Photography by Frederick Manfred Simon © www.steelwheels.photography
Inside This Issue
· Double Trouble: Revenues Dropping as Costs are Rising
· Pacific Grim: Unhappy Q3 for UP; Vena Promises Better
· Coal Hard Reality: For CSX, Coal Euphoria is Now Historia
· Third Quarter Supporter: Construction-Related Freight a Q3 Bright Spot
· Stuffed with Staff: Productivity Suffers as Volumes Drop (But Furloughs a No-No)
· Container Campaigners: Prince Rupert, Mexico’s South, Eye More Box Biz
· New Exec in Quebec: CN Names New Operating Chief
Track Talk
“Our customers are under cost pressure… And one of the ways they can save money is convert their highway business back to intermodal.”
-Darren Field, J.B. Hunt’s President of Intermodal
The Latest
· Union Pacific’s Jim Vena presented his first set of financial results since rejoining the company, this time as chief executive. Compared to last year and the year before, earnings were a disappointment. The fact is, rail freight demand has weakened this year, all while railroad industry costs have risen. Fuel costs were a special case—they dropped sharply but so, therefore, did fuel surcharge revenue. And as fuel began rising again late in the quarter, surcharges didn’t adjust quickly enough to avoid a hit to Q3 margins. As for labor, wages and benefits are up across the industry. And railroads are willing to stomach a period of overstaffing, rather than turn to their preferred reaction in the past: Furloughs. Vena didn’t sound quite so determined to avoid train and engine staff layoffs—pronouncements from NS, CN, and CSX, for example, have been firmer and more explicit. But Vena did acknowledge the need to be ready when demand revives.
· CSX joined UP in reporting Q3 results last week. Despite praiseworthy improvements in service, the Jacksonville-based railroad saw just as much of a y/y profit margin decline as UP. Read on for more detail about how UP and CSX performed last quarter, and what they expect for this quarter and beyond. This week, CN, CPKC, and NS report. We’ll also hear from Ferromex parent Grupo Mexico, as well as other industry stakeholders like the railcar lessor GATX. Executives will share more about the ongoing weakness of markets like chemicals, forestry, and intermodal; the ongoing strength of markets like autos and construction; the future promise of markets like biofuels and Mexico; and the latest on this fall’s grain crop. Coal will of course be in the conversation as well.
· Another note about this week’s earnings calls: CN will introduce its new chief network operating officer Patrick Whitehead, along with new chief field operating officer Derek Taylor. They’ll succeed Ed Harris, who’ll stay on for a while as a consultant. To paraphrase CN, the new executives will be focused on making the plan, running the plan, and selling the plan.
Updates from Mexico and Canada
· A Financial Times report profiled Mexico’s attempt to compete with the Panama Canal. In December, a new single-track rail route will connect newly renovated ports at Salina Cruz on the Pacific and Coatzacoalcos on the Atlantic. Mexico calls it the Tehuantepec Isthmus corridor, which stretches less than 200 miles between the two oceans. It’s a nearly $3b project that will include industrial parks along the overland rail route, located in Mexico’s poorer and less-developed south. Currently, most of the country’s manufacturing occurs farther north, closer to the U.S. border. Optimists highlight the Panama Canal’s increasingly frequent droughts and the proximity of Coatzacoalcos to U.S. markets. Pessimists, however, point to the complexity of taking containers off of ships at Salina Cruz, reloading them onto trains, and putting them back on ships at Coatzacoalcos. Containers, of course, never have to leave the ship when passing through Panama. So far, according to the FT, “International shipping companies, freight groups, and port terminal operators are yet to show interest in the route.”
· Prince Rupert, the Canadian National-served port on Canada’s northern Pacific coast, announced plans to expand its ability to handle rail-to-container transloading. This will give CN an opportunity to ship more cargo to Prince Rupert for export. The port cited agricultural, forestry, and plastic resin products. The same project, meanwhile, will also include the expansion of an existing rail utility corridor that will facilitate 10,000-foot unit trains (with direct access to the site from the CN network). “The project’s large scale, unit train capabilities, access to available empty containers, and proximity and integration into container terminal operations make it a unique model that promises the ability to deliver significant new service offerings to exporters that will greatly improve the quality, cost, and reliability of container supply chains.”
The Economy
· It keeps getting more and more expensive to borrow longterm. It’s getting more expensive to get a mortgage loan, an auto loan, a business loan, or a loan to finance government operations. The U.S. Treasury, for example, is now paying close to 5% for a 10-year loan. This time just three years ago, it was paying less than 1%. Nevertheless, the economy is still humming, thanks a great deal to the many American consumers who 1) have jobs, 2) have longterm mortgages locked in at low rates, 3) have homes whose price has risen sharply since the pandemic, and 3) are earning handsome interest on their savings now. They might even have some stimulus money left.
· As a result, they continue to spend. The U.S. Census showed retail spending up 1% in September (from August). And that doesn’t even count non-retail service spending on items like travel, which has been even stronger. Versus last year, retail sales are up 3.8%, in line with consumer inflation of 3.7%. One thing to keep in mind though: The retail sales report includes spending at restaurants and healthcare stores (i.e., CVS and Walgreens), two of the categories up the most y/y. But this doesn’t do much for railroads. Spending is actually down quite a bit y/y at stores catering to homebuilding and home furnishing, like the big intermodal shipper Home Depot.
· As companies across the economy present their Q3 earnings, railroads are eager for clues on how different sectors are performing. In the automotive space, for example, Steel Dynamics said it doesn’t yet see a major change in volume despite the UAW strike. That’s partly because it sells a lot of its steel to European and Asian automakers—“they are not impacted by the strike as of now… we do have some business with Stellantis and with Ford. But… on a percentage basis, it’s not going to be monumental to volume or earnings.” Auto production estimates for this year, it added, remain around 15m units, though “obviously, with the ongoing strike, the outlook for the remainder of the year is somewhat opaque.” Still, dealer inventories remain “below historical norms, which will be further reduced by the ongoing strike.” In addition, demand remains solid and, with tight supply, “the auto build rate will likely be higher than the already-anticipated 16m unit-plus for ’24.”
· Steel Dynamics also sells a lot of construction steel, and it says, “nonresidential construction remains solid.” At the same time, “the turndown in residential construction seems to be abating with the depletion of available home inventory.” All of this is sweet music to the ears of railroad execs.
· The latest Fed Beige Book, which collects economic anecdotes from across the country, included an entry that mentioned railroads. It was from Atlanta’s Fed district, which described “a pickup in domestic intermodal freight.” On the other hand, shipments of imports were “soft.” Atlanta’s section also had the following to say: “This year’s peak shipping season is expected to be muted as underlying demand remains soft and import activity subdued; container shipping companies have reduced capacity in line with expectations for weaker consumer demand. Warehousing contacts noted that the decline in freight volumes caused a pullback in industrial real estate investments. Florida ports and railroads mentioned minor temporary disruptions from Hurricane Idalia’s landfall in Florida’s Big Bend in late August.”
Q3 Earnings
Union Pacific
· When Union Pacific last reported its quarterly results in late July (for Q2), it delivered the news everyone was waiting for: Jim Vena would return to the company as its new chief executive. Vena would take the reins in mid-August. And last week, he presided over his first quarterly earnings call (for Q3). UP as usual delivered profits that most other companies in Corporate America would envy: a $1.5b net result, accompanied by a Microsoft-like 37% operating margin. Why, then, was Vena so negative? “No doubt about it,” he groaned. “It was a tough quarter.”
· The fact is, UP’s operating ratio (the inverse of its operating margin) dropped to 63.4%, which (excluding special items) was five points worse that what it managed in the same quarter a year ago. It was seven points worse than what it managed in the same quarter of 2021. Vena’s groans reflect this unfavorable trajectory.
· To be clear, this is a pattern affecting most railroads, caused by a combination of weakening demand and rising costs across the industry this year. While the U.S. economy has held up well, key segments of railroad demand haven’t. UP’s traffic declined 3% y/y, while revenues declined 10%. A big part of that revenue decline, keep in mind, was just pricing adjusting to lower fuel prices—as fuel prices fall, so does fuel surcharge revenue, roughly canceling each other out over time, but with lags that can affect individual quarters. As Q3 progressed, fuel prices reversed course and started rising again, but surcharges don’t adjust immediately. When all was said and done, fuel costs in the quarter dropped 25% y/y, but revenue from fuel surcharges plunged 45%.
· Revenue weakness, however, wasn’t just about diesel fuel prices dancing around. UP faced “soft consumer-facing markets,” leading to an 18% plunge in intermodal revenue. The coal market was even worse, with revenues down 20%. Forrest products saw a 15% drop (these declines do include the surcharge effect). All of UP’s major freight categories in fact experienced revenue declines, with the exceptions of autos and fertilizers. Back on the cost side, meanwhile, UP faces pressure from its new labor contracts and other areas of non-fuel inflation.
· This toxic combination of rising costs and weakening demand, UP warned, makes hitting its full-year goals for 2023 increasingly difficult. Management expects annual traffic volume growth to fall short of the U.S. economy’s industrial production growth. It is still confident that it can raise core pricing ahead of inflation but not enough to prevent an increase in operating ratio. It’s not a happy story: “The economic forecast for industrial production looks to stay depressed in the fourth quarter.”
· More specifically on demand last quarter, grain exports declined on tight supply. Coal fell victim to lower natural gas prices. Lumber and corrugated box demand stayed weak. The intermodal market faced tough competition from trucks, fewer imports into west coast ports, and “softness” in the parcel segment. Executives also mentioned a reduction in import beer carloads due to the increased utilization of larger railcars (which is a good thing from an efficiency and productivity perspective). Weather also impacted volumes, notably in August when the southwestern portion of UP’s network saw widespread flash flooding and washouts.
· There were definitely some bright spots too. UP’s rock network is booming thanks to all the construction activity across its network, including the many liquified natural gas plants getting built along the Texas Gulf coast. Petroleum volumes are growing too. Auto shipments benefitted as dealers replenished their inventory and manufacturers increased output (the UAW strike didn’t begin until late in the quarter, without much immediate effect on railroads). Importantly, a more fluid and reliable service offering is enabling UP to handle more volume as it comes. No longer is there a situation where it’s leaving money on the table because it couldn’t handle what’s available—quite the contrary now.
· Encouragingly, UP is finally seeing an uptick in intermodal demand this quarter, thanks to a “seasonal bump.” Looking ahead, imports at west coast ports should see some revival now that labor issues there are resolved. Domestically, UP remains confident of winning more intermodal business from trucks, including shipments into Mexico with the help of new joint offerings with Canadian National and Norfolk Southern.
· A key thing to watch this quarter is the grain harvest. So far, soybean exports have disappointed. But the ag space should see future growth thanks to opportunities to move feedstock for renewable biofuel. UP has new biofuel business coming online in Iowa, Louisiana, and Nevada.
· More specifically on the topic of labor inflation, UP implemented several new side agreements with unions, one for example with its BLET engineers that offers more sick pay and new work-rest arrangements. Overall worker productivity is currently declining, partly because there’s less volume for employees to move. Vena did not mention anything about furloughs, insisting UP “will always keep a buffer of resources” to manage fluctuations in demand and weather disruptions. Productivity is rising in at least one respect though: Since January, “We have increased train length across our system by over 500 feet or 6%.” It also sees “more opportunities to improve the efficiency of our locomotive fleet.” UP has by the way furloughed about 150 workers but none of them train and engine staff.
· UP’s ultimate goal: Deliver “value with speed.” But currently, as Vena acknowledges, cost inflation and demand weakness are “real hurdles that will require price generation and productivity to overcome.” On service reliability, he insists, ‘We’re still nowhere near what I believe we can deliver. There’s still plenty of room to improve.” The railroad wants more volume. No doubt about that. But Vena makes clear, “I don’t chase price,” saying he’d gladly walk away from business that doesn’t add to the bottom line. Finally, one of his top goals is to make UP faster at making decisions. He recited the story of one soda ash customer who wanted to invest a lot of money on its network. But it took UP more than a year to provide a response. Not good.
CSX
· Since taking office last fall, CSX CEO Joe Hinrichs has won largely positive reviews
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