Larkin Says: One can only logically ponder the question of whether or not railroads have an end in sight to the lackluster asset utilization without simply opening the checkbook on enormous capital expenditures. What Do You Say? Click Here to Send Us Your Comments Click Here to See Reader Feedback

New Expert Insight Column on SCDigest: We have partnered with Stifel Financial Corp. to publish its weekly recap of the week in transportation, written by well-known analyst John Larkin. Check the SCDigest home page each Monday morning for the latest edition.

Takeaways from This Week's Fundamental Research

Railroad service and performance has yet to improve since last winter: While we have repeatedly heard from railroaders across the country that Chicago is "back to normal" we have yet to see an improvement in rail operating performance (velocity, dwell, cars on line) or service (CSX, again, reported 43% quarterly on time arrivals during its investor conference call this week). Performance statistics are lapping the middle of last year's wintery Armageddon and y/y comparisons show a continued degradation with cars on line up 13.4%, velocity down 1.7%, and dwell up 2%.

One can only logically ponder the question of whether or not railroads have an end in sight to the lackluster asset utilization without simply opening the checkbook on enormous capital expenditures, such as the one BNSF has recently submitted to. After the Staggers Rail Act through the 1980s and 1990s, railroads were able to successfully grow in both size and
profitability through a combination of consolidation, improvement in operational efficiency, and effective train management; however, those lemons appear to be squeezed fairly dry. The scenario at the beginning of this century is evolving into a landscape that requires thoughtful capital allocation, targeted customer selection, growth with lane density, and integration with broader supply chains.

Investment conclusions: We currently see the Class Is as fully valued with the exception of Kansas City Southern (KSU; Sell; $109.98) which from a valuation point of view we see as being overvalued relative to our 12-month fair value of $94 (or 15x our 2016 EPS estimate of $6.28), which implies 14.5% downside potential over the coming year. Economically speaking we don't anticipate Mexican growth to be as rapid or robust as management projects with a government shaken by low oil prices and lacking a history of fostering strong business, a near-shoring trend which is quickly looking more like an on-shoring trend (i.e. to the USA), and Vancouver being the preferred alternate water port to Lázaro Cárdenas when avoiding the American west coast. We do see Genesee & Wyoming (GWR; Buy; $84.53) as currently undervalued with a
12-month target price of $99 (or 17.5x our 2016 EPS estimate of $5.65), which implies 17.1% upside potential over the coming year.

GWR is the nation's largest regional and short-line railroad holding company with international operations and a recent track record of accretive acquisitions, which benefits from the fragmentation within the short line railroad segment and recurring (but not guaranteed) tax breaks.

GWR TP Risks: Economic contraction would impair freight volumes, leading to a negative variance between reported EPS and our estimates. Government intervention on rail rates is possible as part of the STB reauthorization bill or other legislation, and would impair pricing leverage. Natural events, such as sever weather conditions (blizzards, floods, fires, hurricanes, etc.) could have potentially negative ramifications on the company's profitability. Further decline in oil prices could render domestic production uneconomic, and would negatively impact volume growth for the company. GWR's ability to succeed in implementing its strategic plans and operational objectives and improving operating efficiency will have an impact on the GWR's profitability.

Prices as of close 01/16/2015.

Key Insights from the Analysis of Industry Data Feeds

Trucking: Spot demand ticked up in W01 back toward levels seen at the beginning of December. The ITS Market Demand Index (MDI) measured 17.14 (+9.94% sequentially). As well, the MDI was up 8.75% y/y, compared to an average y/y level of 26% through 4Q14—the prior three weeks have seen spot demand return to much more normalized levels.

For 4Q14 as a whole, the MDI was up 25.1% y/y, nicely improved over 2013 levels, but nothing compared to the 70.9% and 50.7% y/y increases seen in 2Q14 and 3Q14, respectively. On a sequential basis, the MDI for 4Q14 was down 28.7% from the average level seen during 2Q14 and 3Q14.

Load-to-truck ratios on DAT, another measure of relative spot demand, also ticked up on dry van 18.2% sequentially and 31.4% refrigerated sequentially; flatbed was down 10.8% (note: flatbed has exhibited significantly higher volatility on a week-to-week basis than other equipment types in 2014). DAT's load board has shown slightly more stable spot demand indications than MDI, but trends have been the same directionally. For 4Q14 as a whole, dry van load-to-truck was up 17.8% y/y, a bit less impressive than the 38.4% and 20.7% y/y increases seen in 2Q14 and 3Q14, respectively.

Spot rates were down in W01 on a sequential basis, but still remain elevated y/y. On ITS, the overall equipment rate decreased 6.5% sequentially to $2.16, largely driven by an 8.6% decrease for dry van equipment and a reefer decrease of 7.7%. On DAT dry van decreased 3.4% with reefer and flatbed both down a modest 0.4%. For 4Q14 as a whole, overall equipment spot rates were up 7.6% y/y on ITS, while dry van rates were up 8.4%. On DAT, dry van rates were up 8.1% y/y in the quarter.

Rail:

Total unit volume (i.e. commodity carloads & intermodal units) showed a sequential decrease of 10.3% but a y/y increase of 17.7%. This is a reflection of both a soft 15W01, but an even weaker baseline as a result of the Armageddon-like winter this time last year. NSC's large volume gains are driven largely by a weak comp, while UNP's reduced carload volumes are driven by a softening of their energy franchise.

Class I performance metrics still remain at depressed levels, but have begun to turn full cycle into the beginning of the deterioration last year and have reset their baselines to unimpressive levels. High carload demand, matched with infrastructure challenges, has made a full correction near impossible, but it seems unlikely that conditions should worsen from this point—as significant investment has been made on the part of the railroads and we do not often see winter conditions as difficult as we saw last year. For W01 velocity was down 1.7% y/y, dwell was up 2.0%, and cars on line were up 13.4% y/y. So despite a poor baseline, railroads are still not improving performance.

Editor's analytic note: This past year presented an atypical calendar year that resulted in 53 weeks for purposes ofcarload calculations, with a partial at the end of the year. Our methodology of adjusting for this is to allocate the splitfreight into 14W52 and 15W01 based on which days are in which year. This is done to more accurately reflect whichperiods revenues will be attributed to, but proved a short run challenge in comps. Each week is modeled off of a seven day run rate.

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