Fitch: Healthy Economy Should Fuel U.S. Rail Performance in 2005.

CHICAGO -- Following a record year for freight volumes and revenues in 2004, Fitch Ratings expects another strong showing for the U.S. railroad industry in 2005. Fitch's economic forecast predicts a 3.3% increase in the U.S. gross domestic product in 2005, which should translate into continued growth

However, it is not expected that the railroads will use this increased free cash flow to make significant reductions to their debt loads in 2005. Recent activity suggests that the major class I railroads currently place a higher priority on returning excess cash flow to shareholders than they do on reducing debt. This, combined with the capital markets' continued appetite for railroad debt, suggests that, in general, the railroads do not feel pressure to substantially reduce their debt levels. Although the railroads will likely pay some debt maturities with cash on hand in 2005, as they did at times in 2004, Fitch believes that they will continue to focus primarily on finding ways to return cash to shareholders.

Macroeconomic forecasts for 2005 suggest that strong freight demand patterns will continue and that some modest rate hikes, likely in the 2% to 4% range, can be supported. Fitch's forecast of 3.3% growth in the U.S. gross domestic product is one percentage point lower than its full-year forecast of 4.3% for 2004. As the U.S. economy begins to throttle back somewhat from the relatively high growth level seen in 2004, rail demand should remain relatively strong. However, year-over-year carload and revenue growth figures will likely be lower than those seen in 2004.

Demands Outlook

Shipments of raw materials and finished goods are expected to remain strong as U.S. manufacturing output continues to grow. Coal volumes, which are responsible for approximately 21% of the revenue at the top four class I railroads, are expected to be robust. Coal demand from electric utilities, in particular, will remain strong due to a growing need for electrical power in the U.S., combined with a preference for using coal while natural gas prices remain high. If foreign demand for U.S. coal remains strong, CSX and Norfolk Southern, two class I railroads that operate predominately in the coal-rich eastern U.S., should continue to see strong export coal volumes, as well. Intermodal volumes, which lately have driven about 18% of revenues at the largest class I railroads, will also continue to increase, largely due to strong U.S. demand for imported goods and foreign demand for U.S. exports.

The one significant line of business in which Fitch expects potential revenue weakness in 2005 is auto shipments. With questions surrounding inventory levels at the domestic 'Big Three' auto manufacturers, Fitch expects North American auto production will be flat or slightly down in 2005 versus 2004, depressing railroad revenues in that area. Among the top four U.S. class I railroads, Norfolk Southern has the most exposure to the domestic auto industry, with 13% of its operating revenue in the first three quarters of 2004 generated by auto shipments. Union Pacific, at 10%, has the second highest exposure.

Although the railroads have been adding capacity in 2004 to improve operational efficiency and customer service, Fitch expects capacity will continue to remain fairly tight relative to demand in 2005. The railroads have learned from their past mistakes and are now taking a measured approach to capacity growth, adding just enough capacity to improve their operational integrity. In particular, they are being especially careful to avoid the possibility that overcapacity will occur if U.S. economic growth suddenly slows or reverses. They are also keenly aware of the revenue benefits from limitations on capacity and, in some cases, are showing a willingness to turn away business that does not meet their profit objectives. Thus, the relatively favorable supply-demand relationship will continue and should provide some pricing power to the railroads in 2005.

Fuel Prices

Though fuel surcharges have been responsible for a portion of the overall increases in revenue per carload seen in 2004, tight supply of capacity relative to demand has allowed the railroads to increase their spot rates and to negotiate more favorable pricing terms when contracts are renewed. It is unclear how much of the 2004 price increase has been due to surcharges, as most railroads will not disclose that information for competitive reasons. However, in their 2005 planning, the major carriers are looking at opportunities to further increase their rates, as well as to incorporate fuel surcharges into many of the contracts that have not had them in the past.

As with all parts of the transportation sector, oil prices will continue to be a concern of the railroads in 2005. Oil prices are generally forecasted to remain relatively high in 2005, which will continue to negatively impact operating costs, as diesel fuel accounts for roughly 12% of the average class I railroad's operating expenses. However, three of the top four class I railroads have significant portions of their expected 2005 fuel requirements hedged, the exception being Union Pacific. Combined with fuel surcharges, hedging should significantly mitigate the pressure of high fuel prices in 2005. However, the biggest concern of high oil prices is not the effect that diesel fuel costs have on operating expenses but, rather, the potentially negative consequences that sustained high prices could have on the U.S. economy. Should high oil prices begin to slow growth in the economy beyond what is currently forecasted, the railroads are concerned that transportation demand will wane and revenues will suffer.

High fuel prices do have some positive effects in that they magnify the cost differential between railroads and trucks, as trains are relatively more fuel efficient than trucks. The railroads generally view the trucking industry as their primary competition, and as fuel prices remain relatively high in 2005, the railroads' competitive position will be strengthened. In some ways, this can be viewed as a 'natural hedge' against high fuel costs. It is likely, in fact, that the trucking industry will contribute directly to higher rail revenue as it finds intermodal trains an increasingly cost effective way to move trailers and containers over long distances.

Pension Issues

One of the biggest issues facing a number of U.S. 'old-line' industries is the significant level of underfunding in many defined benefit pension plans. Although the major U.S.-based class I railroads maintain defined benefit pension plans for non-operational employees, the majority of railroad employees are covered by the federal Railroad Retirement Plan. As such, although several of the largest U.S. railroads have defined benefit plans that are significantly underfunded, the size of the plans and required contributions are relatively small. Although it is likely that the railroads will make contributions to their defined benefit pension plans in 2005, Fitch does not expect that the amounts contributed will be enough to significantly constrain free cash flow generation.

Rail Capacity and Financial Outlook

With solid economic growth in the U.S., 2004 has been a banner year for U.S. railroad industry volumes and revenues. Following a drop in demand that began during the most recent recession, business began picking up for the rail industry in the latter part of 2003. By early 2004, with the economic recovery in full swing, growth in manufacturing output and increased import and export volumes supported demand for rail transportation at record levels. Demand was also high for other railroad staples such as coal, chemicals, and agricultural products. Adding to railroad demand was a shortage of truck drivers that led to capacity constraints in the trucking industry. Through the end of the third quarter of 2004, year-to-date operating revenues at the top four class I railroad companies were up 8.3% from the same period in 2003. Collectively, the same four companies posted a 5.9% increase in transported carloads and, importantly, a 3.0% increase in revenue per carload.

Against this backdrop of increased demand was a relatively constrained supply of rail capacity. During the recession, the railroads cut back on spending and non-essential investments in track and equipment. They also took steps to reduce employee headcount. However, subsequent to these cut-backs, the relatively brisk recovery in the U.S. economy, combined with the trucking shortage, meant that rail demand quickly exceeded available capacity. Although this supply-demand scenario helped boost railroad revenues, the sudden increase in demand also quickly revealed the weaknesses in railroads' networks. While revenues were up, profitability was challenged as some major rail carriers, most notably Union Pacific and CSX, saw the fluidity of their networks decline. Average train velocities at these carriers fell, and their cars spent increasing amounts of time parked in rail yards. The percentage of on-time departures and arrivals was down sharply, while labor costs were pressured as increasing numbers of standby crews were needed to operate trains when scheduled crews were out of position.

Reacting to this decline in performance, the major railroads have begun focusing on correcting operational problems and are taking steps to add capacity where necessary to improve the flow of their networks. They are growing capacity through a combination of adding locomotives and rail cars, hiring train and engineer employees, and reworking their networks to improve operational fluidity. Union Pacific is in the process of adding over 700 locomotives to its system and hiring 5,400 train and engineer employees. CSX is also adding a significant number of locomotives and employees and has launched an initiative it calls the 'ONE Plan' that aims to improve network flow and available capacity by optimizing car routings. The railroads' focus on improving network efficiency should begin to yield results in 2005. Although the additional capacity will result in some higher costs, particularly in the areas of labor and equipment leases, and may also drive marginally higher levels of capital spending, these increases should be offset by savings related to better network utilization. This should translate into lower costs per carload and improved operating margins.

As the railroads' financial position has begun to improve, returning cash to shareholders has become a key priority. As share prices have risen, this has generally been accomplished through dividend increases, rather than share repurchases. Currently, BNSF is the only U.S.-based class I railroad with a share repurchase program in place. However, three of the four class I railroads have significantly increased their quarterly dividend payouts since early 2003.

Between the first quarter of 2003 and the third quarter of 2004, Norfolk Southern increased its quarterly dividend by 43%, BNSF by 42%, and Union Pacific by 30%. However, CSX kept its quarterly dividend constant. Over the past 12 months, Union Pacific used $291 million in cash for dividend payments, while cash used for dividends was $224 million at BNSF, $133 million at Norfolk Southern, and $86 million at CSX. Fitch expects that higher levels of predividend free cash flow will lead the railroads to consider further dividend increases or share repurchases in 2005. However, with relatively high stock prices, the railroads are likely to favor increasing their dividends over repurchasing shares.