UNP, NSC, CSX, Rail Regulation Outlook Call: Summary, Replay & Transcript


Materials: CLICK HERE 


UNP, NSC, CSX, Rail Regulation Outlook Call: Summary, Replay & Transcript - nbb2



Our Take


Tighter regulation of the railroad industry is likely not a near-term threat, but a real possibility over the next few years.  Of course, valuation is not a near-term exercise, either, and models should probably not forecast ever-expanding margins.  Going forward, it seems quite possible that the regulatory pendulum will start to swing back toward tighter railroad oversight.  When the Staggers Act was passed, there was little hope that the industry would achieve so-called revenue adequacy (e.g. meeting cost of capital targets, as defined).  As a result, the legislation does not explicitly spell out the regulatory changes that should accompany the achievement of revenue adequacy.  With several railroads having achieved revenue adequacy in recent years and the others close behind, legislation or regulation may be adapted over time to reflect a balance between the now higher industry profitability with the natural monopoly aspects of the industry.


A current STB effort is directed toward improving the cost of capital definition used in the determination of revenue adequacy.  The current definition has several flaws, including the use of historical cost of very long lived assets for both the capital base and depreciation expense.  This is an undertaking that may take Board a year or two to complete.  Another key risk is that shippers may continue to seek favorable STB rate case judgments by citing the industry’s achievement of revenue adequacy.  This could hasten a reappraisal of how revenue adequate railroads are treated, but requires both time and the right case.  Finally, safety regulation on tankers and positive train control (PTC) may increase costs in coming years, as recent publicized accidents have shifted such issues back into the spotlight.  These issues also appear to be gradual in their impact.


Any oversight changes appear likely to occur slowly; rail re-regulation is not an investor emergency.  That said, by the time these regulatory issues reach the ‘front page’, rail shares may have already started to reflect less accommodation.  We are not taking a position on 2014 railroad relative performance here, but note that investor expectations for rail margin expansion in coming years may be at risk if and when regulation emerges as an issue.  Over the very long-run, railroad profitability has been disproportionately impacted by regulatory and legislative activity.  Slow changes in regulatory direction are a positive when the regime is favorable, but a serious negative when oversight gets too tight, as the 1970s railroad results appear to demonstrate.



Summary and Partial Transcript


Linda Morgan:


There are some current regulatory issues that affect the industry now and going forward. What I want to do today is highlight key economic regulatory issues as well as touch on a couple of STB proceedings as well as some legislative initiatives in Congress. My disclaimer is of my own personal view and does not necessarily represent any of the firms or clients of the firm.


Brief Summary of Introduction (see Materials like above)


Economic Issues:

  • Revenue adequacy
  • Cost of Capital Rates

STB found 3 railroads to be revenue adequate:

  • UNP
  • NSC 
  • BNSF (private)

Regulatory Issues:

  • Do we now find ourselves in a situation where we are becoming revenue adequate and does the regulation need to change to reflect that as compared to before it was not revenue adequate?
  • Board also has an ongoing proceeding to revisit the measurement of cost of capital in particular the equity component of cost of capital?
  • Rate regulation is a case by case determination. Most of the cases involve coal. 
  • Common carrier obligations affect the railroad industry's obligation to carry hazardous materials. 
  • Open Access: shipper community is very interested in finding a way to bring in a second carrier to lower pricing by the railroads. The current statute is not an open access statute. The board has an ongoing proceeding on access
  • Federal preemption: states and localities are concerned about hazardous materials, environmental issues with rail transportation. The industry is better off when there is a coordinated Federal regulation versus an uncoordinated regulated environment.




Two safety issues important to the industry:


1. Implementation of positive train control (PTC). There is a deadline of 2015 for implementing positive train control. There is concern that the industry is not ready for it. The recent MTA derailment in Bronx, NY has put this issue back into the spotlight.


2. Transportation of crude oil and hazardous materials by rail. The Department of Transportation has a rule making ongoing with tank car integrity related transportation issues. Congress is considering implementing new tank cars and disallowing the old ones.






Jay Van Sciver: I was wondering if you could expand on revenue adequacy and what that means in terms of regulation of railroads’ return. Could you also expand on the cost of capital definition by the STB? I understand the STB calculates the cost of capital in the 11-12% range in recent years, which is far higher than what everyone estimates it. So how did it get there and what does it mean going forward especially for revenue adequacy?


LM: I'll start with revenue adequacy, when Congress passed the Staggers Act the focus was on the industry which was in very bad shape in achieving revenue adequacy, one of the main responsibilities of the STB. Specifically to rate regulation the view is once a determination is made that revenue adequacy has been achieved then does that mean the extra earned by the industry would be allowed. The competitive cost must come from the non-competitive base. The debate will be about how much return the industry needs to operate and put back into the privately funded infrastructure. The question for the regulators is will all the companies have to meet revenue adequacy? These questions are not answered but need to be answered at some point.


On cost of capital, this issue has been around for awhile. The customer has routinely focused on it. There had been an early proceeding exploring how equity is to be determined. It will take some time to sort the issue out in roughly two years.




JVS: What are the complexities around the cost of capital? You would think they would have purchased cost of equity market perspective for what the equity holder needs to hold shares of a railroad. There is a great deal of academic literature on this so it's not something that would take two years to do. 


LM: I don't disagree with you and the board doesn't disagree with you. I think it comes down to the board having a model in place for them to implement without controversy. The decision they issued did not have a consensus record on the way to go as well as the determinations that would have to be made. They have to do everything by the weight of the record. 




JVS: But doesn't the nature of regulation often make them unhappy?


LM: I think you are right. I should have said the weight of the record. When the board makes a decision is there enough evidence to go in that direction based on the record. It is more of the weight of the evidence versus a complete agreement by consensus.




JVS: If the STB lowered the cost of capital, would that push more railroads into the revenue adequate position, as the primary determiner?


LM: That is the primary determiner. Essentially that is how the board determines whether a company is revenue adequate. That is why the customers are concerned about the measurement of cost of capital because the higher the level the more opportunity for higher rates?




JVS: Has the cost of capital trended higher over the years?


LM:  No, in recent years it has been hovering at 11%. 




JVS: What would get the conversation moving toward rail regulatory reform in Congress to deal with GAAP and the Staggers Act dealing with revenue adequacy especially as some of the rail companies have approached or passed as relative adequate? 


LM: Well, I think the first thing that would occur would to get someone's attention on the Hill. The legislation has focused on opening up the marketplace to additional access. The Congress we are in right now will take a lot to get noticed.




JVS: If the STB revisited its cost of capital rates and essentially lowered it would that change their regulatory posture and look at rail proceedings differently?


LM: That's the implication of the statute. There would be a view to revisit how the industry is being regulated. That is the elephant in the room. The specifics of what measure, rates, etc are harder to determine. The interesting point would be the infrastructure spending as it is privately funded.




JVS: Do you know the actual cost of capital calculation? If you lower the cost of capital would you also consider replacement costs instead of book costs in calculating return on investment?


LM: The replacement cost issue has been part of the cost of capital discussion. The railroad industry has submitted material supporting that approach. The board was not supportive of that approach but now they have opened up a proceeding. This tells me they want to look at it as the record may have changed.


JVS: They currently use book costs even though they are old assets?


LM: Yes. 


JVS: Do you have a sense of the total calculation of it? 


LM: I do not. I know the elements of it. The main element of the book value versus the replacement costs. It is a model the board uses with inputs. 


JVS: Is that calculation transparent?


LM: Yes, transparent in the sense the aggregate numbers are transparent.




JVS: Can you give a sense of the regulatory reform being thrown around in Congress and any specific changes and impacts on revenue adequacy?


LM: The first is what Congress has been looking at. Two, what would be the possible discussions involving revenue adequacy. Let me take the first part first. The reform legislation, Senator Rockefeller (sp?) of WVA has been championing this (he is retiring this year) for the shippers who are concerned of too high rates. First, they are concerned with the access issue by rates or routes upon demand. Second, rate complaint specifics and process. The customers have felt for awhile that the process is too cumbersome and costly. They do not have a process to reject reasonably high rates. Third, eliminates the anti-trust exemption that the railroad industry enjoys. There are activities that the railroad industry that can get involved in: mergers, pooling of agreements, and other joint ventures that regulated by the STB but not the Department of Justice. The customers feel that if this anti-trust exemption was removed that would ensure more competition after this period of consolidation. None of these have been passed but is part of the rail package in Congress. 


Turning to your second question about revenue adequacy: this is an area where Congress has not spent any time on. As someone representing the customer community we will have to keep the railroad industry from keeping excessive profits but I am not sure Congress has focused on it and the STB will have to undertake. 




JVS: Who are the key players in Congress and the other side defending the rail industry? Where are these efforts directed?


LM: Sure, Chairman Shuster of the Transportation & Infrastructure Committee. He has been clear that he is not a fan of regulatory reform. He likes the law as it is. Congressmen Rahall shares a similar view. On the Senate side Rockefeller (sp?) Senator Soon (sp??) are more favorably disposed to the regulatory scheme. 




JVS: Touching on the two safety issues you highlighted earlier, PTC and car integrity: what is the probability of those issues being implemented?


LM: I think PTC is going to get extended for some period. I do feel Congress understand the implementation and favor it. As for the car integrity, this seems more likely to be implemented before the PTC. However, there are some concerns such as what is actually coming out of the ground being put into the cars. If we can figure out what materials are inside the car we can measure the flammability to prevent accidents. That is more of a possibility and involving the customers as well versus replacing all the current cars. 




JVS: There sounds like there is need for more investment in tank cars as well


LM: Absolutely.


JVS: I just wanted to make sure the key points come out. The cost of capital proceeding looks like it will take a year or two to be determined.


LM: Yes, that's my guess. 


JVS: In terms of the recent revenue adequacy findings there is no determination that will impact rate decisions but whether the STB will be tougher on ones that are more revenue adequate versus not revenue adequate?


LM: There was actually a rate case filed against Norfolk Southern by the shipper, which claimed that this case should be handled differently because they are revenue adequate. That case was turned as the saying goes. If there was another case in which the railroad company is revenue adequate in which case the board would decide to look at this bigger issue. 


JVS: So if the precedent is set for railroads being treated differently on the basis of revenue adequacy that could be determined anytime? 


LM: That could be. I would offer that this is a huge issue of revenue adequacy, reaching it, and changing how the railroads are regulated. It is the underpinning if you will. It will not be arrived lightly. If it comes to the board they will dig into it. 


JVS: You would expect it anytime?


LM: It is hard to tell. It is a question of whether you have the right case for instance. It will take time to resolve it.


JVS: Would it be a year to resolve it?


LM: No, this is a big issue. It would take a couple of years to resolve.




JVS: How would track the case if it came up targeting revenue adequacy, would we see it in the proceedings of the STB?


LM: Yes in addition to a press release either by the STB or a company.



[video] Jordan: Uber-Bearish on Regional Casinos


Earlier today the Hedgeye Macro Team, led by CEO Keith McCullough, hosted their quarterly Macro Themes conference call in which they detailed their Top 3 Global Macro Investment themes for 1Q14.  The Replay and Presentation Materials can be accessed via the links below.






#InflationAccelerating: Across the globe, reported inflation readings are poised to accelerate from post-crisis lows as easy comps, a commodity base effect and accelerating wage pressures all come to a head in the first quarter of 2014. Moreover, the reemergence of inflation as a core macro risk threatens to materially alter the investment landscape going forward.

#GrowthDivergences: Looking to the U.S., Europe, China and Japan, we see the heavyweights of the world economy diverging from an economic growth perspective as some countries and/or regions are much further along in the economic cycle than others. We highlight those divergences and identify which countries and/or regions you want to be allocating assets to at the start of the year.


#FlowShows: in Q1 we expect a continuation of fund flows out of fixed income and into equities: the "Queen Mary" has indeed turned, aided by the Fed's decision to begin tapering. 


- Hedgeye Macro

investing ideas

Risk Managed Long Term Investing for Pros

Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.

Accommodative ECB on Hold

  • This morning the ECB announced no change to its main interest rates (as expected – we also didn’t think a 25bps cut was warranted in the NOV ‘13 meeting).
  • President Draghi reiterated his inflation and economic forecast from last month.
  • Draghi reiterated that the Eurozone may experience a “prolonged period of low inflation” and the Bank would maintain accommodative monetary policy for “as long as is necessary” and to expect that key rates would remain “at present or lower levels for an extended period of time”.
  • Note that Latvia is now the 18th country to join the Euro.
  • To read a copy of Draghi’s prepared remarks click here.

 Investment Positioning

  • As we discussed in a European data update note yesterday, our preferred investment in the region is long German and UK equities (EWG and EWU) and long the Pound/USD (FXB) – note that today the BOE also left the main interest rate unchanged (at 0.50%) and maintained the asset purchase target (as expected), which is supportive of our long call.
  • Broadly, we believe Draghi’s continued posture of “ready and willing to act” (to ensure the survival of the Eurozone at any cost and keep financial conditions accommodative) will continue to support the common currency and strengthen investor confidence in the equity market.
  • EUR/USD: we expect Yellen to be a continuation of Bernanke’s dovish monetary policy, yet there was a hawkish tone to the Fed minutes this week which cautions our previous #EuroBull outlook.  We’ll be dependent on our quantitative lines (see levels below) to determine how to position ourselves from here.

Accommodative ECB on Hold - zz. eur usd


Matthew Hedrick



While well known, Q4 earnings should be terrific.  WYNN should lead the pack.

  • The charts below highlight our Macau property estimates and company EBITDA estimates relative to the Street
  • We’re projecting the most upside in Macau EBITDA for WYNN (2nd highest upside for company EBITDA) despite lower than normal VIP hold
  • MPEL could post the biggest beat with hold only slightly higher than normal
  • We’re projecting 20%+ GGR growth for Macau in January and February and if we’re right, Q1 estimates will need to be raised as well




E-Commerce: Watershed Moment?

Takeaway: A watershed year in the shift from "bricks and mortar" to

With virtually every single retailer posting disappointing sales, we wanted to highlight a crucial factor we believe is of paramount importance. 


It is our view that this holiday will go down as a watershed year in the shift from "bricks and mortar" to (Yes, we get that the weather was terrible as the month closed out and got worse in January.) 


E-Commerce: Watershed Moment? - bri8


The chart above clearly shows the steady increase over the past decade in e-commerce's share of total spending.


Bottom line? We think when this quarter's numbers are reported, it will reveal the greatest increase in the slope in the the history of the Internet.


E-Commerce: Watershed Moment? - 7789


Our belief is that shopping is ultimately behavorial. An increase in will only feed upon itself and continue to gain share in 2014 and ensuing years.  

This is an excerpt of Hedgeye Risk Management research. For more information on how you can subscribe to Hedgeye please click here.

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