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The Railroad Industry is engaged in hauling freight. Rail operators enable the efficient flow of goods from producers to consumers, and are therefore a vital part of the broad economy. With roots dating back to the 1800s, moving freight by rail is an old-line business that remains capital-intensive and cyclical.

Within North America, the industry is dominated by a handful of large operators, while countless short-line railroads provide regional and local service. Very few of the publicly held railroads are involved in ferrying passengers. However, they do generate certain noncore revenue and income streams, be it from haulage agreements (track usage fees) or railcar switching for industrial customers.

Underpinned by the economic expansion that peaked in late 2007, the railroads produced enviable profit growth and above-average investment returns. Consistent gains led many to posit that the industry had entered a period of sustainable growth. However, the most recent recession had a sizable impact on freight demand (and on industry profits and share-price performance), which largely put to rest the new "less-cyclical rail" paradigm. With that in mind, patient investors, willing to maintain positions throughout the economic cycle, may continue to enjoy positive returns within the sector, especially as these companies focus on improving normalized earnings and the efficiency of operations. At the same time, novice and sophisticated investors alike are urged to survey the greater economic climate before committing funds.

Industry Dynamics

The railroads are part of a broader freight-hauling industry that includes truckers, barge operators, and air transporters. The rails haul an estimated 15% of tonnage in America, a fraction of the 70% or so moved by truckers.

Competition varies widely, depending on the route and freight category in question. Fixed networks limit direct competition between railroads, while speed and flexibility often give truckers an advantage on short routes. Rails have the upper hand on long hauls, and can carry bulk freight, such as coal. Indeed, an estimated 65% of U.S. coal shipments are delivered to final domestic destinations by rail.

On contested routes, railroads are well positioned to take business from truckers. The rails consume less fuel than trucks (to move equivalent freight loads), while emitting fewer carbon emissions. Amid a growing push to adopt "green" practices, shippers may well elect to move more of their wares by rail over time. In a high-fuel-price environment, moving freight by rail also makes better sense cost wise.

What To Watch For

Investors should keep a close eye on revenue trends. Top-line growth is a fairly reliable indicator of underlying freight demand and of the railroad's ability to increase rates. However, customer surcharges tied to diesel-fuel prices tend to muddy comparisons, especially in a period of volatile energy prices. Some railroads still release monthly freight volume data, thereby giving investors a good indication of quarterly progress. What's more, the leading railroads submit weekly results to trade groups (such as the American Association of Railroads), and composite data is released on a regular basis.

Well-managed operators often command a premium valuation. With that in mind, investors should also be watchful for management's ability to both minimize margin contraction during down-cycles and achieve above-average improvements during flush times. The railroads are increasingly focused on wringing costs from operations and doing things more efficiently, so that a greater proportion of revenue flow to the bottom line. To that end, railroad operators are running longer trains, made possible by the use of powerful locomotives and remote-controlled distributive power units. Longer trains mean fewer route runs and crew starts. The railroads are also investing in their networks, so that tracks and crossings can accommodate heavier and taller trains.

Access to cheap capital and cash flow is also important. Indeed, during any given year, railroads typically plow 13%-15% of their revenues into rail-network maintenance and improvements, as well as new more-powerful locomotives. (Comparatively, capital spending by leading nonrailroad industrial and energy companies usually doesn't exceed 5% on an annual basis).

Regulatory Considerations

There are some significant regulatory issues to consider here.  The industry was effectively deregulated in 1980, when the Staggers Act was signed into law. Staggers gives the railroads freedom to set rates on routes with competitive alternatives. However, because of the industry’s close relationship with the economy and, in many cases, material pricing power, regulation issues should be a material consideration for investors.

Conclusion

There is an inextricable link between the railroad sector and the broad economy. Indeed, if the economy catches a cold, the rails sneeze, so to speak. Still, there are many other aspects to consider before investing in the group. The possibility of a return of regulation remains a significant risk. On the plus side, fuel efficiency and a relatively low carbon profile may give the railroads a leg up on the competition.