Renaissance: Rails, Returns, Capital & Capacity

Anthony B. Hatch – abh consulting 155 W68th Street NYC 10023 (212) 595-0457

ABH18@mindspring.com::

Indiana Logistics Summit

November 14, 2006November 14, 2006

Railroads at historic tipping point

Capacity issues across all modesCapacity issues across all modes Volume increasingVolume increasing Share increasingShare increasing Rates increasingRates increasing Services levels (yes) increasingServices levels (yes) increasing Returns increasingReturns increasing A A secularsecular, not a cyclical story, not a cyclical story Capacity and infrastructure – and competitor - issues Capacity and infrastructure – and competitor - issues

remainremain Not fully reflected in the market?Not fully reflected in the market?

Show Me the Money

Share Price is Share Price is thethe Indicator – over time! Indicator – over time! Cash (Flow) is KingCash (Flow) is King High ROIC = High Stock PriceHigh ROIC = High Stock Price And Vice VersaAnd Vice Versa Key is the phrase “through a cycle”Key is the phrase “through a cycle” Old Model: DisinvestmentOld Model: Disinvestment New Model: TBDNew Model: TBD

Spending $: Mgmt.’s #1 Decision

Capex for Maintenance – “base”Capex for Maintenance – “base” Capex for Capacity, Service & GrowthCapex for Capacity, Service & Growth DividendsDividends Share BuybacksShare Buybacks M&A – StrategicM&A – Strategic M&A – Non-strategic (conglomeracy)M&A – Non-strategic (conglomeracy) How management allocates indicates confidence How management allocates indicates confidence

& direction and impacts all stakeholders& direction and impacts all stakeholders

Virtuous Circle 2006

Better returns (half Better returns (half finallyfinally earn returns earn returns equal to the cost of capital)equal to the cost of capital)

Better stock prices Better stock prices Better revenue prospects – up double digit Better revenue prospects – up double digit

’04-05’04-05 Equals more investment – capex up sharply Equals more investment – capex up sharply Equals more capacity, better serviceEquals more capacity, better service ……equals better returns and growth….equals better returns and growth….

Railroad Stock PricesJanuary 2001 – October 2006

050

100150200250300350400450

01-Jan

01-July

02-Jan

02-July

03-Jan

03-July

04-Jan

04-July

05-Jan

05-July

06-Jan

06-July

S&P500 BNI CSX NSC UNP CNI CP

Index Jan 2001 = 100

Sources: MSN and CSI, Inc.

S&P 500 and RailroadsMonthly Data January 1980 – October 2006

Index Jan. 1980 = 100

Sources: MSN and CSI, Inc.

0

200

400

600

800

1000

1200

1400

Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05

S&P500 Railroads

10.3%

11.3%

12.3%

16.1%

16.9%

18.7%

28.4%

24.9%

Forest Products

Electric Utilities

Railroads*

All Industries

Autos & Parts

Chemicals

Pharmaceuticals

Oil & Gas

*BNSF, CSX, NS, and UP Source: Business Week

Even With Booming Traffic, Rail Earnings Are SubstandardMedian Return on Equity in 2005 (S&P 500 companies)

RR CoC vs. ROIC -stocks have done well but… they still trade at a discount to all stocks

0%2%4%6%8%

10%12%14%16%18%20%

81 84 87 90 93 96 99 02 05

Source: Surface Transportation Board

Cost of Capital

Return on Investment

Railroad Capital ExpendituresClass I Railroads

$0

$2

$4

$6

$8

$10

80 82 84 86 88 90 92 94 96 98 00 02 04 06

Billions

Source: Railroad Facts, AAR

e

Capital Expenditures as % of Revenue

Source: Census Bureau, EEI, AAR

Food – 2.6%

Transportation equipment – 2.8%

Petroleum & coal products – 3.0%

Wood products – 3.0%

Average all manufacturing – 3.5%

Chemicals – 4.4%

Nonmetallic mineral prod. – 5.4%

Paper – 4.7%

Fabricated metal products – 3.5%

Electric utilities – 11.6%

Class I RRs – 17.8%

Railroad PerformanceClass I Railroads

050

100150200250300

64 68 72 76 80 84 88 92 96 00 04

Index 1981 = 100

Source: Railroad Facts, AAR

Productivity

Volume

Revenue

Price

Railroads and the EconomyClass I Railroads

0

50

100

150

200

250

80 82 84 86 88 90 92 94 96 98 00 02 04

Industrial ProductionRail FCS Carloads

Index 1980 = 100

Sources: Federal Reserve System and AAR

Railroads and the EconomyClass I Railroads

0

50

100

150

200

250

80 82 84 86 88 90 92 94 96 98 00 02 04

Industrial ProductionRail Ton-Miles

Index 1980 = 100

Sources: Federal Reserve System and AAR

Railroads and the EconomyU.S. Railroads

0

100

200

300

400

500

80 82 84 86 88 90 92 94 96 98 00 02 04

Industrial ProductionRail Intermodal

Index 1980 = 100

Sources: Federal Reserve System and AAR

Railroad Intermodal Revenue Growth Over 5% - Long Live the New King!-

19901995

20002005

.

$0

$2

$4

$6

$8

$10

$12

$14

Bil

lion

s

Source: Carload Waybill Statistics (includes non-Class I railroads)

Coal Intermodal

Intermodal Growth DriversDomestic and International GlobalizationGlobalization TradeTrade Railroad Cost Railroad Cost

AdvantagesAdvantages Share Recovery From Share Recovery From

HighwayHighway Truckload IssuesTruckload Issues

Serious U.S. Transportation and Congestion Problems High Cost of Highway High Cost of Highway

Maintenance and Maintenance and ConstructionConstruction

Interdependence of ModesInterdependence of Modes $67 billion per Year Drag $67 billion per Year Drag

on Economyon Economy Demand for Freight Demand for Freight

Transportation to Double Transportation to Double by 2020by 2020

Coal and Ag – Bulk Comeback

New growth mode?New growth mode? Emissions and environmental issuesEmissions and environmental issues Oil prices and coalOil prices and coal Politics and coal; and grain/reregPolitics and coal; and grain/rereg EthanolEthanol ExportsExports FeedFeed

Major Sources of Railroad RevenueClass I Railroads, 2005 Gross Freight Revenue in billions

Source: AAR *Estimated. Some intermodal revenue is also included in individual commodities.

0% 5% 10% 15% 20% 25% 30%

Coal - $9.4

Chemicals - $5.4

Transportation equipment - $4.0

Farm products - $3.6

Food - $3.3

Lumber & wood - $2.3

Pulp & paper - $2.0

Primary metal products - $1.7

Stone, clay & glass products - $1.5

Nonmetallic minerals - $1.3

Intermodal* - $10.1

Railroad Rates- the old story Class I Railroads, Revenue Per Ton-Mile

0123456

80 82 84 86 88 90 92 94 96 98 00 02 04

Cents

Source: Railroad Facts, AAR

Current $: Down 9% since 1980

Constant $: Down 56% since 1980

Pricing - the new paradigm Rates up 3% in ’04 – post-Staggers bestRates up 3% in ’04 – post-Staggers best Up 11%Up 11% in ’05 (Secular rate of 2-3%?) in ’05 (Secular rate of 2-3%?) Fuel surcharges similar to TLFuel surcharges similar to TL Yet Price Gap to the highway Yet Price Gap to the highway widening, even in ’05 and widening, even in ’05 and

’06 YTD’06 YTD Capacity (still) short across all freight modes, despite Capacity (still) short across all freight modes, despite

temporary surplusestemporary surpluses Rails moving toward tariff and spot marketsRails moving toward tariff and spot marketsConclusion: Conclusion: Best Ever Rate EnvironmentBest Ever Rate Environment““The new Golden era” – cost of capital The new Golden era” – cost of capital within sightwithin sight; not there ; not there

yetyet

RRs and Investment

Is growth affordable? Capex up 10% in ’07?Is growth affordable? Capex up 10% in ’07? Can the intermodal model extend to carload?Can the intermodal model extend to carload? Is additional capacity necessary? Desirable?Is additional capacity necessary? Desirable? Wall Street’s constrictive role (“fighting the Wall Street’s constrictive role (“fighting the

last war”) – last war”) – changing?changing? Is this disconnect between the Renaissance Is this disconnect between the Renaissance

and the Street the opportunity of a lifetime?and the Street the opportunity of a lifetime?

Sources of capital

FCF – booming at most carriers (capex vs. FCF – booming at most carriers (capex vs. ROIC)ROIC)

Governments – states, PAs, FedsGovernments – states, PAs, Feds Governments – Canada as contrastGovernments – Canada as contrast Traditional Street sources & BanksTraditional Street sources & Banks Private EquityPrivate Equity

Railroad Issues Fall 2006 Economic/industrial recovery - durabilityEconomic/industrial recovery - durability Service metricsService metrics – recovery or a meltdown (again)? – recovery or a meltdown (again)? Trucking troubles also a Trucking troubles also a secularsecular issue issue Capacity – coming shortage? Capacity – coming shortage? Or “creative tension”?Or “creative tension”? Intermodal – new king of the hillIntermodal – new king of the hill Coal and Grain: Comeback? Thanks to oil!Coal and Grain: Comeback? Thanks to oil! Is Growth Affordable?Is Growth Affordable? (Who will pay?) (Who will pay?) Alliances vs. Mergers?Alliances vs. Mergers? Hurricanes, other AoGHurricanes, other AoG Labor – 1 Man Crews off the table? Coming shortage?Labor – 1 Man Crews off the table? Coming shortage? Safety and security – new risk?Safety and security – new risk?

ABH ConsultingAnthony B. Hatch155 W. 68th StreetNew York, NY 10023(212) 595-0457ABH18@mindspring.com

“Big Six” Rail H106 results

All six beat Street consensusAll six beat Street consensus EPS up an average 58% vs. tough comps; range EPS up an average 58% vs. tough comps; range

from +27% to +140%from +27% to +140% Revenue growth averaged 14%Revenue growth averaged 14% Estimated Yield growth (ex FS) was 6%Estimated Yield growth (ex FS) was 6% Fuel surcharges added another ~6%Fuel surcharges added another ~6% So Far Q306 5 for 5 beating Street; solid So Far Q306 5 for 5 beating Street; solid

forecasts (DPS increases, share buybacks & forecasts (DPS increases, share buybacks & splits) – operating ratios in the 50s?!?splits) – operating ratios in the 50s?!?

Capital Expenditures 2005Class I Railroads

All Other11%

Locos9%

Ties18%

Rail & Track Material

26%

Ballast10%

$6.4 billion for Roadway & Structures and Equipment

Source: AAR and R-1 annual reports

Excludes new operating leases.

TOFC/COFC Terminals 2%Public Improvements-Const. 2%Computer Systems & WP 2%Freight Cars 3%Grading 3%Bridges, Trestles & Culverts 6%Signals and interlockers 8%

New Freight Car DeliveriesRailroad and Private Owners

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

Beginning 1995, Canadian cars included with U.S.

New Locomotives InstalledU.S. Class I Railroads

0

200

400

600

800

1000

1200

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

Note: New locomotives may also be installed by Canadian, Mexican, or U.S. regional railroads.

Return on Total Capitalby Industry 2001-2004 average

5.2%6.0%

7.3%8.7% 8.9%

14.3%

Auto Railroad Hotel Trucking Airline PackageDelivery

5.2%6.0%

7.3%8.7% 8.9%

14.3%

Auto Railroad Hotel Trucking Airline PackageDelivery

Railroad Return on EquityClass I Railroads

0%

2%

4%

6%

8%

10%

12%

14%

91 92 93 94 95 96 97 98 99 00 01 02 03 04 05

n.m. - not meaningful (negative value) Source: Railroad Facts, AAR

n.m.

Railroad Employee ProductivityClass I Railroads, Ton-Miles Per Employee

0

2

4

6

8

10

12

80 82 84 86 88 90 92 94 96 98 00 02 04

Source: Railroad Facts, AAR

Millions