Railways not immune from slowdown
Published: October 8th 2008
Source: Nathan VanderKlippe, Financial Post
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VANCOUVER – Until mid-September, just about the only thing not falling off the economic rails was the railroad companies themselves. Fuelled by rising Asian demand for bulk commodities and growing container traffic through the port of Prince Rupert, Canadian Pacific Railway Ltd. and Canadian National Railway Co. consistently beat the TSX composite index. In the U.S., the top railway stocks posted 30% gains that one analyst called "spectacular."

That train, it seems, has now left the station. In the past two weeks, CN has dropped 16%, CP is down 21% and investors appear to have discarded the notion that the railroad companies can painlessly glide through the implosion of financial and commodity markets.

"The outlook is kind of bleak for everybody but bankruptcy lawyers right now," said Bill Waters, a professor emeritus in transportation economics at the University of British Columbia.

Assessing how bleak it is for the railways remains, however, a challenging proposition. The rail lines have enough free-cash flow that they don't have to worry about the credit crunch, while their business has been surprising resilient. In the past year, the sector has barely noticed the 20% declines in two of its stalwarts, forestry and auto shipments, as it ramped up delivery of other goods and poached truck volumes. CN, in fact, has managed to post a 0.5% increase in traffic volumes so far this quarter compared to last year.

But there are worrying signs that those days may be over. CP is already showing a 3.4% volume decline so far this quarter, and industry observers said future slippage for both players is likely as demand falls for consumer goods.

"If the total shipping is going to go down in a slowdown of an economy, you're trying to capture market share of a shrinking market," said Paul Bingham, a managing director in the global trade and transportation practice at Global Insight, Inc.

Particularly worrisome are shipments of bulk commodities like potash and coal, whose movement to overseas markets has helped shield the Canadian railways from troubles in the U.S. market.

"If the economies of those foreign trading partners slow down, the sales will drop and the shipments by rail will decline," Mr. Bingham said. "If the underlying demand goes away, then the railroads are just stuck, there's nothing they can do to induce it to start happening. And that's where the real risks are."

On the other hand, the railways are in a unique position to profit even from loss. With a sparse competitive landscape and extraordinarily high barriers to entry, they have what RBC Capital Markets analyst Walter Spracklin called "great pricing power."

In this quarter alone, they have pushed through price increases of 4-6%, he said.

"That's why in this environment we have been very favourable on the railroads as an industry on a long-term basis," he said.

"But I'm not saying there's not going to be weakness. The slowdown in motor vehicles, in intermodal, in overall commodities is going to weigh down this group."