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The rail industry has faced its share of volatility recently, but are there opportunities emerging for investors? Juliana Faircloth, Industrials Analyst at TD Asset Management, speaks with Greg Bonnell about why investors may consider giving the North American rails a closer look.
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* No shortage of headlines in the rail sector recently, but is there opportunity for investors in the space longer term? Joining us now with more, Juliana Faircloth, Industrials Analyst at TD Asset Management. Juliana, great to have you back on the show.
* Thank you. Thanks for having me.
* So as we said, if you scan the media headlines, the rails are in the headlines for many, many, many reasons. What do we need to be thinking about that space as investors in the here and now and going forward?
* Sure. So I think starting with why is the rails a place that investors might gravitate towards in the first place is probably an interesting place to start. There's a lot of reasons to like the North American rails-- not necessarily always the case. If we go back kind of 50 years ago, it was a very regulated industry, very competitive. There was dozens and dozens of small rail networks operating across North America.
In 1980, the industry was deregulated, which sparked a huge consolidation wave, a lot of price competition, not necessarily a great time to be an investor in rails back then either. That started to stabilize, I would say, in the early 2000s, and the industry became quite investable through the implementation of something called precision scheduled railroading, which was pioneered by someone named Hunter Harrison. All that really means is a simplified operating model for the rails, leaving trains on a fixed schedule rather than at sort of random times at different days of the week.
That's left a pretty attractive industry, so there's high barriers to entry. There's no new cross-continent rail networks being constructed, pretty limited competition. There's now just six class one rails left today in North America. Generally, the industry grows kind of alongside economic growth with GDP, and there's potentially some longer term opportunity to regain some share that was lost to trucking over decades of consolidation period.
* In the shorter to near term, if we're talking about a very-- because I have watched the rails over the years for that very reason, really tied to the economy and how things are going. We can't decide, I guess, as investors, or even pundits can't decide, is there going to be a recession, or are we already in a recession. Will it be soft? Will it be hard? What kind of landing are we going to get? Is that's something you need to be aware of in the near term if you're thinking about the rails?
* Absolutely. So again, since it's quite an economically sensitive sector falling within industrials, volumes are very tied to GDP growth and general economic growth. So the path for the broader economy is certainly important over the near term for the rails, and so something that investors should be watching closely.
* You talked about consolidation over the years in the railway sector. Of course, we have a deal that's been around for quite some time. What's the latest on what's happening with CP?
* Absolutely. So yes, the CP acquisition of Kansas City Southern has been topical for a couple of years now. We're in the very late stages of that development. The Surface Transportation Board, which is the regulator for North American rails, is in the very final stages. We really should be expecting a decision imminently. It could be within the next couple of days.
So that is kind of the situation for Canadian Pacific, and again, that's quite a transformational deal for the industry and for Canadian Pacific specifically. It will create the only single rail network that joins Canada, the US, and Mexico. So there's all sorts of opportunities that we can think of that that would stimulate for Canadian Pacific.
* Yeah, when you take a look at the map of it, it's quite the footprint that would come on the other side of that deal. Does that leave much opportunity going forward in this space for any other mergers or consolidation? Are we sort of seeing all the marriages we're going to see for a while, do you think?
* I would say it's probably pretty unlikely to see any large-scale M&A within the rails. This will, again, bring the class one rail count down to just six rails operating in North America in a lot of instances, kind of depending on the region and the area within the network. One rail is really only competing with one other rail. So from a competitive perspective, you're probably unlikely to see anything of that size again.
* OK, apart from corporate activity, M&A activity, of course, we have seen derailments, as well, most recently one in Ohio, I believe, that caught a lot of attention because of just the massive burn that was involved. I mean, what do investors need to think about when they see headlines like that? Because those aren't positive headlines for the space.
* Definitely not. It's a very unfortunate situation. Just for a bit of context, so a Norfolk Southern train derailed early in February in Ohio, as you mentioned. It happened to be carrying hazardous chemicals that were then burned and has had a tragic impact on the environment and on the community there.
In terms of what caused that, the investigation is still underway trying to determine whether that was a mechanical error or operational. Was it human error? That is yet to be seen. For investors, I think what's important to consider is there will likely be a regulatory impact from this type of event. I believe, last night, there was a piece of legislation kind of put in front of the house related to rail safety that will call for additional safety measures, a higher degree of fines going forward for any large rail wrongdoings.
So it's definitely a cost to think about going forward for all of the rails. And then safety has always been a big priority for the rails, and it should be a priority for investors. It's something that we have engaged with management teams on in our discussions and is part of our investment process, and so that should be a consideration for all investors.
* We've covered a lot of ground, and there's even more ground to cover in terms of the headlines around the rails recently. Now, I'm thinking of the headlines we saw just in recent days about Union Pacific, an activist investor pushing for change there and, seemingly, getting some change at the very top.
* Yes, so you're right, no shortage of headlines within the rails. So on Sunday, an activist investor in Union Pacific sent out a presentation and a letter calling for a change of management. Later that day, Union Pacific sent out their own press release saying, we've been working on succession planning and hope to have a new CEO in place by the end of 2023.
A bit of background, what drove that-- Union Pacific in the context of the US publicly listed rails has a advantage network. It's a longer length of haul, which means there's less competition from trucking, and the business mix is pretty nicely diversified between intermodal, which is consumer-facing volumes, industrial volumes, and commodities-- so a nice balance there. I would say, in light of that advantaged network, the management team has not executed up to the company's full potential. So that's what kind of opens the door for these types of activist investors.
It's a great reminder that, of course, when we look at any company, understanding the management team, their track record, their skill, and level of execution is always important. The rails is a particular industry where we have seen management changeovers drive very significant improvements in operating results and very divergent stock outcomes. So very curious to see who ends up in the seat at Union Pacific.
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* Thank you. Thanks for having me.
* So as we said, if you scan the media headlines, the rails are in the headlines for many, many, many reasons. What do we need to be thinking about that space as investors in the here and now and going forward?
* Sure. So I think starting with why is the rails a place that investors might gravitate towards in the first place is probably an interesting place to start. There's a lot of reasons to like the North American rails-- not necessarily always the case. If we go back kind of 50 years ago, it was a very regulated industry, very competitive. There was dozens and dozens of small rail networks operating across North America.
In 1980, the industry was deregulated, which sparked a huge consolidation wave, a lot of price competition, not necessarily a great time to be an investor in rails back then either. That started to stabilize, I would say, in the early 2000s, and the industry became quite investable through the implementation of something called precision scheduled railroading, which was pioneered by someone named Hunter Harrison. All that really means is a simplified operating model for the rails, leaving trains on a fixed schedule rather than at sort of random times at different days of the week.
That's left a pretty attractive industry, so there's high barriers to entry. There's no new cross-continent rail networks being constructed, pretty limited competition. There's now just six class one rails left today in North America. Generally, the industry grows kind of alongside economic growth with GDP, and there's potentially some longer term opportunity to regain some share that was lost to trucking over decades of consolidation period.
* In the shorter to near term, if we're talking about a very-- because I have watched the rails over the years for that very reason, really tied to the economy and how things are going. We can't decide, I guess, as investors, or even pundits can't decide, is there going to be a recession, or are we already in a recession. Will it be soft? Will it be hard? What kind of landing are we going to get? Is that's something you need to be aware of in the near term if you're thinking about the rails?
* Absolutely. So again, since it's quite an economically sensitive sector falling within industrials, volumes are very tied to GDP growth and general economic growth. So the path for the broader economy is certainly important over the near term for the rails, and so something that investors should be watching closely.
* You talked about consolidation over the years in the railway sector. Of course, we have a deal that's been around for quite some time. What's the latest on what's happening with CP?
* Absolutely. So yes, the CP acquisition of Kansas City Southern has been topical for a couple of years now. We're in the very late stages of that development. The Surface Transportation Board, which is the regulator for North American rails, is in the very final stages. We really should be expecting a decision imminently. It could be within the next couple of days.
So that is kind of the situation for Canadian Pacific, and again, that's quite a transformational deal for the industry and for Canadian Pacific specifically. It will create the only single rail network that joins Canada, the US, and Mexico. So there's all sorts of opportunities that we can think of that that would stimulate for Canadian Pacific.
* Yeah, when you take a look at the map of it, it's quite the footprint that would come on the other side of that deal. Does that leave much opportunity going forward in this space for any other mergers or consolidation? Are we sort of seeing all the marriages we're going to see for a while, do you think?
* I would say it's probably pretty unlikely to see any large-scale M&A within the rails. This will, again, bring the class one rail count down to just six rails operating in North America in a lot of instances, kind of depending on the region and the area within the network. One rail is really only competing with one other rail. So from a competitive perspective, you're probably unlikely to see anything of that size again.
* OK, apart from corporate activity, M&A activity, of course, we have seen derailments, as well, most recently one in Ohio, I believe, that caught a lot of attention because of just the massive burn that was involved. I mean, what do investors need to think about when they see headlines like that? Because those aren't positive headlines for the space.
* Definitely not. It's a very unfortunate situation. Just for a bit of context, so a Norfolk Southern train derailed early in February in Ohio, as you mentioned. It happened to be carrying hazardous chemicals that were then burned and has had a tragic impact on the environment and on the community there.
In terms of what caused that, the investigation is still underway trying to determine whether that was a mechanical error or operational. Was it human error? That is yet to be seen. For investors, I think what's important to consider is there will likely be a regulatory impact from this type of event. I believe, last night, there was a piece of legislation kind of put in front of the house related to rail safety that will call for additional safety measures, a higher degree of fines going forward for any large rail wrongdoings.
So it's definitely a cost to think about going forward for all of the rails. And then safety has always been a big priority for the rails, and it should be a priority for investors. It's something that we have engaged with management teams on in our discussions and is part of our investment process, and so that should be a consideration for all investors.
* We've covered a lot of ground, and there's even more ground to cover in terms of the headlines around the rails recently. Now, I'm thinking of the headlines we saw just in recent days about Union Pacific, an activist investor pushing for change there and, seemingly, getting some change at the very top.
* Yes, so you're right, no shortage of headlines within the rails. So on Sunday, an activist investor in Union Pacific sent out a presentation and a letter calling for a change of management. Later that day, Union Pacific sent out their own press release saying, we've been working on succession planning and hope to have a new CEO in place by the end of 2023.
A bit of background, what drove that-- Union Pacific in the context of the US publicly listed rails has a advantage network. It's a longer length of haul, which means there's less competition from trucking, and the business mix is pretty nicely diversified between intermodal, which is consumer-facing volumes, industrial volumes, and commodities-- so a nice balance there. I would say, in light of that advantaged network, the management team has not executed up to the company's full potential. So that's what kind of opens the door for these types of activist investors.
It's a great reminder that, of course, when we look at any company, understanding the management team, their track record, their skill, and level of execution is always important. The rails is a particular industry where we have seen management changeovers drive very significant improvements in operating results and very divergent stock outcomes. So very curious to see who ends up in the seat at Union Pacific.
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