TD Cowen Insight: Merger to Dominate Rail Earnings Despite Diverging Q3 Operations
Where We Stand
We update our rail estimates to reflect QTD carloadings, fuel, and mix changes. QTD U.S. rail carloadings are +0.5%, with motor vehicles & equipment leading the growth at +6.5%. IM volumes have decelerated through the quarter now -0.4% QTD and -4.7% last week, with most of the pressure coming from the West Coast. We lower estimates for both eastern carriers, with the largest downward revision at NSC; full likely year guidance likely unachievable given muted demand environment that will pressure OR significantly in Q3. NSC continues to be a special situation given deal announcement so NT results less impactful to stock reaction. We continue to see a 90% deal approval probability.
At the NEARS conference earlier in September, NSC and western rival the BNSF offered sobering industrial development outlook noting that the number of projects moving into engineering and construction declined from 30 in 1Q to 20 in 2Q and then sharply down to 5 in 3Q. Tariff uncertainty was attributed to the freeze and 3Q’s number was the lowest number the NSC panelist has ever seen. Tariffs present a hurdle to reindustrialization due to the degree of import input that takes place in industrial projects.
CSX has been affected by a meaningful slowdown in chemicals, ag, and food. Margins are expected to step down meaningfully sequentially, though Howard Street tunnel is expected to open up this week, and the company should benefit from easy comparisons in 4Q given the hurricane impact last year. In a surprising announcement, CSX announced a CEO change that will take effect immediately after Joe Hinrichs spent 3 years running the rail. The incoming CEO comes from a non-rail background, though he oversaw and led the successful integration of a large industrials merger at Praxair. Investor feedback on the incoming CEO has been positive.
UNP is the only U.S. rail we are raising estimates for ahead of earnings, largely driven by intermodal that has come in much better than feared and strength in coal. LA+LB ports saw modest declines in August though better than commentary from Executives that suggested much larger import declines into the critical peak season that could leave shelves empty. UNP and NSC have announced that their shareholder vote for the deal will be November 14.
3Q25 Rail Shipper Survey
Survey results are a negative for the U.S. rail group. Pricing continues to decelerate in Q3, running well below the survey’s average. Business growth expectations worsen, akin to COVID lows. Economic confidence skews negative. Shippers would move LSD volume onto rails if transcon service offered though we acknowledge it will take time before rails can market this single-line service to customers in a transcon setting.
Transcon Watershed Opportunity Could Surprise to Upside
We believe a unified UNP/NSC sees potential upside to disclosed revenue synergies as we quantify the watershed opportunity. As such, we expect synergy estimates to be walked up over time (as observed in the CP-KCS merger detailed in table below). Our recently published deep-dive analysis of over 4,000 watershed O-D pairs suggests that even ~10% truck conversion exceeds UNP’s total net synergy target disclosed in a recent S-4 filing (noting that UNP’s estimate includes the larger transcon intermodal piece). Further upside should not be ruled out given rails’ price advantage over truck.
We believe a transcon faces significant conversion TAM but outcomes hinge on execution, which will occur over a multi-year period. The fmr Class I CEO we hosted recently highlighted the opportunity to strike contracts with customers (auto mainly) for ~75%-80% of their volumes (full note here). Such outcomes likely represent the upside scenario given that our 10% capture assumption yields outsized EBITDA gains. The chart below visualizes the watershed EBITDA opportunity in various share capture scenarios relative to UNP’s disclosed total synergy estimate.
Both NSC and CSX are trading above their 5-year forward PE average, with NSC trading the highest in the U.S. group at 21.4x due to the pending deal with UNP. UNP is the only U.S. Class I trading below its average as the company embarks on a multi-year effort to create a transcontinental railroad. The rail group has outperformed the rest of our coverage YTD despite an industrial economy that has been under continued pressure. September ISM data contracted for the seventh consecutive month. See our supply chain tracker for a more detailed look at how the macro has evolved through September.
