1980. In 2009 as the world was crumbling under the weight of the financial crisis, Warren Buffett drew a similar conclusion when Berkshire Hathaway made what was at the time the largest acquisition in its history: the $34 billion purchase of Burlington Northern Santa Fe Railroad (BNSF).
Six Class I railroad businesses operate in North America: Union Pacific, CSX, Norfolk Southern, BNSF, Canadian Pacific, and Canadian National. Ten years ago, the group reported EBITDA Margins (a measure of cash flow as a percentage of total revenue) of 38.5%. Today, that measure stands at 53.4%, reflecting efficiency gains that provide significant cash flow for distribution to shareholders through dividends and share buybacks. The railroads’ average shareholder yield (a measure of dividends + share buybacks) stands between 4-6%. This yield should continue to climb as growth in cash flow allows for more flexibility to return cash to shareholders.
Finally, consider the fact that rails carry an incredibly comprehensive competitive business advantage. The oligopolistic nature of the industry and the massive amount of capital required to build out a Class I network make it virtually impossible to build another railroad. Ever. We believe railroads are immensely underappreciated as a business model while meeting the changing distribution demands following the retreat of globalization.
Imagine buying a software company with few competitors growing revenues at 5%+ annually with 40%+ operating margins. What earnings multiple would you pay? Railroads offer similar characteristics and sell for valuations much less than those of software or technology companies, any of which can be replaced by the next new idea.
Railroads have downsides, foremost their heavy exposure to the economy and GDP growth. They are a bet on America. Should we enter a recession, railroads will suffer. During the Great Financial Crisis, railroads saw a 50% drawdown in share price, exceeding that of the S&P 500.
In addition, since 2008, railroads have done more long-term pricing, angling to lock in customers for many years instead of historical short-term deals. Those contracts may come under pressure in an environment of heavy inflation as wage, fuel, and capital expenditures costs rise quicker than the renewing contract.
We’re betting on America.
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