EUR 850.00 For Business Accounts Only

Morningstar | Short Line Specialist Genesee & Wyoming a Well-Run Rail Enterprise, but Narrow Moat Hard to Justify

Upon a fresh review of Genesee & Wyoming’s competitive dynamics, we are adjusting our economic moat rating to none from narrow. G&W's best-in-class North American short-line railroad portfolio has the building blocks of a narrow moat, but high capital intensity, variable commodities shipment demand across its geographies, and the 2015 U.K.-based Freightliner acquisition (which has largely underperformed) temper our confidence that G&W will be generating material economic profit on average throughout the economic cycle. That said, G&W enjoys a long history of impressive execution in its core North American operations, and we wouldn’t hesitate to recommend the shares of this unique, high-quality rail operator at an adequate margin of safety to our fair value estimate.

Despite the moat downgrade, we are increasing our fair value estimate to $72 from $68 after incorporating short-line tax credits (45Gs) into our long-term model assumptions. We previously assumed this benefit wouldn't recur because of crowding out from broader U.S. tax reform. However, in early 2018 Congress retroactively renewed 45G tax credits for 2017, and given continued bipartisan support, we now consider it more likely than not that 45Gs will be renewed in the years ahead as well. Following this change, the shares are trading in fairly valued territory.

Hints of efficient scale and cost advantage show up in G&W’s core North American short-line operations. In terms of efficient scale, replicating G&W's cluster of rail networks borders on impossible because the cost of obtaining rights of way and installing new steel rail and ties in the company's operational corridors would be financially devastating. If a would-be short-line competitor attempted to duplicate G&W’s North American rail assets, significant excess capacity would destroy returns for all players. On the cost advantage front, while trucks also haul freight, for most of the commodities G&W hauls (about 70%), railroads are the low-cost option where no waterway connects origin and destination, especially for freight with low value per unit weight. This is because railroads claim quadruple the fuel efficiency (per ton-mile) compared with trucking, and due to greater railcar capacity and train length, rails make more effective use of manpower despite the need for train yard personnel.

However, G&W's ROICs averaged only about 7.0% between 2005 and 2017, slightly below our approximate 7.5% cost of capital estimate. We are currently forecasting midcycle ROICs of 7.0%-7.5% by 2022, which compares with roughly 5% in 2017 and our 5.5%-6.0% forecast for 2018. The lack of material economic profit stems in part from the capital intensity of railroading, which is among the highest of any business. G&W’s net capital expenditures have averaged more than 14% of total revenue over the past decade, and we estimate that more than 80% is for maintenance and equipment replacement rather than expansion. G&W did not build its network infrastructure from scratch. Rather, it’s rolled up smaller short-lines and purchased rail assets from Class I carriers that have shed branch lines in past decades because of consolidation and infrastructure rationalization (especially following the 1980 Staggers Rail Act).

Variability in commodities shipment demand has also played a role in tempering G&W’s ability to materially out-earn its cost of capital. To illustrate, its Australian operations grappled with plummeting iron ore carloads in 2014 and 2015 thanks to the depressed commodity prices, which drove customer mine closures; and in 2015, North American steam coal volumes contracted heavily on competition from low-cost natural gas, and steel and scrap volumes compressed because of pressure from heightened imports.

Furthermore, in 2015, the firm acquired U.K.-based Freightliner, which is among the largest railroads in the region offering intermodal (including major port service) and bulk rail freight (aggregates and coal). While Freightliner's U.K. intermodal franchise is a solid business, railroads in the U.K. operate in an "open access" environment. That is, track assets are government owned and managed, and rail infrastructure is open to qualified third-party operators. Thus, for its above-rail haulage operations, G&W doesn’t enjoy the benefit of exclusive access to owned rail assets like it does in North America, and to a lesser degree Australia. As a result, it faces greater competition. On top of that, Freightliner’s U.K. coal-haulage franchise all but collapsed in 2017 on the back of regulatory changes, and it recently decided to divest an underperforming intermodal operation in continental Europe. Overall, Freightliner (including the addition of goodwill and intangibles amortization) has weighed heavily on G&W's adjusted ROICs and will likely continue to do so longer term.