DBRS Comments on New U.S. Railway Company Ratings

Dominion Bond Rating Service (“DBRS”) has today assigned ratings to the U.S. Class 1 railway companies as follows:

Burlington Northern Santa Fe Corporation – BBB (high)p, Stable trend
Norfolk Southern Corporation – BBB (high)p, Stable trend
CSX Corporation – BBBp, Stable trend
Union Pacific Corporation – BBBp, Stable trend

DBRS is upgrading coverage to include credit ratings following several years of producing research on each company. DBRS’s decision to proceed as such is based on growing interest from institutional investors, who are demanding greater diversity in credit research. The “p” indicates DBRS has used public information only.

DBRS’s newly assigned credit ratings are based on a number of factors, including:
(1) Industry risk – competition, evolving products, and consolidation/structural change;
(2) Company risk – performance measures, operating margins, and return on equity (ROE);
(3) Financial risk – leverage, maturities, leases, and off-balance-sheet items; and
(4) Liquidity risk – capital market access, cash, bank lines/commercial paper.

The U.S. Class 1 rail industry has historically been characterized by slow growth and aggressive leverage. However, the financial profile of the industry has gradually strengthened over the past several years, with significant improvement in 2004 and into 2005. U.S. economic growth, surging Asian trade, and strong commodity markets led to rising demand and above-average volume growth. Combined with tight industry capacity, this has resulted in pricing power for the rails for the first time in decades, and primarily drove the rebound in earnings. Earnings growth largely contributed to increased average free cash flow, despite high and rising capex requirements for locomotives and network investments. The U.S. rails have used free cash flow toward debt reduction. However, debt-to-total capital (adjusted) remains moderately aggressive, averaging approximately 52%.

Network fluidity has emerged as a key issue impacting the U.S. rail industry. The railroads with sufficient capacity, namely Burlington Northern Santa Fe Corporation and Norfolk Southern Corporation, have benefited from rising demand and are rated highest by DBRS. This is primarily due to their resulting above-average profitability and strong growth profile. In contrast, the railroads experiencing network congestion-related issues, including Union Pacific Corporation and CSX Corporation (“CSX”), have lower credit ratings largely due to higher service-related costs. However, network upgrade initiatives are being implemented and are expected to improve fluidity and earnings over the near to medium term.

Fuel costs have become an increasingly larger share of total rail expenses, given the sharp rising in diesel prices. However, the implementation of surcharges by the rails in 2004 was a first for the industry, and has helped mitigate the impact of high fuel costs on margins. Furthermore, rail competitiveness increases relative to trucks, as rails are far more fuel efficient. A longer term issue facing the industry is the macroeconomic impact of high/rising fuel prices.

Over the near term, the outlook for the U.S. rails is favourable. Further price increases and fuel surcharges are expected from continuing strong supply/demand fundamentals, and are likely to lead the growth in earnings and free cash flow. Furthermore, most of the rail companies remain committed to debt reduction. Stronger balance sheets will better position the rails to weather future downturns.

The longer term earnings outlook has improved for the U.S. rail companies. Even though volumes have generally followed domestic GDP, there are developments that will help support stronger growth for the rails, including: (1) truck industry challenges (i.e. road congestion, labour shortages, high fuel costs, and more stringent regulations), which are expected to lead to rail market share gains, (2) increased rail industry discipline, and (3) price sustainability, following years of gradual declines. Hence, margins are expected to trend generally above historical levels.

For more information on these credits or on this industry, visit www.dbrs.com or contact us at: info@dbrs.com.