The Railroad Week in Review:
Week Ending October 10, 1998

Earnings Week begins in NYC 10/19 and actually runs through about 11/5. Running the numbers through my Industry Spotlight format, it's a mixed picture at best. Burlington Northern Santa Fe (NYSE: BNI) looks for 19% growth this year, $2.39 over $2.00, yet trades at just 13x the 1998 estimate, handily within the PEG buy range of 50 to 100. Norfolk Southern (NYSE: NSC) is looking at $1.90 this year vs. $1.84 last year, 3% increase. Norfolk trades at 13 times earnings, so there may be a reason the price has been flat forever.

Over at CSX (NYSE: CSX) '98 estimates have been steadily ratcheted down over the past three months to $2.94, more than 20% behind last year's $3.73. Union Pacific is looking at a 15 cent loss for the year vs. last year's $2.24 to the good. The silver lining behind this cloud is the $2.40 estimate for 1999. North of the border, Canadian National (NYSE: CNI) figures to make $4.09 vs. $3.30 last year, up 24%. Canadian Pacific remains the underdog, estimating $1.65 this year vs. $1.79 last year, off 8%.

For the quarter, BNI and NSC are the standouts, up 11% and 9% respectively on just pennies a share. CSX is down 38% and UNP will be off 88%. Even CNI will be off a third from last year's number, while CP will hold its quarterly hit to just 8%. All the rails look for improved results for 1999 and for 5-year earnings growth in the 11% to 12% range.

The STB has told privately-held South Orient Railroad (SO) it may not abandon its former Santa Fe line from San Angelo (TX) to Presidio. This 400-mile railroad was acquired in 1992 for $5.5 mm, according to Ed Lewis' most excellent American Shortline Railway Guide, 5th Edition. Though Lewis does not provide car counts, this line would have to do something like 40,000 cars a year to be profitable. Presidio lies about half way between El Paso and Eagle Pass, both of which BNI reaches, the latter over rights on former SP.

A look at the map tells the story. When SO was formed it was a second Mexico outlet for BNI, one that did not involve the trek west to El Paso via Albuquerque. Now the second access is Eagle Pass over SP as one of the UP/SP merger conditions, and the 40,000 cars may not be there for the shortline. The STB let the SO quit service, though ruling the line has to remain in place citing evidence of potential traffic, objectives of NAFTA, and another railroad in the wings to take over service.

Frank Wilner, in his weekly Rail Intelligence letter, correctly notes that SO doesn't actually own the line; Texas does. Even so, the ruling allows Texas to retain ownership while allowing the railroad "to extinguish its common carrier obligation." Wilner writes, "Had the STB approved abandonment of the line SO doesn't even own, the state would have lost its ability to retain rail service over it even though it's the state that actually owns the ROW."

Another BNI spin-off, the Arizona & California (ARZC) has quite a different story. This is the former Santa Fe line connecting Phoenix with California via Parker and Cadiz. When the I-5 corridor, another bit of fallout from the UP/SP merger was put in place, all of a sudden Phoenix was open to all manner of goodies from the Pacific Northwest (PNW) by a far superior route: no more PNW-Billings-Denver-Albuquerque-Williams Jct.

Traffic is up 38% on ARZC through August. Half the increase is lumber, double what it was a year ago. Cement is running in unit trains, and that's up 850 cars. Butane and LPG are up 30% to 450 cars. Beer, wine, iron, and steel round out the increases. The message here is that thanks to the shortline BNI has added new business and cut costs on existing traffic. No capex or direct operating cost in Arizona required. Now the question becomes whether they can use the new Industry Agreement (WIR 9/26) to get access to UNP in Phoenix and by extension to the Copper Basin RR so the latter can have a direct new business route to BNI points.

Short takes: UNP made another fund manager's list this week. On Tuesday the Wall Street Transcript released in-depth interviews with four leading money managers. Among them was James Holmes, portfolio manager of Heartland Advisors' Large Cap Value Fund. UNP is "currently favored" by his ten-point grid system approach.... Merrill Lynch made some recommendation changes last week: CNI to Near Term (NT) Accumulate from NT Neutral, LT buy remains; BNI to NT Accumulate from NT Neutral, LT accumulate remains; RailTex (Nasdaq: RTEX) to NT Buy from NT Neutral, LT buy remains in effect.

Kansas City Southern (NYSE: KSU) may have to shelve temporarily plans to spin off the railroad if the IRS rules against a request that the transaction be tax free to shareholders. The IRS will have to rule promptly lest KSU push the breakup into next year. Sources say subsidiary DST's stock acquisition USCS International (WIR 9/12/98) is the cause. According to the WSJ, SEC regulations say "no transaction that affects DST stock -- such as the spinoffs -- can occur 30 days before or about 60 days after completion of the USCS acquisition." So if the IRS delays much longer and Kansas City Southern then tries to go ahead with the spinoffs, that could also delay the USCS deal, which the company hopes to complete by the end of the year.

Genesee & Wyoming (Nasdaq: GNWR) has been busy on the expansion trail. First, GNWR confirms it has a memo of understanding with Chile's CB Transporte e Infrastructura SA (CBT), a firm with railroad operating interests in Chile and Bolivia. The memo contemplates the purchase by a GNWR subsidiary of about 30% of CBT's stock for $8 mm cash and 350,000 shares of GNWR stock. This raises an interesting liquidity question. GNWR has about 5.5 mm diluted shares en toto, all but 110,000 are insider-held. See separate essay at home page.

On the other side of the Pacific, Australian newsletter "Rail 2000" reports that GNWR/Australia may be in the bidding for the Victoria Line freight business. The news from Down Under is that the government is simultaneously encouraging rail investment, expanding the highway infrastructure and luring bigger trucks. We've already seen Wisconsin Central (Nasdaq: WCLX) shares hammered in part due to its adventures in that part of the world. Will the Aussies follow the example of Great Britain's "Transportation White Paper" (WIR 8/1/98) sooner rather than later?

Continuing in the expansion mode GNWR subsidiary Genesee Rail-One has an agreement in principle to acquire 364 miles of line north of Jasper, Alberta from CNI. The line serves shippers in the coal, forest, industrial products and grain industries and transports about 50,000 carloads of freight traffic annually. The start-up of the new shortline is scheduled to take place by the end of the year.

September carloadings for RTEX were up 5,400 cars or 13% over Sep 97; same store results were up 9% for the month. YTD, same railroad results increased 11% over last year to 394,564 from 356,060. No revenue figures were given, though the monthly total railroad carloads include the Central Properties operation begun in August. That property, pieced together with Indiana & Ohio and Indiana Southern, gives RTEX a 900-mile system running from Evansville to Detroit via Indy and Cincy. The Alphabet Route redux?

All this expansion has to make one wonder about where the money is coming from. Both RTEX and GNWR sport debt levels greater than equity and thus more than half the total capitalization. Moreover, the desired EBITDA/interest ratio of 6:1 is scarcely attained, falling to half the target or less. Word on the street is that both RTEX and GNWR are bidding on the Toledo, Peoria & Western (TPW), now jointly controlled by CSX and NSC through the Delaware Otsego deal that was part of the Conrail merger. Also bidding is Pioneer Railroad (OTC: PRRR). And therein lies a cautionary tale.

Offers - judging by a thread on the Yahoo financial page - appear to be running in the $30 mm range. This is especially troubling for a bidder like PRRR where the $16 mm total capitalization is three-quarters debt. Depreciation is nearly half the EBITDA and only $150,000 more than interest exposure. Larding on $30 mm more debt for TPW would add $3.8 mm a year if paid off in ten years at 10% interest, an amount equal to PRRR's present cash flow. Even if TPW is only worth $20 mm tops, what does the high bid do to the other more solvent players?

--Roy Blanchard

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