5 Takeaways From Class I Railroads' Earnings Season

The first-quarter 2021 earnings season for the Class I railroads is over. An optimistic volume outlook, especially for the second half of 2021, plans to improve operational efficiency and take market share away from trucks, and a proposed Class I Canadian railway merger with Kansas City Southern (NYSE:KSU) were among the key themes expressed by railroad executives.

"The underlying message is there are expectations that the efficiency improvements are going to continue and they'll be able to leverage the improvements in volumes throughout the course of the year and be able to look at opportunities to grow their business," said Jeff Windau, an equities analyst with Edward Jones. "As they're able to improve their efficiencies, it potentially gives them opportunities to look at other types of business to gain more volumes, like trying to get some more volumes from trucks."

Here are five takeaways gleaned from earnings calls over the past month.

A Merger Is Still On Everyone's Minds

Kansas City Southern (KCS) said late Thursday that it is leaning toward going with CN (NYSE:CNI)'s proposal to acquire KCS. CN and its rival Canadian Pacific (NYSE:CP) are both seeking to acquire KCS.

2021 maritime import shipment volume coming into the ports of LA and Long Beach remain above 2020 (orange) and 2019 (green) levels. (Source: SONAR)
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KCS was still deciding between the two merger offers during the weeks that the Class I railroads held their first-quarter earnings calls, and so many investors and Wall Street analysts wanted to know what individual Class I railroads thought about the efforts to merge with KCS.

While KCS and Norfolk Southern (NYSE:NSC) declined to give their thoughts about a merger, CP and CN each gave their reasons why they are the better railway to merge with KCS. Meanwhile, Union Pacific (NYSE:UNP) and the privately held BNSF (NYSE:BRK) said they would ensure that any merger wouldn't encroach upon their customers' cross-border service needs.

A KCS-CN merger is far from a done deal, and the Surface Transportation Board must still review it. But now that KCS is leaning toward CN's offer, investors and analysts could be watching whether CP will seek to merge with another partner should the KCS-CN be approved by KCS shareholders. But first, although CP has said it will not counterbid, the company hasn't yet conceded defeat and so the story is far from over.

Easing Congestion At US Coastal Ports

With U.S. imports coming into ports at high levels and vessels waiting outside West Coast ports to berth earlier this spring, the railroads were asked how they've contributed to clearing up the congestion at the ports.

For Union Pacific (NYSE:UP), port congestion meant working with the ports and the ocean carriers about how to clear up congestion in the first quarter. In addition to trade and labor issues, the warehouses by the ports were "just full" and "unable to physically take the container," according to Kenny Rocker, UP executive vice president for marketing and sales.

"We stay very coordinated with the customers on what they plan to do and what their forecasts are. … We've got visibility just talking to our customers from that perspective," Rocker said during UP's April 22 earnings call. "We've made some changes to our accessorial charges to incentivize our customer to get the equipment moving. Regardless, whether it's our equipment or their equipment, we are sitting down with our customers to talk about efficiency and turn times and dwell and things they can do to get the network moving."

2021 maritime import shipment volume coming into the ports of LA and Long Beach remain above 2020 (orange) and 2019 (green) levels. (Source: SONAR)

Said CSX (NASDAQ:CSX) President and CEO Jim Foote during his company's April 20 earnings call, "We're part of a chain. We're a link in the chain. … It's easier to move the chain when it's not kinked and there's no problems in it and everything is working smoothly. So I think that all of us … could move more. Listen, the port guys don't want to put boxes on the ground because they don't have a chassis, because they don't have a truck to dray it. … The railroads are backed up because the railroads don't want to deal with somebody putting the box on the ground because of this. We all would like things to be smoother."

North American Intermodal Traffic Anticipated To Show Strength Through 2021

An improving economy and continued e-commerce strength are macroeconomic factors that could support intermodal traffic through much of 2021, executives said during earnings calls.

"There's no more news on the second-half guidance. I would also just remind you that there is some kind of very high optimism on what the second quarter is going to look like just because the comps are so easy. But then when you get in the third and fourth quarter, we're starting to lap now the real acceleration in domestic intermodal, particularly the parcel world," said UP President and CEO Lance Fritz. "And we're also then starting to lap some of the real strength in grain. So it has yet to be seen exactly how that plays out. But even in that context, our guidance stands."

2021 U.S. domestic intermodal volume (blue) will begin to face a more difficult comp to 2020 (orange) in the third quarter. (Source: SONAR)

Although the chip shortage hampered automotive production in the first quarter, the rail market is hopeful that production will resume to more normal levels so that the automotive sector can meet pent-up consumer demand.

"The automotive sector continues to see strong consumer demand and low vehicle inventories. And we believe the OEMs will look to recover production, which was lost due to the semiconductor shortage, in the second half of the year," said KCS Chief Marketing Officer Mike Naatz during his company's April 16 earnings call.

Bringing Back Power And Crews

To meet anticipated growth in volumes, some of the Class I railroads said they have positioned equipment and locomotives to relieve potential pressure points. They have also begun hiring and training conductors while also searching for potential employees along certain areas of their networks.

"We're actually hiring conductors right now, getting ready for the second half of this year. So we're prepared, we're optimistic about the second half of this year in terms of the volume and that's really where our focus is preparing to move that," said CN Chief Operating Officer Rob Reilly during CN's April 26 earnings call.

Operating Ratios And Revenue Targets Are Still In Effect

Severe winter weather may have dampened rail volumes in February, but Class I executives were upbeat that their companies could still meet their targets for revenue and operating ratios for 2021.

"If you look in the quarter, there were definitely some pressures on operating ratios, and again, the weather was an impactor. We had a pretty sharp rise in fuel prices versus last quarter, and so those types of things really did weigh on the operating ratio," Windau said.

"But really, the rails were all feeling that they were able to handle those types of issues and were sticking with their forecasts and being able to improve operating ratios and that's what the market is expecting. The big picture is that the market is looking at the ability of these rails to leverage those operations improvements and improvements in costs management versus those rising volumes, to leverage that to the bottom line," he continued.

While anticipated volume growth will help boost revenues, efforts to reduce costs or keep them flat should help lower operating ratios, the railroads said.

"Our outlook is to generate strong incrementals throughout the balance of the year, and that's how we're going to … shrink our operating ratio," said Norfolk Southern CFO Mark George during his company's April 28 earnings call. "Our goal here is on pretty much all line items to absorb and … absorb the volume and hold the cost as flat as possible. And that's kind of the challenge and the mandate we've given to the organization."

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