Shippers expect 3.4% rate increases over the next 6-12 months, up 30bps sequentially and roughly in line with our survey average. Business growth expectations improved while economic confidence stepped down. 24% of shippers may pull forward peak season due to congestion, and most shippers see restocking within the next quarter. We modestly lower 2Q estimates for the U.S. rails, as volumes QTD were slightly below prior estimates and included a mix headwind that was somewhat offset by a drop in diesel prices. We analyzed 2018 tariffs and its impact to ocean and rail volumes, given increased investor concern.
Pricing Expectations Increased Sequentially
The 3.4% expected rate increase was roughly in line with the survey’s long-term average of 3.5%. Despite the sequential move, it is likely pressure from the OTR (over the road) market that continues to weigh on overall freight pricing. On the bright side, rail carloadings are showing some signs of more typical seasonality. However, some executives at our “Suds with Sluggers” event were somewhat negative on Q2 IM trends and noted a continuation of depressed rates. We continue to monitor for signs of pulled-forward demand, though it is not evident in ocean volumes through May.
24% of Shippers Are Considering Pulling Forward Peak Season
For the first time, we asked shippers if they were considering pulling forward their peak season freight due to the elevated congestion we have written about at length in recent months, driven primarily around 1) supply constraints via ocean that are driving up spot pricing and creating delays, and 2) looming potential changes to trade policy. 24% of rail shippers stated that they are considering pulling forward peak season freight, a fairly material percentage, in our view, that may cause freight rates to see a seasonal impact earlier this year vs. a historical late summer peak at the ports.
About 50% of shippers expect shipments to remain in warehouses for less than a month before needing transportation to customers; this suggests that restocking demand is evident (34% of shippers say they are already seeing restocking demand and another 26% expect restocking in 3Q).
Business Growth Expectations Stepped Up Sequentially, But Still Below Survey Average
Business growth expectations over the next 12 months increased 40bps to 2.5% in Q2, though still below the survey’s long-term average. We have now seen three consecutive quarters of business outlook growth, which we can partially attribute to 2.6% carloadings growth YTD for the U.S. Class I’s. Economic confidence stepped down 6% sequentially, and 46% of rail shippers are still having trouble hiring employees, flat sequentially.
While an election year is causing broad uncertainty (we have received increased inbounds from clients on the implications of tariffs under a Trump presidency), data we looked at from Trump tariffs in 2018 suggest that tariff fears may cause a short-term pull forward in demand and modestly impact freight costs, though immaterial to longer-term trends (breadth of tariffs will be important).
Shippers Consider Shifting Freight to the West Coast
18% of shippers stated they moved volumes to the West Coast in the past 6 months (50% had not and 33% stated it was not applicable). Of the 40% of shippers that have applicable freight and are considering shifting coasts, 25% of them are considering 0%-5% of their volumes, 50% are considering 5%-10% of volumes, and 25% of shippers may move more than 10%.
2Q RAIL EARNINGS PREVIEW
We lower our 2Q estimates for all three U.S. Class I rails (UNP, NSC, CSX) as we tweak our volume and yield assumptions lower given QTD trends, while adjusting our fuel cost assumptions, given diesel has declined 5% through the second quarter. Rail volumes continue to track below pre- COVID levels. Our new estimates bring us just below 2Q Street consensus for the three U.S. rails (recent conversations with clients suggest the buy side is largely expecting sluggish 2Q results from the U.S. Class I group). As usual, we did not make significant changes beyond 2Q as we wait for management commentary on the upcoming earnings calls. All three U.S. Class I’s are currently trading below their forward five-year PE average (though UNP less than half a turn), and well below their five-year highs. NSC and CSX are both trading at more than a turn below their forward five-year averages.
U.S. Rail Volumes Continue to Track Below Pre-COVID Levels
U.S. rail volumes are +2.5% QTD and YTD, driven largely by the outperformance of intermodal volumes (+8.9% QTD), which were partially offset by coal volumes (–19.4% QTD). We modestly lower our volume assumptions in Q2 for the U.S. rails, due primarily to 1) lower coal demand 2) weaker metals traffic (–4.5% QTD has been impacted by high inventories and less demand for non res construction) and 3) severe weather events. We expect mix to be a slight headwind in Q2; a strong international intermodal market vs. soft domestic has pressured IM yields and should step down sequentially in the second quarter. While intermodal volumes have been the segment leader, a private IMC at our recent “Suds and Sluggers” event noted a continuation of depressed rates.
We are continuing to monitor a potential pull forward of freight demand as shippers weigh 1) supply constraints via ocean that are driving up spot pricing and creating delays and 2) looming trade policy. While May import data (the most recent) does not show any volume inflection (the Port of LA saw volumes decrease 3% y/y in May and 2% sequentially over April; the Port of Long Beach saw an 8% y/y decrease in May and 8% sequentially), ocean spot rates through June continue to increase at a double-digit clip (+19% through the first three weeks of the month from Shanghai to Los Angeles, and +10% from Shanghai to New York).
Tariff Concerns Could Modestly Weigh on Near Term Shipper Behavior When Looking at 2018 Trump Tariffs
We have received increased inbound calls from clients on the implications of tariffs under a potential Trump presidency. We analyzed rail volumes, ocean volumes, sequential rail yields, and ocean spot pricing during the period of 2017 (pre tariffs) through 2019 (Trump tariffs were announced in March 2018 and began July 2018). U.S. rail volumes, beginning in 4Q17, outperformed vs. its historical average for 5 consecutive quarters until 1Q19 (we note that 2019 was a difficult freight environment).
When looking at the ports (we analyzed the Port of LA+LB which make up ~40% of imports), ocean volumes vs historical averages saw two months of minimal outperformance right before the tariffs were enacted and immaterial volume trends compared to averages in August 2018.The most noteworthy part of the freight markets that saw an impact from tariffs in 2018 was ocean spot rates; beginning in March 2018 (when tariffs were first announced), ocean spot rates rose 46% (average East/West Coast) through November 2018. Ocean spot rates then began to cool through 2019.
We believe increased chances of a Trump presidency and tariff fears may cause a short-term pull forward in demand and modestly impact freight costs. The breadth of tariffs on Chinese goods will have a significant role in the impact (recall the first round of Trump tariffs were just on imported steel and aluminum, and expanded across more categories in months following), which we will continue to monitor.
Rail Estimate Changes
We lower our 2Q estimates for all three U.S. Class I rails as we tweak our volume and yield assumptions lower given QTD trends, while adjusting our fuel cost assumptions given diesel has declined 5% through the second quarter. Rail volumes continue to track below pre-COVID levels. Our new estimates bring us just below 2Q Street consensus for the three U.S. rails (recent conversations with clients suggest the buyside is largely expecting sluggish 2Q results from the US Class I group). As usual, we did not make significant changes beyond 2Q as we wait for management commentary on the upcoming earnings calls. All three U.S. Class Is are currently trading below their forward five-year PE average (though UNP less than half a turn), and well below their five-year highs. NSC is currently trading at the largest discount to its historical average, though CSX is currently at the largest discount compared to the U.S. group.
Port of Baltimore Resumed Service in Q2
Following the tragedy on March 26th which caused the Port of Baltimore to halt operations, partial service began to resume in late April. The first order of business at the port was to allow ships stuck at the port to leave which should ease congestion. On June 12th, the governor announced the port fully resumed service; the Port of Baltimore represents an economic impact of $192MM daily and $70 billion a year (13% of Maryland’s GDP). NSC and CSX had the largest financial impact mostly due to coal exports out of the port, $500MM- $100MM a month for NSC, and $25MM-$30MM a month for CSX. The opening largely fell in line with management expectations laid out during Q1 earnings, and despite the service disruption, Eastern coal volumes are significantly outperforming the West.
Rail Service
Rail service metrics and results of our proprietary shippers’ survey indicate that Class I service quality stepped down slightly in 2Q but remain materially improved relative to COVID congestion levels. Average ‘positive’ ratings for the U.S. Class I’s came in at 58% which is materially above the post COVID average of 51%. CSX’s train speed held flat through 2Q after deteriorating through 1Q but remains the best among the public Class I’s. Survey results indicate a drop in the proportion of participants citing “positive” service from CSX though our chart below shows that this is still significantly above the post COVID U.S. Class I average.
NSC’s new operating plan appears to be yielding dividends with train speed and positive ratings up materially in 2Q. Positive ratings jumped roughly 7 points albeit from low levels and are now in the same ballpark as those of CSX and UNP. While improved metrics are a positive for NSC’s operations, investor expectations are high given NSC’s promises to deliver a 64%-65% OR in 2H.
While UNP saw a sharp decline in train speed in the quarter mainly due to recurring harsh weather episodes in the South, our survey points to stability in service ratings, a positive for the Western rail.
Canadian Rail Strike Could See Some Volumes Diverted to U.S.
Historically, most rail strikes in Canada have not occurred simultaneously at CN and CP, allowing shippers to switch to another Canadian Class 1 in the event of a strike. For example, during the weeks of the CP strike in March 2022 and the CNI strike in 2021, carloads moved over to the CN network which recorded a 7% W/W uptick to CP’s -8% W/W. Carload data suggests a similar shift during the November 2019 strike on the CN network. Most of the volume diversion was observed during the week of the strike itself. We believe some U.S. bound container volume could find itself temporarily on the U.S. network in the event of a July 9, 2024 Canada-wide strike though low TL rates will likely allow volumes to be absorbed on the OTR network as well.
Fuel
Diesel fuel should prove a modest tailwind to Class I earnings in 2Q with on-highway diesel -5% QTD and average prices during 2Q -2% y/y. Diesel prices fell through most of 2Q but ticked up in the last three weeks though we remind investors that fuel surcharges operate on a 6- to 8-week lag for the rails.
