Little Class 1 Traffic Growth in 2nd Quarter

The second quarter was a rough one for North America’s Class 1 railroads.

Trains magazine reported on its website that only Canadian National gained traffic during the quarter, seeing a gain of 0.4 percent compared with the same period of 2022.

U.S. carload volume is down 8.5 percent for the first half of 2022 compared with 2019, according to figures compiled by the Association of American Railroads.

During the first quarter CSX and Canadian Pacific were the only Class 1 carriers to see growth in intermodal traffic.

For more information, read the article at https://www.trains.com/trn/news-reviews/news-wire/cn-posts-slight-quarterly-traffic-gain-while-other-big-systems-see-volume-declines/

Industry Observers Adjusting Rail Outlooks

North American Class 1 railroads will be issuing their second quarter financial reports later this month and ahead of that Wall Street analysts are issuing their expectations about what the carriers will report.

Cowen and Company, whose insights appear often in the trade publication Railway Age, said it has adjusted its rail models to reflect a number of factors that influence railroad performance in the second quarter, including carloads, fuel, foreign exchange, and cost implications as the supply chain remains tight.

It expects carloads trends to exceed previous expectations, noting total carloads are up approximately 23 percent.

Because the second quarter of 2020 was the height of the COVID-19 pandemic, Cowan has been comparing this year’s performances against 2019 to get a more accurate reading on 2021.

In that comparison, carload traffic last week was down 2 percent compared with 2019, the second consecutive week that 2021 has underperformed 2019.

“Unlike the first quarter, there were no material weather impacts for the railroads that affected volumes,” Cowan wrote.

Cowan expect supply chain tightness to persist for the remainder of 2021 and it also expects intermodal to continue to be robust as well.

The report said big box retailers have yet to see a slowing of orders. Thus far this year, intermodal traffic is up 18 percent.

The elevated demand has enabled railroads to choose their business, but increased intermodal traffic volume also has meant a decline in rail service.

This has included embargoes at terminals that are unable to take in more cargo.

Costs associated with these developments are expected to increase costs.

Diesel fuel prices are rising, although these tend to have a two-month lag in how they affect railroads because the carriers contract for fuel in advance to lock in prices.

CP Won’t Get in Bidding War for KCS

Canadian Pacific CEO Keith Creel said this week that his company won’t engage in a bidding way to acquire Kansas City Southern.

Speaking to the North East Association of Rail Shippers, Creel said Canadian National has more resourcess to finance a more expensive deal.

He was referring to a bid of $33.7 billion that CN has made to buy KCS whereas CP has offered $29 billion

If CP loses out on acquiring KCS, Creel said that would leave CP as the smallest Class I railroad and force it to eventually would have to find a merger partner.

“We don’t want a bidding war and it’s not something we’ll participate in. And ultimately, it’s a war that we would not win,” Creel said.

Ciurrently, KCS is North America’s smallest Class 1 system.

Creel did not rule out cooperating with CN and KCS.

“Listen, anything’s possible. We’re reasonable people at Canadian Pacific,” Creel said. “Should that happen, we’ll do our best to represent our customers’ interest. Is it possible in some instances? Yes. Is it probable? I would suggest probably not.”

In the meantime, Creel said shippers should tell the U.S. Surface Transportation Board their concerns about how a CN-KCS combination would “snuff out” rail competition at a “multitude” of locations and eliminate CP’s friendly connection to KCS in Kansas City.

CN contends its acquisition of KCS will boost rail competition and it plans to keep all KCS gateways open.

CP has told federal regulators there are more than 340 shipper facilities on a combined CN-KCS system that are currently served by both railroads.

Many of these are concentrated in a 65-mile stretch in Louisiana between Baton Rouge and New Orleans.

CN has suggested it will address this issue and that might include selling the KCS line in the region to another railroad.

“When you’re already talking about divestiture from the very beginning to provide a remedy to enable a deal, I would suggest it’s a bit deeper. I would suggest that the customers care,” Creel said.

The KCS board of directors has already accepted CP’s offer and it now considering the CN offer.

If KCS changes its mind and accepts the CN offer, CP will have five days to respond. Creel said CP would likely give up trying to acquire KCS and keep a $700 million breakup fee from KCS.

By comparison, KCS’s total revenue for the first quarter was $706 million.

In the short term, Creel expects CN to be hindered by the “exorbitant” price it will pay for KCS, suggesting it could increase CN’s operating ratio as high as 75 percent.

“And then you get to a point where I can compete in markets, and share that cost advantage with my customers so that they can continue to grow whereas CN cannot,” Creel said.

However, Creek said CP and its customers will eventually be at a disadvantage from CN’s far larger system, forcing it to seek a merger partner.

KCS to Talk With CN About Purchase Offer

Management of Kansas City Southern will discuss with its counterparts at Canadian National their counter proposal to buy North America’s smallest Class 1 network.

CN has proposed buying KCS for $33.7 billion. That offer came not long after the KCS board of directors approved an offer from Canadian Pacific to buy KCS for $29 billion.

In the meantime, CN and CP have engaged in dueling statements as to whose offer would be best for KCS and its customers as well serve the public interest.

The KCS board said in a news release that it had determined the CN bid could reasonably be expected to lead to a “company superior proposal,” as defined in its merger agreement with Canadian Pacific.

In response CP issued a statement saying it is confident that talks between KCS and CN will expose the flaws of the CN offer.

A Bloomberg News report cited unidentified sources within KCS as saying the company sees greater antitrust risks in the CN offer although it doesn’t consider them to be insurmountable.

In its statement, the KCS board said it remains remains bound by the terms of its agreement with CP and has not made a determination that the CN offer is superior.

The statement also said there is no assurance that the talks with CN will lead to an agreement.

CSX OK With STB Reviewing CP-KCS Merger Under Old Rules

CSX is the lone Class 1 North American railroad system not to object to the efforts of Canadian Pacific and Kansas City Southern to get the U.S. Surface Transportation Board to impose 1990s era rules in reviewing their proposed merger.

CP wants to buy KCS in a $29 billion transaction. Two decades ago the STB granted KCS a waiver from new merger review rules that became effective in June 2001 if it sought to combine with another Class 1 system.

Norfolk Southern, BNSF, Union Pacific and Canadian National did object and asked regulators to consider the merger under the 2001 rules.

CN has since proposed to buy KCS in a $33.7 billion cash and stock transaction.

In a letter to the STB, CSX said it intends to comment on the merits of the transaction at a later date.

In the meantime, it supported the STB applying the waiver to the CP-KCS merger.

“Successful consolidation proponents have traditionally met the public interest standard in the statute by demonstrating that the efficiencies expected to result from their transaction, with reasonable mitigation of potential reductions in competition, would result in more competitive and efficient rail transportation,” CSX said in its letter.

“The applicants should have to do that here. To achieve that goal, however, there is no need to subject the transaction to the uncertainties associated with the 2001 rules.”

Railroad economist Jim Blaze said NS may be seeking greater scrutiny of the merger because it serves Kansas City whereas CSX does not.

“Kansas City Southern and Canadian Pacific are so small in network now that we’re not talking about globs of traffic that is going to get shifted and diverted,” Blaze said. “We’re talking about minor flows over certain selective lanes.”

Agreeing with that assessment was Nick Little, the managing director of the Railway Management Program at Michigan State University.

“If there was going to be a merger that had a minimal impact, this would be the one,” Little said. “The two routes that Canadian Pacific and Kansas City Southern have, they really don’t duplicate each other. They interchange at one point in Kansas City. It gives Canadian Pacific the same sort of advantage as Canadian National has in that they have access to both coasts and with the Gulf of Mexico. That means they have a really good opportunity to have one company to consignments in a given area.”

CN, CP Jockey to Gain Advantage in Buying KCS

Canadian National and Canadian Pacific submitted dueling filings to the U.S. Surface Transportation Board on Wednesday as they jockey for advantage in their respective efforts to by Kansas City Southern.

The KCS board of directors has already agreed to a $29 billion bid from CP, but CN this week countered with a $33.7 billion offer in a cash and stock transaction.

CN notified the STB of its bid for KCS while CP asked regulators to expedite their review and approval of its purchase of the smallest Class 1 rail system in North America.

In its filing, CN said it plans to file an application seeking authority to combine with KCS.

The filing indicate that CN would seek to have the merger reviewed under the STB’s current merger rules whereas CP is seeking to have its acquisition of KCS reviewed under an exemption regulators granted KCS more than 20 years ago were it to seek a merger with another Class 1 system.

The CN filing cited “seamless service and enhanced competition” from its acquisition of KCS.

It further asserted that its proposed acquisition of KCS would be in the public interest and CN would welcome the opportunity to provide a full forum for stakeholders to comment on the proposed transaction.

CN said it is confident it will be able to effectively address any reasonable remediation concerns and ensure rail customers and other stakeholders benefit from the proposed combination with KCS.

If CN and KCS were to merger, it would create the fifth largest Class 1 North American system. Currently there are seven such systems.

“Our proposal to KCS is simple,” said CN President and CEO Jean-Jacques Ruest. “We are providing greater and more certain value, and a clear path to closing. We have a better bid. We are a better railroad. We will be a better partner for KCS and the communities it serves. And we believe the STB and our customers will recognize that CN presents the best solution for the continued growth, development and prosperity of the North American economy.”

For its part, CP claimed that CN’s acquisition of KCS would reduce competition.

It called CN’s stated benefit to acquiring KCS “illusory and inferior to the proposed CP/KCS transaction.”

CP said the STB should promptly confirm uniquely what it termed straightforward and beneficial transaction proceeding under the pre-2001 rules with no further voting trust approval required.

In a letter to regulators, CP said it “respectfully suggests that the Board should see things the same way: the only combination involving KCS that is in the public interest is the one that Canadian Pacific has proposed, and which has already garnered support from more than 400 shippers and other stakeholders.”

A CN-KCS merger, CP asserted, would “destabilize” the North American rail network balance “that has prevented further consolidation of the six largest railroads for two decades.”

If CP were to lose its friendly connection at Kansas City with KCS, it would weaken if not destroy the viability of CP’s lines through southeastern Iowa and northern Missouri and leave CP an asymmetrically disadvantaged “odd-man-out” in a six-railroad North America.

That would put pressure on CP to find a way to expand its market reach through further consolidation.

CN has argued that its combination with KCS would offer shorter, faster, and more efficient routes than tying together the CP and KCS networks.

The war of words in the dueling filing with the STB is likely to result in CP having to pony up more money for KCS, some industry analysts believe.

“We can’t rule out a full-scale bidding war,” Wolfe Research analyst Scott Group wrote in a note to clients.

Another analyst, Anthony Hatch, told Trains magazine, CP has room to increase its bid although CN is seen as the wealthier Canadian Class 1 system.

The last time Class 1 railroads got into a bidding war was in 1996 when CSX and Norfolk Southern fought over Conrail.

That battle ended with NS and CSX dividing Conrail and the railroads paying 27 percent more to buy their respective shares.

Although industry observers predict the STB would likely approve acquisition of KCS by either CN or CP, some believe a CN-KCS combination would create more regulatory challenges  because the two systems have more overlap than CP and KCS.

 “While financially superior and strategically compelling, CN’s proposal may entail a more complicated regulatory review given the larger pro forma rail network,” Baird Equity Research analyst Garrett Holland wrote in a note to clients.

Holland believes CP will submit a higher bid for CP and rely heavily on the argument that it provides better strategic value and a potentially more feasible regulatory review process.

Credit Suisse analyst Allison Landry said, though, that the ovetlap between CN and KCS is relatively small and largely confined to a handful of shippers in Louisiana.

At the same time Landry said in a note to clients that a CN-KCS deal that create a railroad larger than CSX or NS would make those carriers merger targets.

Class 1 Systems Saw Traffic Gains in 1st Quarter

Impressive gains in intermodal traffic helped North America’s Class 1 railroads systems post volume gains during the first quarter of 2021.

Industry observers say a surge in retailers seeking to restock shelves has boosted interemodal volume.

That was welcome news for railroads because the first quarter saw them see suffer slight declines in carload volume.

Among the seven Class 1 systems, Canadian National came out on top with an 8.2 percent increase in overall volume compared with the same period in 2020.

However a mitigating factor in CN’s case is that it looks good compared with last year because this year it didn’t have to deal with illegal blockades of its tracks that lasted for weeks.

Norfolk Southern posted a 5 percent volume gain fueled largely by 8 percent intermodal growth and a nearly 5 percent rise in coal traffic.

At CSX traffic was up nearly 3 percent, led by a 12.3 percent boost in intermodal business.

CSX and NS alike enjoyed increased traffic from East Coast ports as well as parcel traffic related to e-commerce.

Traffic gains for other Class 1 railroads included BNSF, 7.3 percent and Union Pacific, 1 percent. Canadian Pacific’s first quarter traffic traffic was flat compared with last year’s first quarter, when it had a 10 percent gain partly due to picking up some traffic that could not move on CN during the blockades.

 “When much of the economy shut down around this time last year, rail volumes plummeted too. We have to take that into account when comparing rail traffic this year to last year,” said Association of American Railroads Senior Vice President John T. Gray.

“That said, rail traffic has clearly rebounded from last year’s depths. Looking ahead, rail volumes are highly correlated with manufacturing output, so recent signs of strength in manufacturing are good signs for railroads too.”

Class 1s Say Review CP-KCS Merger Under New Rules

Four Class 1 railroads have asked the U.S. Surface Transportation Board to evaluate the proposed acquisition of Kansas City Southern by Canadian Pacific under more stringent rules.

BNSF, Canadian National, Union Pacific and Norfolk Southern have urged the STB to use its 2001 merger review rules in the case.

KCS had earlier received a waiver from the current merger review rules. KCS nd CP have sought to have the transaction reviewed under the pre-2001 standards.

That idea received support from CSX, the only Class I railroad to support the KCS waiver.

In their filings with federal regulators, the other Class 1 systems said CP and KCS should be required to submit service assurance plans, demonstrate that the deal would provide public benefits and enhance competition, and explain how existing gateways would be preserved.

In their filings, the Class 1 systems said the KCS of 2021 is a vastly different railroad than the KCS of 2001, with significantly more revenue, traffic, and mileage due to its having gained a full interest in the Texas Mexican Railway and KCS de Mexico.

“Any justification for the potential KCS exception has evaporated,” CN wrote in its filing. “KCS’s expansion of its Mexican operations post-2000 make it a transnational carrier and a very different railroad from the one it was in 2000. Indeed, KCS’s revenues now exceed the $1 billion threshold that it claimed in 2000 would be an appropriate trigger for full review under the new rules.”

UP said the STB never should have adopted a waiver for KCS while BNSF said all Class I railroad mergers should be judged by the same standards.

NS said in its filing that the old rules are out of step with the industry today.

“The prior rules are antiquated, adopted over 40 years ago. The railroad industry has transformed itself since then, and the STB modernized its major merger guidelines in sync with those changes,” NS said.

No Class 1 merger has been reviewed under the current STB merger rules.

STB Chairman Pledges Expeditious Review of Class I Acqusitions

U.S. Surface Transportation Board Chairman Martin Oberman said on Wednesday that his agency will move expeditiously on two mergers involving North American Class 1 Railroads.

The STB will publish today in the Federal Register a notice announcing whether it will review the CSX acquisition of Pan American Railways as a “minor” or “significant” transaction.

CSX has asked the STB to review the deal as “minor,” which would mean it would receive less scrutiny from regulators.

Opponents want the acquisition to be deemed “significant” and thus give more exacting review.

In a statement, Oberman said the STB has exclusive authority to determine the scope of review of matters that come before it.

There is little doubt, though, that the STB considers the acquisition of Kansas City Southern by Canadian Pacific to be a “major” transaction.

Oberman said the CP-KCS deal will be the first “major” transaction to seek board approval in more than two decades.

“The agency intends to scrutinize the transactions carefully and diligently, in keeping with the applicable statutory and regulatory frameworks,” he said.

“Additionally, the agency is committed to moving forward expeditiously, while ensuring meaningful opportunities for public participation and stakeholder comment.”

Wall Street May be Backing Away From OR Obsession

A Wall Street analyst said this week that some institutional investors have begun to move away from their obsession with ever lower railroad operating ratios.

Most North American Class 1 railroads have in recent years striven to drive their quarterly operating ratios into the 50s.

The operating ratio is a measure of what percentage of operating revenue is spent on operating expenses and is widely viewed as a measure of efficiency and profitability.

The quest for a lower operating ratio has driven management into taking aggressive cost-cutting measures, including selling real estate, closing and consolidating facilities, and operating longer trains manned with fewer crew members as a way of reducing labor costs.

An analysis published on the website of Trains magazine said the shift in thinking would represent a major change for how Wall Street investors view publicly-traded railroads.

One implication of what some have termed “the cult of the operating ratio” is that railroads have sacrificed traffic gains in order to focus on the most profitable commodities that they haul.

Allison Landry of Credit Suisse said the new outlook on Wall Street is a desire for railroads to focus more on attracting higher traffic volume.

The Trains analysis noted that analysts in the recent years have seen unconcerned that railroad freight volume peaked in 2006.

Instead, their objective was to see earnings growth driven by rate increases, cost-cutting, and share buybacks.

The popularity of precision scheduled railroading, which had aggressive cost cutting as a byproduct in how it has been implemented at most railroads, played into that line of thinking.

Now, the Trains analysis said, investors seem to be concluding that PSR was a one-trick pony.

“While there is still plenty of room (particularly for the U.S. rails) for margin expansion, at some point, expense cuts will . . . bottom out; whereby the O.R. will approach a number for which it will not go below,” Landry wrote in an outlook note to clients earlier this year.

“The bottom line is that long term rail valuation will be dictated by growth; the margins at which the growth comes; and how much it costs to maintain the asset base.”

The Canadian Class 1 systems, Canadian National and Canadian Pacific, have already moved in the past couple of years toward giving a higher priority to traffic growth.

CSX, Norfolk Southern and Union Pacific may not be far behind as railroads seek to reverse a steady loss of market share to trucking companies that has been ongoing for decades.

In January CSX CEO James Foote hinted at a change in thinking when he said, “If we wanted a 50 operating ratio, we’d have a 50 operating ratio. We would do it . . . quickly. I’m not sure what would be left of the company in the process.”

Railroad management is not going to give up its laser focus on keeping down costs because otherwise it might lose some competitive edge. Railroads are, by nature, a high fixed costs business.

Nor are railroads going to stop turning away low margin business.

However, the fixation on ever lower operating ratios has meant sacrificing some profitable volume growth.

The average operating ratio last year for North American Class 1 railroads was 60.4 percent, an improvement of 10.4 percentage points since 2012.

Todd Tranausky, vice president of rail and intermodal at FTR Transportation Intelligence, a freight forecasting firm, told Trains that even if operating ratios were to skyrocket into the 70s there would still be plenty of profitable business for railroads to seek to capture.

Some railroad executives, among them Union Pacific CEO Lance Fritz, have argued that the cost cutting of recent years has created a situation in which business that once didn’t look attractive now looks good because UP has a lower cost structure.