Rail Renaissance: Returns, Capital & Capacity

AB HATCH abh18@mindspring.com

155 W68th St Suite 1117 NYC 10023

www.abhatchconsulting.com

July 13, 2010

2010 Midwest Regional & Short Line Railroad Summer Conference

Economic malaise Rising capital

requirements Regulation Maritime trade flows

Rail Assessment

Opportunities Threats

Strengths

Pricing Volume Growth Service levels /

productivity Modal shift Consolidation?

Strong secular growth Favorable market

structure Supply constraints Solid barriers to entry Limited alternatives

Challenges Capital intensity Capacity bottlenecks Port congestion Reliability vs. trucks

Railroad PerformanceClass I Railroads

0

50

100

150

200

250

300

64 68 72 76 80 84 88 92 96 00 04 08

Index 1981 = 100

Source: Railroad Facts, AAR (Based on a design by R. Gallamore)

Productivity

Volume

Revenue

Price

Street influence on RRs – and Why that affects ALL stakeholders

Battle for cash

Management’s reactions to pressures

Investors, competitors, regulators, politicians, labor – oh,

yes, and customers

Rare Industry: Short term decisions (current economic

outlook)/long term consequences (40+ year life of a

locomotive)

Remember 2004! (?) – rails unprepared for volume;

embargoes

Which “bucket” (Capex, share repo, DPS) will they place

their chips?

Simple Math

RatesReturnsCapital ExpendituresCapacityService

ARE ALL CONNECTED!

Virtuous Circle (’03-07) or Disinvestment?

Rail Freight Volume

Major studies done in 2005-07 (ie; at the cyclical peak): DOT, Global Insight, Cambridge Systematics/AAR

New Studies being undertaken – due late 2010 Visibility coming off of all-time lows (“no solid feel for

H2/10”) Government role both supportive (PPPs, etc) and a

threat (re-reg, coal) Major intermediate-to-longer term variables for coal,

autos, paper, housing, retail, and trade sourcing Emissions a two-edged sword (coal flattens,

intermodal growth accelerates) GDP has the highest correlation – by far

Future Growth Potential

Oil, Carbon, Infrastructure & EfficiencyIntermodal – International and DomesticGrain – the world’s breadbasketCoal? ExportsThe Manifest/Carload “Problem”MSW (garbage), perishables, othersPoint-to-point vs. Hub & Spoke (or

Southwest vs. United)

Grain TrafficMajor U.S. and Canadian railroads

22,000

24,000

26,000

28,000

30,000

32,000

34,000

36,000

38,000

40,000

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Combined U.S. + CanadianAverage Weekly Rail Carloads of Grain

2006

2009

2008

Data are weekly average originations for each month, are not seasonally adjusted, and reflect revisions from original reporting. Source: AAR Weekly Railroad Traffic

2007

Jan. 2010

Source: AAR Railroad Time Indicators, February edition, page 12

Intermodal Growth DriversDomestic and International

Globalization

Trade

Railroad Cost

Advantages

Share Recovery

From Highway

Truckload Issues

U.S. Railroad Intermodal Traffic(millions)

0

2

4

6

8

10

12

14

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09e

U.S. Railroad TOFC/COFC Units

Source: Association of American Railroads’ Weekly Railroad Traffic Year 09e week 52 is estimated

Long-run Railroad Intermodal Revenue Growth Has Outpaced Coal (Short-run has not)

1990 1995 2000 2005.

$0

$2

$4

$6

$8

$10

$12

$14

Bil

lion

s

Source: Carload Waybill Statistics (includes non-Class I railroads)

Coal Intermodal

17%18%

19%20%

21%22%

23%24%

25%26%

98 99 00 01 02 03 04 05 06 07 08

Coal Intermodal

*Data for BNSF, CSX, KCS, NS, and UP Source: Railroad financial reports

Intermodal and Coal as a % of Revenue*

Coal and Intermodal are the Top Sources of U.S. Freight Rail Revenue

U.S. Railroad Intermodal TrafficTrailers vs. Containers (millions)

0

1

2

3

4

5

6

7

8

9

10

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09e

U.S. Railroad TOFC Units U.S. Railroad COFC Units

Source: Association of American Railroads’ Railroad Facts Year 09e week 52 is estimated

Domestic Intermodal

The real growth opportunity is the age-old goal of taking trucks off of the highway

Driving down the LOH (requires very tight service standards)

Corridor development (see NS’ “Crescent”); truck partnerships (see JBHunt)

Fuel price, carbon footprint, infrastructre shortages and congestion, driver shortages (CSA 2010)

Trailer (TOFC/”Piggyback”) the gateway drug” for containerization

Opportunities in unitized carload as well

0 10 20 30 40

2035p

2002

DOT: Future Demand for Freight Transportation Will Continue to Grow

p – U.S. DOT projection

Billions of Tons of Freight Transported in the U.S.

CS: Future Corridor Volumes Compared to Current Corridor Capacity (Cambridge/AAR)

2035 without improvements

Below capacity

Near capacity

At capacity

Above capacity

Carbon Footprint– from cocktail chatter to decision point

2003 – 221/F500 report on carbon; 409/F500 in ’09

Green supply chains enforcement by Wal-Mart (from $2B transport spend to $4B+ by ’11); GE, P&G, etc….

Anticipating future EPA regs and emissions law

S0 -What is the growth rate?

Great studies done – in 2007 Is there a “Great Re-set”? (paper, autos, retail, coal) Or do we look past 2035 and simply add a few “lost”

years? (the emerging consensus save for the coal question)

AAR new assumptions suggest coal is flat from DOT projections while the rest reaches 2025 targets despite Great Recession impact (ie; future intermodal/carload growth is higher than recent studies…)

Will the government policy help to increase modal share by 10%?

UNCERTAIN Domestic Coal

Rail Intermediate term volume prospects

ABOVE GDP

BELOW GDP Paper Auto Parts (?)

ABOVE GDP Intermodal – Domestic (+

+) Intermodal - International Agricultural products Export Coal Ethanol

GDP-GROWTH Autos Lumber Chemicals (+?) Aggregates Metals

Growth is Expensive

Huge Capex - $40B in the last 5 years in the US – through the Great Recession!

AND: Comeback of the share repo/DPS?EPS beat the Street consistently, yet:

Uneven returns in the Modern AgeRecent improving trend lineThreats to ROIC threaten capacity

Regulatory Review/Discussion

Staggers (1980) and predecessor ActsFreedom to set ratesFreedom to sell/abandon low density

track (growth of short line industry)Freedom to exit passenger businessImpetus to cut costs, divest massive

non-rail holdings & become “pure” rail plays

Source: AAR

0306090

120150180210240270300

'64 '67 '70 '73 '76 '79 '82 '85 '88 '91 '94 '97 '00 '03 '06 '09

Revenue

Volume

Productivity

Price

Staggers Act Passed Oct. 1980

The Staggers Act: An American Success Story

(Index 1981 = 100)Productivity decline due

mainly to fuel price volatility.

0%5%

10%15%20%

25%30%35%

40%45%

'80 '83 '86 '89 '92 '95 '98 '01 '04 '07

Pipeline excludes natural gas. Source: U.S. DOT

Railroads: The Leader in Freight Transportation

Railroads

Trucks

Water

Pipeline

(% of Ton-Miles)

$0

$1

$2

$3

$4

$5

$6

$7

$8

$9

'99 '00 '01 '02 '03 '04 '05 '06 '07 '08

$ b

illio

ns

Finally, Railroads Making Decent Money...

Net Income

Source: AAR

Railroad Return on EquityClass I Railroads

0%

2%

4%

6%

8%

10%

12%

14%

91 93 95 97 99 01 03 05 07

Source: Railroad Facts, AAR

n.m.n.m. = not meaningful (negative value)

RR CoC vs. ROIC – RR Stocks have done well but… they still trade at a discount to all stocks

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

Cost of Capital Return on Investment

Source: Surface Transportation Board Note: Cost of equity estimation method changed by Board effective 2006 and 2008.

Rail Regulatory Risk?

STILLSTILL Biggest Uncertainty in 2010 Safety Bill done/UTU influence S2889 (“STB Reauthorization Act”, formerly the

“Competition” Bill AKA“M-A-D”) + Anti-Trust And yet, STB makes it 3-straight shipper “wins” Cost of Capital Revision shock (no replacement costs

mandate – a “study”) Mandated STB, CTA “Reviews” AAR/RAC/ASLRRA have great “D” but hard to score

on defense Compromise or fight? Quid pro quo in the future?

Rocky & The Dark Star – new horror movie?

Other DC Issues

S2889 not fatal, would be a long time before changes manifest themselves; compromise could lead to future monies, for example:

($500B)Transportation Bill (SAFTEA-LU 2) already behind schedule, under extension – could have increased monies for intermodal - and yet potential truck size (TSW) threats

Rail is not a particularly partisan issue (more regional)

Administration – supports a 10% modal shift toward rail

Rail Capacity and Capex

Rail Capacity is extremely fungible Heavier/faster track, double track., sidings; Larger cars (avg size: ’80 79tons; ‘90 88.2 ’08 110.5) Unitization, shuttle trains Denser systems (2001 8.9mm RTMs/mi; ’08 11.6) IT – planning, signaling, communications (PTC?) Unitization Equipment in storage (down to the dregs) T&E employees System Velocity

12

13

14

15

16

17

18

19

20

'99 '00 '01 '02 '03 '04 '05 '06 '07 '08

Mill

ion

s...And Tighter Capacity

Up 31%

Source: AAR

(Ton-Miles Per Mile of Railroad)

35,000

40,000

45,000

50,000

55,000

60,000

65,000

70,000

75,000

1987 1990 1993 1996 1999 2002 2005 2008

High Density* Rail Miles Have Increased

*Track with freight density of at least 20 million gross ton-miles. Excludes way and yard switching tracks. Source: AAR

(Miles)30

% o

f C

lass

I N

etw

ork 72%

13,00013,50014,00014,50015,00015,50016,00016,50017,00017,500

1987 1990 1993 1996 1999 2002 2005 2008

Second, Third, and Fourth Main-Line Miles Have Increased

Data are for Class I railroads. Source: AAR

(Miles)

1987 - 2008 Density of Heavy Duty Main Lines for US Class I Railroads

0.00

10.00

20.00

30.00

40.00

50.00

60.00

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

Year

Den

sit

y (

million

s o

f Ton

-Miles p

er

Mile)

Avg Density - Class A MainLinesAvg Density - Class B MainLinesAvg Density - Combined AB Main Lines &

Reflects two years following SP/UP merger. UP wasconforming SP reporting to its own standards. During this time, miles were reported but densitycould not be determined for the entire system and so remained unreported.

Average density of Class A mainlines has continued to grow even astotal mileage has increased

Class A main lines have > 20,000,000 gross tons annually; Class B main lines have >5,000,000 gross tons annually but < 20,000,000.

$0$1$2$3$4$5$6$7$8$9

$10$11

1980 1984 1988 1992 1996 2000 2004 2008

Roadway and Structures

Equipment

Railroad Capital Spending($ billions, constant 2008 dollars)

Data are for Class I railroads. Source: AAR

-$2

$0

$2

$4

$6

$8

$10

$12

'80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08

Source: Association of American Railroads

Net Income

Capital Spending

Class I Railroad Capital Spending vs. Net Income

(Current Dollars)

Rail Service Cycles

Is the recent improvement in the metrics

sustainable? Systemic?

Is it a product of huge capex injection

and IT?

Or, is it merely a product of lower

volumes/less stress on the network…

Capacity Constraints

The revival of passenger railroading (the vast majority of which is on freight network)

HSR (and HrSR)TIH/NIH issues TSA and secuirityNIMBY – see the CN and its tortured

purchase of the EJ&E; efforts on MSW

02468

101214161820

1980 1984 1988 1992 1996 2000 2004 2008

New Passenger Service Must Compete With Freight Growth

Data are for Class I railroads. Source: AAR

Millions of Revenue Ton-Miles Per Mile of Road Owned

0

50

100

150

200

250

300

350

400

1980 1984 1988 1992 1996 2000 2004 2008

RR Fuel Consumption

RR Volume

Avg. RR Price of Fuel

Double the Freight on Same Amount of Fuel!

Volume = revenue ton-miles. Source: AAR

(Index 1980=100)

$0$1$2$3$4$5$6$7$8$9

'99 '00 '01 '02 '03 '04 '05 '06 '07 '08

$ bi

llion

s

Net Income

$100,000

$125,000

$150,000

$175,000

$200,000

$225,000

$250,000

'99 '00 '01 '02 '03 '04 '05 '06 '07 '08

RRs Still Making Record Re-Investments

RR Spending Per Mile

Source: AAR

Current Issues

Rails in the RecoveryAfter the Rereg Fight what? Partnership with government?The Green mantleNew “Golden Age”?PE &Infrastructure funds – back for

good?Service

Key Class1 Issues in Recession ‘10

Re-regulation Bigger Threat than EverRates (versus Volumes)The Recovery (Pace & Durability)Service – The Key to the Future!Green Ramifications – positive/negativeStimulus, TIGER 1&2, MAP21, ATRK,

“HSR” & HrSR - (ONERail)PTC-”unfunded”- and unknown -mandate

Service will be the Key to the Next Cycle

Service at all time highs$40B spend in last 5 years (service

ought to be better!)Putting increased traffic back on at

current velocity means: Higher asset utilization, more market share gains, greater operating leverage (perfect circle affects all stakeholders)

Implications for equipment fleets

Threats to the Renaissance

Cyclical vs. secular argument New Congress –impacting labor & shippers Mandated Reviews – STB, Canada Rereg – the MAD answer Emissions impact shakeout (coal down, intermodal up,

ethanol?) Execution: service Execution: merger (unlikely) Activist hedge funds? (unlikely) Liquidity? (proven not to be a direct issue in Q408)

Warren’s $44B “all-in” bet

Advantages of going private? (capex cycle)

Influence in DC“Robber Baron” vs. “Sage”Bets not (just) on economy – rereg, coal,

western intermodalBought on the cheap!

RR/Investor Issues Summary-3Rs3Cs

Recovery?The Re-SetRe-RegulationCapital NeedsCapital CooperationCash Flow

Developing website

www.abhatchconsulting.comTopShipper SurveyRailTrends 2010 September 28-29

ABH ConsultingAnthony B. Hatch155 W. 68th StreetNew York, NY 10023(212) 595-0457ABH18@mindspring.com