Shares of American railroads have been enjoying an even stronger rally than the S&P 500. Despite so much intense media focus on revolutionary technology firms such as Netflix and Apple, good, old-fashioned railroads have been chugging along just fine. Apple earns profits on phones that it upgrades every few months; the railroads make money on locomotives, some of which are thirty years old. Facebook was launched in 2004. The Union Pacific was named after the “Union” won the Civil War. Yet Norfolk Southern shares have jumped almost 50% in the past year, with Union Pacific not far beyond. Can the railroad rally continue? Will investors allocate more to rails in 2018?
Some green lights are flashing brightly. Railroads benefit from the growing economy. Simply put, more spending by consumers and more business investment translates into loading more items on railcars. In 2017, rail traffic climbed almost 3%, according to the Association of American Railroads. Intermodal traffic was especially strong. This is key because intermodal statistics include containers that could, instead, be carried by trucks. Therefore, rising intermodal traffic may signal a stronger economy and that rails are competing well with trucks.
The new tax law is also a boon to rails: First, it slashes the corporate tax rate from 35% to 21%, aiding after-tax earnings in a year in which corporations are earning record sums. Just as important for the rails, though, the new law allows companies to immediately expense purchases of new equipment. This move boosts the rails in two very different ways. First, it gives them the wherewithal to upgrade their own equipment. Class 1 rails like CSX, Norfolk Southern, and Union Pacific are attempting to expand their ownership of the supply chain. This means building, installing, and owning their own facilities at ports and terminals. Expensing will advance this cause. Second, expensing will generate more freight for railroads to carry. When Navistar ships more engines from Indiana to its customers, those engines will likely ride in a railroad car. In the end, the tax law will lead to more efficient railroad systems and more customers for the railroads.
But there are risks, too. Consider the array of goods shipped by rail. Rails generate significant profit from transporting automobiles—indeed, 70 percent of new autos get to dealers by rail, according to the Alliance of Automobile Manufacturers. A single train may carry 750 cars, and America’s 70 automobile manufacturing plants are found not just in Michigan, but also in Texas, Tennessee, Georgia, etc. Yet auto sales seem to have peaked. With the economic recovery reaching its ninth year in 2018, there’s little pent-up demand. Combine this with slightly higher interest rates, Uber, and a future of self-driving cars, and it’s possible that rails will have to shave back their expectations for shipping automobiles. This year auto analysts expect sales to fall below 17 million units, for the first time in several years.
Commodity prices will impact the rails as well. Higher oil prices will likely lead to more fracking and the uncapping of wells. Railroads like Union Pacific ship a great deal of frac sand, and should benefit from the upturn. However, other commodities, such as grains, remain weak.
The biggest risk for rails may come on the trade front. With NAFTA negotiations underway, a falling out could threaten rail profits, especially for Kansas City Southern, which has often been called “the NAFTA Railroad” due to its cross-border routes. If the Trump administration pulls out of NAFTA, it will threaten automobile imports from Mexico and Canada, as well as agricultural trade in both directions. The U.S. sends corn, chickens, and wheat to Mexico; Mexico ships tomatoes and avocados north of the border. U.S. farm interests are trying to pressure the White House to stay within NAFTA, as Mexico buys 12% of U.S. agricultural exports. Last fall, Kansas City Southern boosted its dividend by about 10%. Union Pacific has paid dividends for 118 years, and it also boosted its dividend by nearly 10%. It will be harder for rails to stick to this happy trend if the northern and southern borders become impenetrable to trade.
The railroads may be roaring into 2018, but trade disputes and sagging auto sales could raise a few caution flags.