Is Export Coal the Top Concern for Railroads in 2013?

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I have already covered Kansas City Southern (NYSE: KSU) in one of my earlier posts. In that article, I wrote how growth is scarcely found in transportation stocks in recessionary times. The railroads have been severely hit by the shale gas boom as a sharp decline in natural gas prices led to a drastic decline in coal consumption. Coal, by far, accounts for the largest slice in the carload pie transported by the railroads. In this article, I intend to touch upon two railroads that have a large exposure to coal. However, this article will focus more on exported coal volumes rather than coal transported within the U.S. Moreover, it will give an outlook for 2013.

Earnings Season

With the earnings season on the go, and several railroads reporting this week, it will be important to see how domestic and export coal volumes have performed in the last quarter.

The following chart shows us the different revenue streams for different railroads:


<img src="/media/images/user_15211/capture4_2_large.PNG" />

We can easily figure out that Norfolk Southern (NYSE: NSC) and CSX Corp (NYSE: CSX) both have the largest exposure to coal as compared to their peers.

Within large cap transportation, the most controversial and discussed names in early 2013 are the eastern U.S. rails, CSX and Norfolk. While many investors agree that the eastern rails appear cheap, the near-term sentiment remains negative given lingering coal headwinds. However, it is still expected that both CSX and NSC will have positive earnings growth in 2013, after facing one of the most challenging coal markets in history last year.

There is no doubt that coal is a profitable segment for both CSX and NSC, but since the decline in coal consumption (due to the shale gas boom), the demand has softened drastically. However, I do not expect a repeat of 2012 eastern coal volume declines of around 14%, especially with a recent improvement in the domestic utility consumption.

Domestic coal quietly showing improvement – The utility coal consumption improved in the last two months of 2012, up roughly 5%. Although comparisons are easing on prior warm winter weather and significant gas switching, the improvement suggests at least a near-term floor for utility coal demand. CSX and NSC coal also improved with average December non-holiday weekly loadings increasing roughly 10% from November levels.

However, export markets remained more challenging in 4Q – The U.S. export tonnage declined in 4Q12, especially for the metallurgical volumes, which were down more than 20%. This will represent a headwind for both eastern networks. But at less than 10% of total revenue for CSX and sub 5% for NSC, we think export reductions in 2013 can be manageable, especially following a year in which eastern coal volumes declined 14% in aggregate.

Beyond coal, mostly reducing 4Q12 rail forecasts – Apart from coal, volumes in the fourth quarter slightly underperformed prior expectations. And higher headcount levels at the U.S. carriers suggest a slightly higher cost outcome as well.

Even with a lower outlook, I expect NSC to beat – NSC is one of the more challenging rail models right now, especially given the recent earnings performance. A slight fuel tailwind, improving merchandise volumes and encouraging coal loadings at the end of 2012 all signal a relatively improved 4Q outcome for NSC, especially against relatively low Street expectations.

Valuations and Conclusion

I expect a stable outlook from CSX and NSC for 2013. This will help regain market confidence in both companies’ future earnings potential. Though, I have mentioned that both CSX and NSC do not expect much growth in 2013, but still it is important to note that most of the future coal declines have already been factored in their stock prices, which means that downside is limited in 2013. The following chart explains it:


<img src="/media/images/user_15211/capture1_12_large.PNG" />

*This table shows the worst-case scenario in which coal consumption declines at a rate similar to that witnessed in 2012.

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