Rail Industry Trends 2019

Over a day and a half in the middle of January, I attended the winter meeting of the Midwest Association of Rail Shippers. About 700 industry executives representing rail shippers, carriers, service providers, equipment providers, investors, and bankers jammed into the Westin Lombard ballroom for various presentations and continuous networking. MARS has now become the largest and arguably most important rail conference in the U.S.

Attendance Remains Strong

As has been the case now for at least the last five years, the venue barely contains the crowd, with standing-room-only overflows along the back of the room. The MARS board deserves credit for keeping the conference topical and also attracting a quality group of speakers.

The high-level speakers, plus the networking opportunities and the logical location of Chicago as the capital of the railcar industry, have kept attendance high. But it should be noted that attendance at conferences such as MARS is also boosted by the presence of the investment community.

Even through the normal business cycles, the rail industry continues to attract outside capital. Hedge funds, private equity, institutional investors, and family offices are looking for opportunities in the space, and the adage of “more capital than quality deals” certainly applies. One recent short line transaction was rumored to have gone for a 14-15x multiple, despite the rail industry’s mature status and growth tendency to follow GDP. More on that below.

Speaker Highlights

I’ll recap a few highlights from some of the speakers I found most interesting, and then provide analysis of the so what implications for the rail industry.

MATT ROSE, EXECUTIVE CHAIRMAN, BNSF

Matt Rose, executive chairman at BNSF, is always a good draw due to his thoughtful analysis of the big picture of railroading in North America. One of his most interesting insights touched on the expectation that autonomous trucks (AT) may at some point take significant market share from intermodal, now the fastest growing market for US railroads.

Rose suggested that trucking, in general, may get more competitive with rail due to tightening fuel efficiency comparisons between the two modes, and the possibility of a breakthrough in electric battery storage and performance.

Meanwhile, Rose called a “virtuous cycle” the $25B of private reinvestment undertaken by railroads each year, and noted that by contrast there is the nearly complete failure of public investment in highways and waterways.

WILLIAM STRAUSS, SENIOR ECONOMIST, FEDERAL RESERVE BANK OF CHICAGO

I have long thought that a best practice for any industry conference is to bring in an economist who can speak to the broader economic trends and help tie them out to what is going on in industry. This is sometimes a gamble because not all economists are well suited for compelling and thought-provoking public speaking. The Chicago Fed’s Strauss was no gamble, as his presentation was cogent and insightful and his style was highly engaging. Here are a few of his key points:

• Despite the heart-pounding ups and downs of the stock market, political dysfunction in Washington, and saber-rattling on trade, the Chicago Fed does not predict a recession through 2021
• At the same time, the 2018 “sugar high” growth surge resulting from the December 2017 tax cut is not sustainable, and we are in line for a return for the tepid growth of ~2% that has persisted over the last 10 years since the Great Recession. Strauss noted that the mild growth over the last ten years is the slowest growth of a recovery since the Great Depression.
• Part of the reason that higher growth cannot be sustained is that it depends on both population and productivity growth. The combination of America’s low birth rate and a now slowing rate of immigration has created population growth of only about 1%. So, to get GDP growth above 2% means we would have to double the current productivity growth of 1% – a tall order.

JEFF LYTLE, PRESIDENT, CIT RAIL

Representing the railcar and locomotive leasing industry was Jeff Lytle, the widely respected industry veteran who last year rose to become the head of CIT Rail. Lytle reported that CIT is making management and IT investments in improving shop times and providing mobile repair services.

Lytle also described CIT’s activities in the star-crossed endeavor of tank car retrofits, once thought to be a booming opportunity (and underpinning the strategic plans of several repair companies) but which may now be topping out at around 10,000 cars per year.

In CIT’s case, Lytle reported that they spent $175MM to retrofit 3,000 legacy tank cars (which I interpreted to mean DOT-111), with plans to retrofit another 2,000 CPC-1232 cars. He acknowledged that there was some risk in the event that retrofitted cars become disadvantaged, but that CIT was finding markets for retrofitted cars beyond ethanol and crude that include refined products and specialty chemicals.

Lytle said that CIT would continue to listen to customers as a way to guide decision-making on equipment offerings.

Connecting the Dots

At PLG Consulting, we continue to help shippers, carriers, service providers, asset owners, and private equity investors mitigate risk, reduce costs, penetrate markets, and invest wisely by linking economic and industry trends to actionable opportunities.

Several big picture observations come to mind when considering the crosscurrent of ideas shared at MARS last week:

The specter of autonomous trucks (AT) vs. intermodal

I believe the issues of AT and our chronically underfunded highway infrastructure problems are interconnected. Although some are projecting as much as a 20% volume loss for intermodal due to autonomous trucks, what the AT crowd fails to address is how our underfunded and under-maintained highway infrastructure could practically absorb tens of thousands of containers per day that ride the US intermodal network on trips of 500+ miles.

Near-term rail industry growth prospects

The rail industry is primarily tied to the industrial economy, for which industrial production is probably a better metric than GDP. After all, coming out of the Great Recession it was the industrial economy that recovered first and more quickly.  And rail volumes reflected that. The boost in 2018 industrial production can be attributed in large part to the 2017 tax cut, but some forecasters are now projecting a flat-lining of industrial production for the next several quarters.

There is no reason to panic about a near-term recession, but the overall slowing of growth means that rail carriers and rail terminal, transload, technology, equipment, and other providers will need to distinguish themselves with strong service and other added value.

Lytle’s comments around maintenance align with those of other railcar providers. They view maintenance as a core service element in the leasing business, particularly with tank cars. This requires continued investment even in the face of overall tepid lease rates in the non-tank car types.

Where opportunities lie  

I am proud to say that several speakers noted some rail market trends that PLG Consulting was forecasting as far back as early 2017:

• Growth in Canadian crude by rail
• The opportunity for refined products to Mexico
• The decline in frac sand volumes (which is now almost entirely responsible for the recent uptick in cars-in-storage).

Going forward, we view intermodal, chemicals, and refined products as areas for higher than average rail industry growth potential:

• Intermodal continues to be supported by the confluence of macro trends, primarily online retail growth and the truck driver capacity shortage
• As we have long reported, chemicals is just starting to benefit from the multi-year, $140B of domestic plant capacity expansions.
• Finally, until recently, refined products has been similar to the frac sand story circa 2011 – a previously sleepy rail commodity that came alive following the refinement and massive expansion of hydraulic fracturing.

In the case of refined products, the stars have aligned for rail transport and transloading due to three key structural elements coming together:

1. Two of the most cost-efficient and productive regions (Permian and Eagle Ford basins) for oil and NGLs in the world, in close proximity and connected via pipeline to
2. the world’s largest and most technologically advanced refining capacity in the world (US Gulf Coast), which in turn is in relatively close proximity and well connected via rail to
3. the Mexican energy market, which combines growing inland demand for fuels, declining domestic refining capability, and a national pipeline network that is over capacity, under-maintained, and subject to billions of dollars of product theft each year, often with tragic consequences.

As has been the case for the past several years, I will be presenting a detailed analysis of these market trends and opportunities in early March at Tony Kruglinski’s Rail Equipment Finance Conference, the pre-eminent conference for the North American railcar and locomotive equipment industry. I look forward to seeing friends and colleagues there and welcome your thoughts, feedback, and inquiries.

PLG will also be presenting at several other upcoming high caliber industry events within our various industry verticals.