Railroads boost capital spending

As the economy rebounds, many companies are coming under fire for hoarding cash instead of making capital investments that could spur job creation.

Based on their 2011 capital expenditure plans, it would be hard to lump U.S. and Canadian railroads in that category.

In recent weeks, the seven biggest U.S. and Canadian railroads have disclosed robust capital expenditure (CapEx) plans for 2011, coming to market with budgets that, in aggregate, are at or close to all-time records for the venerable industry.

Leading the way is the privately held Burlington Northern Santa Fe (BNSF), with a company record $3.5 billion capital expenditure budget—up from $2.6 billion in 2010. No one with an institutional memory remembers any railroad with such a large CapEx budget in either constant-dollar or inflation-adjusted terms.

BNSF, a unit of Warren E. Buffett's Berkshire Hathaway empire, will spend $2 billion on what it calls "core network initiatives and related assets," industry lingo for infrastructure maintenance. It has budgeted $450 million to buy 227 locomotives, and $350 million for freight cars and equipment. The program also includes $300 million for terminal, line, and intermodal expansion projects focused on improving coal routes and routes in North America's midsection.

Perhaps mindful of Buffett's comments in 2009 that his purchase of BNSF—the largest in Berkshire's history—represented an "all-in bet" on the future of the U.S. economy, BNSF Chief Matt Rose said the railroad "remains committed to making the necessary investments to maintain and grow the value of our franchise's capacity."

But BNSF isn't the only rail bringing a big wallet to the game. Following close behind is the Union Pacific Railroad Co. (UP), whose $3.2 billion CapEx budget for 2011 represents a 23-percent jump from 2010 levels. CSX Corp.'s $2 billion spend is an 11-percent increase from year-earlier levels; Norfolk Southern Corp.'s $1.74 billion budget represents a 19-percent increase, while Canadian Pacific's budget of $950 million to $1 billion represents a 25-percent increase.

Only Canadian National, with a $1.7 billion budget, and Kansas City Southern, which didn't disclose a specific dollar amount but said CapEx would total 17.5 percent of its 2011 annual revenue, have rolled out spending plans that are virtually unchanged from their 2010 levels.

On a growth track
What's driving the strong numbers? One factor is favorable tax policy. Language in the U.S. tax bill signed into law in December accelerated the depreciation timetables for capital investments, giving railroads a major incentive to deploy capital. In addition, the railroads have virtually no problems accessing the capital and debt markets, as the value of their assets is well understood and recognized by the lending community.

But the principal driver is the general health of the industry. Car loadings and intermodal traffic are growing at a brisk pace above strong comparable figures in early 2010, although volumes are not near the levels seen in 2006, the year before the rail freight recession began. In addition, the railroads have been flexing their muscle on pricing and are seeing improved operating margins as a result. The carriers show no signs of easing off the pricing throttle—much to the chagrin of shippers but to the delight of shareholders.

A look at Union Pacific's cash flow performance speaks to the industry's momentum. According to an analysis by investment firm Robert W. Baird & Co., UP generated free cash flow (FCF) of $1.6 billion in 2010, compared with $1 billion in 2009. FCF in the fourth quarter alone was $590 million.

For 2011, Baird projects UP will generate $1.9 billion in FCF, despite the $700 million increase in capital expenditures. In addition, Baird expects UP to return $700 million to shareholders through dividends and share repurchases; during 2010, UP repurchased 16.6 million shares and increased its dividend roughly 40 percent, for a total payout of $600 million.

Traditionally, the railroads spend about 80 percent of free cash flow on capital expenditures. In absolute terms, the percentage may dip to 70 percent or so in the next few years. However, as FCF continues to grow, so will the funds allocated to CapEx. That's why experts like Tony Hatch, a veteran transportation analyst who now runs his own consulting firm, believe the cash flow projections will easily support increased capital investment while at the same time rewarding shareholders through share repurchases and dividend hikes.

The trend is telling for more than just the dollar numbers and the magnitude of the increases. BNSF's privately held status means that it's in the hands of "patient capital" willing to spend for long-term returns without worrying about short-term results. And, to be sure, few allocators of capital are more patient than Warren Buffett. However, the other railroads are publicly traded enterprises, with all of the short- and long-term performance obligations that accompany it. The willingness of investors to look beyond the short-range cost headwinds of higher CapEx levels demonstrates that they view the railroads as a long-term strategic investment, not just a cyclical play as is common with transportation companies. It also speaks to investor confidence in the railroads' financial strength, business outlook, and margin performance, analysts say.