Rough Ride for Railroads. Plus, Big Tech Earnings Preview

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Even with less volume, we've seen the rails really struggle to be able to hold up their end of the bargain from a service perspective. Headcount seems to be a big piece of that. All of the rails have talked about trying to hire and sort of long pipeline and extensive training process that goes into bringing new employees onto the network, but they've struggled to do that.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Christian Weatherby. He's a transportation analyst at Citigroup, and he's talking about freight railroads. They've been solid stock market performers over the past decade, but Service has been slipping and workers are unhappy. The industry just narrowly avoided a strike. Christian thinks railroad earnings estimates could be too high. We'll hear more about that in a moment. And we'll preview upcoming earnings reports for big tech. Listening in is our audio producer, Jackson. Hi, Jackson.

Hi, Jack.

How's your heat wave going?

I got this window AC unit, but I had to turn it off because it's too loud for the podcast. So we'll see how it goes.

Well, we'll stop if we need to along the way to give you an AC break.

We're already up 2 degrees.

Oh, you know, things are tough all over. On my daily big screen treadmill hikes that I'm taking, I've had to switch to snowy locales to stay mentally cool.

Oh really? Yeah. What do you got up there? What are you looking at, like icebergs?

I'm doing a Himalaya trail now. I'm on my way to Everest base camp, virtually.

Well, I'm gonna give you a virtual kudos there.

Let's take a quick look at expectations for FAANG stocks. FAANG, of course, is the acronym for Facebook, Amazon, Netflix, and Google. You can double up on the A's to add Apple if you want. Still pronounce Fang, not Fang. If you want to add Microsoft, you can make Fanmag. And with Tesla, you get Fatman G. Only Facebook is now called Meta Platforms, and Google is of course Alphabet. So technically, that leaves Tan Mama. Seems inappropriate, but I don't make the rules. Now, one of the Tan Mamas has already—

Jack, it's not catching on. It's official.

How could you possibly—

the poll numbers just came in. Everyone hates it.

That was fast.

Fatman G pulled a little better for the record.

One of the tech giants reported quarterly results this past week. Netflix's prior two reports could hardly have been more disastrous. The stock plunged 21% after the company reported fourth quarter results from last year and another 35% after first quarter results from this year. At the time, it predicted that it would lose 2 million subscribers during the second quarter, and that pretty much marked the company's abrupt shift from a fast grower to a former grower. Well, it turns out that it lost fewer than a million subscribers during the second quarter, not 2 million. Bulls said that it beat expectations. Bears said that it just set expectations sufficiently low. Either way, the stock gained 7% in response. The company didn't give many details about its plans to launch a cheaper ad-supported subscription tier, which seems like the key to restarting growth. If many Netflix subscribers trade down, it will have to sell a lot of ads to make up the lost revenue. And if it wants to run ads against all of its content, it might have to pay more money for additional rights on content that it doesn't own. Netflix said that if it wanted to, it could launch the cheaper tier today with enough content to provide a good experience. It plans to launch the service early next year, and it will use Microsoft as a partner. Netflix stock recently went for $224 a share, down from an all-time peak of around $700 a share last fall. And speaking of Microsoft— It reports quarterly results on Tuesday, July 26th. Alphabet reports the same day and Meta the following day, and Amazon and Apple the day after that. 3 of those will give a good read on cloud computing spending. UBS says its conversations with big cloud customers show little slowdown in spending momentum. One analysis of cloud spending earlier this year found that it grew 34% during the first quarter. And that Amazon was the clear leader with a 33% share, and Microsoft was second at 22%, and Alphabet third at 10%, and that Microsoft had been gaining share. Amazon, of course, will have something to say about its retail business and the success of its Prime Day sales event. BofA Securities, which calls Amazon its top FAANG pick, says that Bank of America credit card data points to healthy e-commerce spending. But it recently lowered its sales and profit margin estimates for Amazon just a smidgen to account for the effects of currency exchange and inflation. Alphabet and Meta will give a read on spending for online advertising. Shares of another ad-driven internet name, Snap, plunged this past week on a revenue and earnings miss driven by soft advertising trends. That company said it would slow hiring. Credit Suisse, which is bullish on Alphabet, nonetheless recently took down its earnings estimates because of what it describes as marketer feedback showing declining budgets due to economic uncertainty. Note that Alphabet has been the much stronger stock performer of the two ad giants. Its stock is down 11% over the past year. Meta stock is down 48%. Wall Street on average greatly prefers Alphabet stock from here But Morgan Stanley says it sees much more upside potential for Meta. That stock now trades at 18 times next year's projected free cash flow, assuming those estimates are reliable. TikTok is not part of this roundup because it's not publicly traded. It's owned by a privately held company in China called ByteDance, but it has seen massive success with short-form videos such that it forced Meta and Alphabet to respond with short-form video services of their own. Called Facebook Reels and YouTube Shorts. It will be interesting to see how those services are growing, not because they would move the needle much for Meta or Alphabet, but because those companies have such massive user bases to draw from that they could create headaches for TikTok. I noticed that TikTok just announced layoffs and that the market value that's implied for ByteDance by private investment transactions has been falling. Jaxon, what's left?

Apple and Tesla.

Apple is coming off what is typically a seasonally slow quarter for iPhone sales, and there have been supply chain disruptions, but UBS says that its checks on sales and supplier channels indicate that phone sales for Apple have been solid. Customers are buying higher-end models, and Mac computers featuring Apple's in-house chips have been selling well too. Apple has become boring in a good way, but its stock now trades at a sizable premium to the broad market relative to earnings. And that leaves Tesla, which reported results this past week. Profits were up versus a year ago but down from record profits the quarter before on COVID-related production shutdowns in China. Deliveries declined from the first quarter, but They reached a monthly record in the month of June, suggesting production is improving. The company stuck by its long-term goal of 50% yearly production growth, even though it said hitting that goal will be difficult this year. Investors like what they heard. Shares jumped 10%. And that takes care of TANMAMA, which now that I hear myself say it aloud again sounds awful. Jackson, I don't know what you were thinking when you came up with that one.

It's, it's starting to grow on me.

On now to trains after this quick break.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

Welcome back. Jackson, could I get a temperature check?

It's 75. It's like San Diego.

Is that what you're shooting for?

Not exactly, but let's hope we don't hit Phoenix anytime soon. I'm sorry, buddy.

Railroads are sometimes called the canary in the coal mine for the US economy because They carry roughly 40% of the country's long-distance freight. It's an awkward metaphor because much of what freight trains have historically delivered has been coal. Canaries are notoriously bad at predicting secular demand shifts, otherwise the one in the coal mine would have warned that American mines produced too little of the metallurgical coal used in steelmaking and too much of the thermal coal used in power plants. Which in the U.S. have moved away from coal in favor of cheaper and cleaner natural gas. That shift has been a challenge for railroads, but on the whole, the industry has gotten much more profitable over the past decade. Before I tell you about the Tennessee railman who made that happen, let's get a quick lay of the land. The rail business is a duopoly. Actually, it's three duopolies with 7 players, soon to be 6. It's a classic sextuplo-triduopolistic structure. Here's Citigroup transportation analyst Christian Weatherby.

You have CSX and Norfolk Southern, which are the two Eastern rails in the United States. They operate east of the Mississippi River. You have BNSF and Union Pacific west of the Mississippi in the United States. And in Canada, you have Canadian National and Canadian Pacific. Now they also kind of trend down into the United States, but as you sort of think about those three geographies we just talked about, you basically have 2 competitors in each one of those, 2 main competitors in each one of those, which I think has helped the competitive dynamic.

There's a 7th big freight railroad called Kansas City Southern, which operates between the U.S. Midwest and Mexico. It's being bought by Canadian Pacific to create the first Canada-to-U.S.-to-Mexico railroad. Technically, it has already been bought, but the share has been placed in a voting trust pending review by the Surface Transportation Board. Mergers in the railroad business are heavily scrutinized, and this will surely be the last big one for the foreseeable future. These 7 soon-to-be-6 freight railroads, plus Amtrak, the big passenger carrier, make up the Class 1 or largest railroads, and collectively they've shed 29% of their workers over 6 years. An early overreaction during the pandemic explains only part of that. The other part is called Precision Scheduled Railroading, or PSR. See, there was a Tennessee train executive called E. Hunter Harrison who worked for a company that was bought by Canadian National and ended up running Canadian National and then Canadian Pacific and then briefly CSX in the U.S. before his death in 2017. Freight rails historically used a hub-and-spoke system where trains ran once they were full and stopped at yards so that cars could be switched around so that each train was carrying similar goods. Hunter pushed for more of a passenger model where trains move at scheduled times from point to point with mixed goods and limited car switching. Does that make sense? The main takeaway is that Freight railroads have figured out how to move much longer trains using far fewer workers. That has reduced expenses as a percentage of revenues, and it's boosted profits, and mostly it's driven shares to outperform over the past decade. But now there are signs of strain. Here's Christian.

We've seen the rail struggle more with service than we really ever have seen them struggle with service, and they were challenged to some extent through the pandemic and did not win the pandemic in the respect that volume was market share was actually lost to truck in a pretty meaningful way over the course of the last several years. So even with less volume, we've seen the rails really struggle to be able to hold up their end of the bargain from a service perspective. Headcount seems to be a big piece of that. All of the rails have talked about trying to hire and the sort of long pipeline and extensive training process that goes into bringing new employees onto the network, but they've struggled to do that Freight rail volumes in June fell more than 3%.

At the much-watched Port of Los Angeles, containers are backing up again, and more than three-quarters of ones that have been sitting around for the longest are rail boxes. JP Morgan recently downgraded rail stocks, saying that the industry's inability to hire or even retain workers is the biggest obstacle to volume growth.. But finding workers isn't easy.

It is challenging to find someone who wants to be a railroad conductor or engineer. It means you're away from family for days or even weeks at a time. It's very long shifts. You're in the middle of nowhere.

That's Rachel Premack. She's the editorial director at FreightWaves, a research group.

It can be a kind of isolating and not a very sexy, exciting sort of job. So it definitely takes a certain type of person who wants to be be working on the railroads.

As Rachel puts it, there's no Top Gun type movie that glamorizes the freight rail industry. Technically, there used to be a reality show called Railroad Alaska, which had an avalanche and a bear attack and a porcupine infestation, but that's just not the same. Pay at freight railroads is good. Trainees can make more than $50,000 their first year. That compares favorably with starting pay for electricians and plumbers and carpenters. But the schedules are difficult. Many rail workers are always on call. If the phone rings at 3 a.m. on a holiday, a rail worker might have 90 minutes to report for a trip that will take him or her away from home for days. And as railroads have found themselves shorthanded, they've leaned harder on remaining workers. As you might imagine, that has not gone over well after so many years of layoffs.

Morale has just kind of crumbled. The hours are just much longer. You're away from home for much longer. And the people who are in the job, even though they have, you know, significant sort of benefits and pensions and all these sort of things built up, they're just like, I can't take this anymore. And the trainees who are trying to get into this industry, they're seeing what other folks in the industry are saying and they're like, I don't wanna be part of this either. I'll go work in construction or manufacturing, do something where I'll at least be home every night. Maybe I don't get the union benefits or the pension, but my day-to-day life is a little better.

The first major industry strike in 3 decades was recently dodged when President Biden ordered an emergency board to oversee talks between management and labor. That board will issue a non-binding recommendation on August 15th, and that starts the 30-day cooling-off period. After that, if there's no deal, workers could walk off. That's unlikely according to Susquehanna Financial Group. It points out that White House intervention has historically led to a deal, and that even if it doesn't this time, Congress can force a deal. But it also says that wage increases could come in well above what much of Wall Street is predicting. That would pull down earnings estimates. Workers are the biggest cost for railroads at around 20% of expenses. Citi recently downgraded US rails, not just because of difficulty hiring or the threat of big raises cutting into profits, but for something altogether different—signs that economic growth is deteriorating. I asked him if he thinks rails can regain any of the share they've lost to trucks. He does.

You do have shippers who are going to be under some degree of pressure from a decelerating economy and maybe lower demand for the goods that they want to ultimately sell. And this is a cost savings opportunity, particularly if fuel prices remain high. Rail is significantly more fuel efficient than trucks. So generally you'd be saving on the base rate that you'd be paying. You'd also be paying less from a fuel surcharge perspective. So I think there is compelling economic reason for shippers to trade down from truck to rail in a more normalized demand environment.

I asked what it would take for Christian to turn bullish again on the group. He says better service and volume growth.

Given how much improvement has already occurred in the rail margins as an industry, we're not sure how much more is left for them to improve. And so without volume, the earnings growth scenario maybe isn't quite as good as it, as it maybe once was. And I think the other factor that we were worry about is this whole mismatch with the cycle. Again, if volume is decelerating, the rails are in the process of adding resources like we just talked about in terms of hiring headcount. That's a little out of sync with where they would normally be in a little bit of a shaky macro environment. So it could put them in a scenario where the margins aren't quite as good. So if we were to see volume get better, if we would see service get better as a result of this hiring, I think it would make us more confident.

Note that Christian remains bullish on the Canadian freight rails in part because volumes there have been growing. That's actually part of a decade-long trend of cost-cutting everywhere but better growth in Canada. Canada, remember, pioneered precision railroading. Initially, some U.S. executives pointed to Canada's growth as a sign that cost-cutting would make the group more competitive and attractive to customers. But in the U.S., That hasn't happened, and it's starting to look like structural factors explain Canada's results. It has less exposure than the U.S. to that challenged thermal coal business that I mentioned and more to the still-healthy metallurgical coal business. Also, Canada's big cities are further apart than U.S. ones, and there are fewer highways connecting them. That makes rails there less vulnerable to competition from trucks. If the U.S. rail industry has a plan for recruiting new workers, it had better hurry. Other transport groups are hiring too. America is short an estimated 80,000 truckers. It needs 10,000 more pilots. Based on likely retirements, it could need 25,000 pilots by the end of the decade. We've heard widespread reports of hiring freezes and layoffs at ad-driven internet companies like Snap, and TikTok, which I mentioned earlier. It's difficult to imagine that former workers from those companies would be tempted by life on the rails, but if freight train companies want to hang on to the reputation for delivering dependable investor returns, they're going to need creative answers to making the work more attractive. Thank you, Christian and Rachel, and thank all of you for listening. Jackson Cantrell is our producer, He wants me to remind you to send us your questions by taping on your phones using the voice memo app. And what do you do? You email it to jack.hough@barons.com. Did I get all of that? You did.

I'm approaching Dallas temperatures, by the way. Okay.

Subscribe to the podcast, rate it, review it. Stay cool. See you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.