Value Idea: Train left the station and I got onboard

I work in supply chain process management applications industry. As a result part of my limited knowledge in this life is in the logistics and transportation field, and as limited as it may be, it gives me certain insight and ability to look for investment themes that I can exploit in this sector. Now, if you look into my holdings there are not any business I own that operates in this sector. This is by design so far, as a large part of my net worth is tied in the business I started with my partners a year ago. However I may add some stocks as there are very compelling opportunities.

I have added Burlington Northern Santa FE (BNI) to my portfolio at adjusted cost basis of $65. I was looking at third party logistics and intermodal companies but the more I researched them the more compelling BNI and the rail roads case became. First I will make the
case for rail roads and their competitive advantage against trucking. Second I will make the case for BNI, the risks it faces and its valuation.

Rails vs Trucks

Railroads have made huge productivity improvements over the last few years. Railroads are more fuel efficient as they can travel about double the distance they used to travel in 1980 on the same amount of fuel. Moreover they can transport more, see diagram below. Another
strong point for railroads is shift in pricing power to their favour with high fuel charges.

An increased use of rail freight could allow the supply chain to accommodate these increased volumes while minimizing highway congestion and improving energy efficiency in the transportation sector. Shippers and policymakers are concerned that the existing infrastructure — much diminished after decades of track
abandonment — lacks sufficient capacity to accommodate the increased
demand for rail freight.

Railroads have improved their productivity in the past three decades,
mitigating immediate concerns about capacity, but concerns about future
capacity constraints appear to be justified.

The competitive advantage for rail roads over trucks:

• Fuel remains historically high at these levels and will favour rail over trucks. Moreover, oil marginal production cost is much higher than what it is trading at, $35-45, with such dynamic you should see oil higher in the future.
  
• Trains are becoming faster and more fuel efficient than road, due to severe congestion on highways and deteriorating transport infrastructure.
• Capacity is being sucked from the trucking industry at an alarming rate. More than 45,000 trucks left the market in the second quarter in 2008 and more is expected due to high fuel costs. Truckers average fleet size fell to 2725 trucks in 2008 from 2946 in 2007 (source:inbound logistics 2008) Capacity shortage is imminent. Rail will be the main beneficiary of this trend.
• shippers are beginning to shift from the need of fast delivery due to the re-engineering of their supply chains. Most companies are opening smaller but many distribution centres closer to their markets, doing away with hub and spoke model of centrally located warehousing. This reduced the need for fast cross country shipping so shippers are ok with
  longer but cheaper mode of transportation. Again rail will benefit from this trend.
• competition can be fierce in trucking while rail not so much. it is almost impossible to enter the rail business.
  

As a result the rail Pricing power is significant. The railroad industry is highly concentrated in the hands of seven railroads. Competition is further limited by their geographical concentration, with rail transport in the East predominantly carried by CSX and NS and, in the West, by Union Pacific and BNSF. There are significant barriers to potential competitors entering the market, and this gives existing railroads pricing power.

Railroads can also price discriminate between commodities and are attempting to specialize in their fastest growing businesses—predominantly coal and intermodal unit trains. Railroads occasionally choose to limit the amount of traffic they will accept from some customers because that traffic generates low profits or the operating requirements reduce the capacity of the network and profitability is reduced. U.S. rail industry transports about 40 percent of the nation’s goods, in terms of tons handled and distance moved, for only 13 percent of the overall transportation cost.

Next Post will tackle the specifics of BNI operations and its risks.