The Case for a Rail Valuation Re-Rating and Multiple Expansion

Research evidence excerpt

The Case for a Rail Valuation Re-Rating and Multiple Expansion

The Railroad Earnings Growth Algorithm is Not Broken

The North American railroads earnings algorithm is dependent on their ability to accelerate volume

growth, increase pricing, and control operating expenses. Over the years, we have extensively

documented our view that the algorithm has become increasingly dependent on volume growth; from a

revenue perspective, for years the rails have pushed pricing ahead of inflation. However, the opportunity

remains confined by both regulatory restrictions and competition (namely from trucking). Volume growth

has largely been a function of the core markets in which the rails operate (being coal, agriculture,

chemicals, forest products, automotive, et al.) and their ability to defend market share, tethering the

rails volume opportunity to the underlying markets. Where we have observed considerable torque is in

the railroad' ability to optimize operations—following the broad implementation of Precision Scheduled

Railroading (PSR), we observed a strong period of optimization (underpinned by network simplification

and asset utilisation), which reduced the railroads' capital intensity and leaned the cost structure (from

here, the railroads have less leverage to remove further costs). With an increasingly lean, fixed cost

structure and limited opportunity to improve pricing beyond inflation, we argue the railroads' earnings

algorithm is heavily dependent on volume growth and the high incremental margin volumes come with.

Exhibit 1 - North American Rails Yield Over Time Have Grown at a Exhibit 2 - North American Rails Have Delivered RTM Growth at a

CAGR of +3.3% vs. Inflation +2.6% CAGR of +0.3%

7.00 130.0

6.00

120.0

5.00 (2010-2020)

4.00 110.0

CAGR

3.00 100.0

2.00 10-year