Market Spotlight: Railroads

CSX Corp. Union Pacific Corp., and Burlington Northern Santa Fe Corp. all reported third-quarter profit that beat analysts' expectations, as efficiency improvements and cost controls offset lower demand for freight and higher fuel costs.

Canadian National Railway Co., however, posted lower third-quarter earnings citing lower fuel surcharges, weak forest product revenue and a tough Canadian dollar/U.S. dollar exchange rate. Canadian National also predicted flat earnings for the year due to soft market conditions.

Stifel Nicolaus analyst John Larkin expects Canadian Pacific Railway Ltd. to beat Wall Street's expectations when it reports earnings on Oct. 29, and Kansas City Southern is also expected to post one of the strongest quarters among its peers.

Eastern rail Norfolk Southern Corp. should come in slightly below analysts' forecasts when they report this week, Larkin predicted.

Two weeks ago, Norfolk Southern Corp. reduced its profit guidance to 97 cents per share from $1.02 per share, to account for certain one-time tax charges and higher crude oil prices that cut gains from synthetic fuel investments.

Analysts, who typically exclude certain one-time items, still expect the company to earn $1.02 per share, according to a poll by Thomson Financial.

Robert Jankowitz, senior vice president of Moody's Investors Service, on Monday offered a "Stable" outlook for the North American rail group, saying the sector's overall operational strength and strong pricing are balanced with increasingly aggressive financial policies, including large share buybacks, and higher spending.

Jankowitz expects profits at the rails to remain strong overall in the next few quarters, although slumping demand could cause pricing to weaken into 2008.

"Demand for railroad capacity is at an inflection point as the U.S. economic outlook weakens, and it remains to be seen how well pricing will hold up in a more challenging economic environment," Jankowitz said.

So far in the fourth quarter, volume losses are continuing, as demand for paper and lumber -- hurt by the turbulent housing market -- drags down overall carloads. Volumes for intermodal -- the rails' largest segment -- have also been dwindling, Bear Stearns analyst Edward Wolfe said.

Wolfe suggested volume losses should continue for the railroads throughout the quarter, as the softness in the larger economy continues. But he noted the rails still enjoy strong pricing and favor over the trucking sector, which is suffering even more significantly from lowered consumer spending and elevated fuel costs.

Compounding the demand slump, the rails are currently facing a slew regulatory hurdles.

The Rail Safety Bill, which is aimed to revise service rules, cut waiting time and implement training standards for rail workers, passed a House vote last Thursday.

Wolfe believes the bill will likely require the rails to hire more staff and will possibly limit productivity in the future. And although the timing of a Senate vote is unclear, the analyst said he anticipates that some form of the bill will pass within six to 12 months.

The Surface Transportation Board, an economic regulatory agency affiliated with the U.S. Department of Transportation, is also expected to rule on several rate and procedural issues in the near future.