After Buffett’s investments in a handful of major railroads – Union Pacific (UNP), Norfolk Southern (NSC), and most notably Burlington Northern Santa Fe (BNI) – the industry garnered plenty of attention. The attractive industry dynamics and a myopic focus on the major players makes me interested in the small number of publicly traded regional railroads – among them Kansas City Southern (KSU) and Genesee & Wyoming (GWR).

Why railroads? Foremost, it’s an industry with significant tangible barriers to entry, and it provides a vital economic service. Although fixed asset investment is substantial, I also believe that the general consensus underestimates the variability of the typical railroad’s cost structure – yes, there’s operating leverage there, but there is also room to reduce headcount as unit volumes decline. Below is a graph of quarter-over-quarter revenue growth compared to QoQ operating expense growth for two major carriers (Norfolk Southern and CSX), one larger regional (Kansas City Southern) and the short-line amalgamation G&W.

A fixed asset business is going to have scale, but there’s still a fair degree of correlation for those companies. For the quarterly dataset going back to the beginning of 2006, the slopes vary from 0.51 (NSC) to 0.87 (GWR), so some flexibility exists in aligning expenses with revenues.

Next is a list of several metrics used to compare the four railroads, focusing primarily on their track infrastructure. Although other equipment is needed to operate a railroad, the real economic asset I’d be buying is the network.

A few explanations: there’s a strong correlation between revenue per track mile to market value per track mile. I chose to use enterprise value in addition to market cap, since these rails all have some level of debt attached and the end results cluster around 2.5x revenue per track mile. Also, the capital spending necessary to maintain the track network is important, and for the larger and more continuous players, spending is substantially higher than for a fragmented short-line company like G&W.

One red flag that makes me tread with caution is that railroad stocks have generally seen a robust recovery since the March lows, though I’m wary of mentally anchoring to those prices. On the whole, the rail industry has several positives about it – so even if a cross-section of some stocks don’t show any great bargains, it’s an understandable industry with competitive advantages, and that means good returns can be obtained at the right price.

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If you needed something to temper the bullishness that’s gripped the markets, here it is… wallboard maker USG reported second quarter earnings yesterday. From the conference call:

Looking ahead at the remainder of 2009 and into next year, we are not expecting much improvement in our markets. More specifically, we are planning for low levels of residential construction, though some stabilization seems on the horizon, a continuing slowdown in repair and remodel and a fairly significant drop in new non-residential construction.

The new residential construction market has fallen so far that there’s really not much more room for further declines. The market appears to be stabilizing and the June starts figure of 582,000 is somewhat encouraging, but there’s no evidence yet of a meaningful rebound.

Looking down 2009, stability in the new residential and repair and remodel markets will be a welcome relief. The major area of concern right now is non-residential construction. It declined on the second quarter and is likely to continue declining for the next several quarters.
-USG CEO Bill Foote

With USG’s last earnings report, I noted that unit pricing for wallboard was still improving, despite falling demand and a huge amount of excess capacity in the industry. While giving kudos to USG for being able to raise prices, it was a puzzling phenomenon and one that wasn’t sustainable. This quarter, the amazing levitating pricing power came to a halt, and slipped back half a percent, to $120.79/msqft. While far from huge, it snaps a string of four consecutive quarters where average realized price rose, although the streak of consecutive quarters with declining shipments hit five.

USG is also carefully monitoring their liquidity after having to accept $400 million in new capital at a high interest rate and on heavily dilutive (35% or so) terms. CapEx is forecast to be $50 million annually over the next two years, an extremely low figure relative to earlier spending. There’s been too much building in the wallboard industry, USG included, and their plants are on the newer side – this shouldn’t be a problem, but it is an indicator that they don’t expect a material improvement in cash results and are being extremely cautious. Various non-strategic asset sales were also discussed, with the hope of raising an extra $50 to $100 million.

Another exchange of note: commercial demand is expected to be down 20% to 25% year-over-year, but are there pockets of residential real estate that are less bad?

I’m sure it won’t come to any surprise Florida, Arizona, Nevada are still under extreme demand pressure, and the outlook is a pretty tough market. The inner mountain area is a good area. The Midwest area is still fairly solid and pockets in the Northeast.
-USG COO Jim Metcalf

To conclude, a few updated charts relating to various data on USG’s operations and stock performance. First, wallboard prices, the stock price, and the historical price-to-sales (P/S) – even if things look grim, the P/S multiple has been steadily improving, and that’s not because sales are going up.

On to quarterly financial results – again, management deserves credit for controlling what can be controlled. End user markets are terrible, but losses have narrowed and the cost structure is such that a $400 million drop in comparable quarter revenue didn’t move the needle on operating loss.

Finally, a chart of wallboard volumes and how shipment rates have changed. The year-over-year decline was the worst seen at any point in this cycle, and the quarter-over-quarter numbers were marginally worse than last time as well.

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Disclosure: No personal position in USG. Some chart data sourced from Gridstone Research.

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