Rail Renaissance: Returns, Capital & Capacity

AB HATCH abh18@mindspring.com

AREMA

September 21 2009::

Railroads at historic tipping point

The Railroad Renaissance is here – will it last? Capacity issues across all modes – or so we thought? Volume increasing – right? Share, rates, service levels (yes) – and returns increasing But pushback (shipper/regulator/union) also increasing! A secular, not a cyclical story – right? Capacity and infrastructure – and competitor - issues remain Fully reflected in the market? Or is this just another cyclical

slowdown? NET/NET- The industry is poised to go up – or down –

based on decisions made here & now

Railroad PerformanceClass I Railroads

0

50

100

150

200

250

300

64 68 72 76 80 84 88 92 96 00 04 08p

Index 1981 = 100

Source: Railroad Facts, AAR (Based on a design by R. Gallamore)

Productivity

Volume

Revenue

Price

Street influence on RRs – and Why that affects ALL stakeholders

Battle for cash

Management’s reactions to pressures

Investors, competitors, regulators, politicians,

labor – oh, yes, and customers

Short term decisions/long term consequences

Remember 2004! (?)

Which “bucket” will they place their chips?

Simple Math

RatesReturnsCapital ExpendituresCapacityService

ARE ALL CONNECTED!

Virtuous Circle (’03-07) or Disinvestment?

Key Class1 Issues in Recession ‘09

Re-regulation Bigger Threat than EverRates (versus Volumes)The EconomyServiceGreen RamificationsStimulus, MAP21, ATRK, “High” Speed

Rail (ONERail)

New Sources of Capital – Threat or Opportunity?

Fortress-RailAmerica/FEC (etc)

Infrastructure Funds (Toll Roads)

Hedge Funds & “Activists” (TCI)

PPPs – Heartland, Nat’l Gateway, CREATE

Share repos

C-1 Buyouts (DM&E)

JVs – Meridian, Patriot corridors

Threats to the Renaissance

Cyclical vs. secular argument New Congress –impacting labor & shippers Mandated Reviews – STB, Canada Rereg – the MAD answer Execution: service Execution: merger Hedge funds? Liquidity?

Cyclicality – Rails & Suppliers

What happened to the “end of the cycle”?

Thinking strategically vs. tactically?Panic Mode?Passenger the new lead dog?

North – or South – of the Border

Canada as the new model for rail regulation? NAFTA review? The “J” (& The MidAmerican, etc) Auto Restructuring Customs/Border issues Detroit tunnel? Rebirth of passenger rail? RR Days on the Hills

S&P 500 and RailroadsMonthly Data January 1980 – April 2007

Index Jan. 1980 = 100

Sources: MSN and CSI, Inc.

0

200

400

600

800

1000

1200

1400

Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05

S&P500 Railroads

07Q107Q2

07Q3

07Q408Q1

08Q2 08Q3

08Q4

09Q1-18%

-16%

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

Change in U.S. Railroad Non-Intermodal Carloads

Source: AAR Weekly Railroad Traffic

07Q1

07Q2

07Q3

07Q4

08Q1

08Q2 08Q3

08Q4

09Q1

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

Change in Canadian Railroad Non-Intermodal Carloads

Source: AAR Weekly Railroad Traffic

07Q1

07Q2 07Q307Q4

08Q1

08Q2 08Q3

08Q4

09Q1-18%

-16%

-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

Change in U.S Railroad Intermodal Units

Source: AAR Weekly Railroad Traffic

07Q107Q2

07Q3 07Q408Q1

08Q2 08Q3

08Q4

09Q1-14%

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

Change in Canadian Railroad Intermodal Units

Source: AAR Weekly Railroad Traffic

Railroad Intermodal Revenue Growth Over 5% - Long Live the New King!-

19901995

20002005

.

$0

$2

$4

$6

$8

$10

$12

$14

Bil

lion

s

Source: Carload Waybill Statistics (includes non-Class I railroads)

Coal Intermodal

17%18%

19%20%21%

22%23%24%

25%26%

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Coal Intermodal

*Data for BNSF, CSX, KCS, NS, and UP Source: Railroad financial reports

Intermodal and Coal as a % of Revenue*

Intermodal was the Top Source of U.S. Freight Rail Revenue, but Coal will be Number 1 in 2008

U.S. Railroad Intermodal Traffic(millions)

0

2

4

6

8

10

12

14

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

U.S. Railroad TOFC/COFC Units

Source: Association of American Railroads’ Weekly Railroad Traffic

U.S. Railroad Intermodal TrafficTrailers vs. Containers (millions)

0

1

2

3

4

5

6

7

8

9

10

88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

U.S. Railroad TOFC Units U.S. Railroad COFC Units

Source: Association of American Railroads’ Railroad Facts

Intermodal Growth DriversDomestic and International

Globalization

Trade

Railroad Cost

Advantages

Share Recovery

From Highway

Truckload Issues

Railroad Return on EquityClass I Railroads

0%

2%

4%

6%

8%

10%

12%

14%

91 93 95 97 99 01 03 05 07

Source: Railroad Facts, AAR

n.m.n.m. = not meaningful (negative value)

RR CoC vs. ROIC – RR Stocks have done well but… they still trade at a discount to all stocks

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08p

Cost of Capital Return on Investment

Source: Surface Transportation Board Note: Cost of equity estimation method changed by Board effective 2006 and 2008.

Railroad Capital ExpendituresClass I Railroads

$0

$2

$4

$6

$8

$10

$12

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Billions

Source: Railroad Facts, AAR

-$2

$0

$2

$4

$6

$8

$10

$12

'80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08

Source: Association of American Railroads

Net Income

Capital Spending

Class I Railroad Capital Spending vs. Net Income

(Current Dollars)

RRs and Investment

Is growth affordable? Capex up 10% in ’07, up 12% in ’08, so far only down 5-10% for 2009F

One rail cuts, most increase capex during ’07 What will 2010 look like? (long term growth

v short term weakness) Is additional capacity necessary? Desirable? Can the intermodal model extend to carload? Wall Street’s constrictive role (“fighting the last

war”) – is it changing? Is this disconnect between the Renaissance and

the Street the opportunity of a lifetime?

0 10 20 30 40

2035p

2002

Future Demand for Freight Transportation Will Continue to Grow

p – U.S. DOT projection

Billions of Tons of Freight Transported in the U.S.

Future Corridor Volumes Compared to Current Corridor Capacity

2035 without improvements

Below capacity

Near capacity

At capacity

Above capacity

Railroad Rates- the old story Class I Railroads, Revenue Per Ton-Mile – another (related) New Paradigm

01234567

'81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07

Cents

Source: Railroad Facts, AAR

Current $: Up 17% since 1980

Constant $: Down 49% since 1980

150,000

152,000

154,000

156,000

158,000

160,000

162,000

164,000

166,000

168,000

170,000

2001 2002 2003 2004 2005 2006 2007 2008

Total Class I Employment: Jan. 2001-Nov. 2008

Rail Employment is Up for the First Time in Decades

Source: Surface Transportation Board

Railroad Employee ProductivityClass I Railroads, Ton-Miles Per Freight Service Employee

0

2

4

6

8

10

12

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08

Source: Railroad Facts, AAR

Millions

Rail Service Cycles

Is the recent improvement in the metrics

sustainable? Systemic?

Is it a product of huge capex injection

and IT?

Or, is it merely a product of lower

volumes/less stress on the network…

Rail Regulatory Risk

Biggest Uncertainty Entering ’09 Safety Bill done “Competition” Bill (“M-A-D”) vs Anti-Trust STB makes it 3-straight shipper “wins” Rocky & The Dark Star – new horror movie? Cost of Capital Revision shock Mandated STB, CTA “Reviews” AAR/RAC/ASLRRA have great “D” but hard to

score on defense

25% tax credit for projects that expand rail capacity

Expense other infrastructure capital expenditures

Leverage private investment

Tax Incentives to Leverage Capacity Expansion

RR/Investor Issues Summary-3Rs3Cs

Recovery?The Re-SetRe-RegulationCapital NeedsCapital CooperationCash Flow

ABH ConsultingAnthony B. Hatch155 W. 68th StreetNew York, NY 10023(212) 595-0457ABH18@mindspring.com