THE TD COWEN INSIGHT
Following a high-profile derailment in February and a Surface Transportation Board (STB) that has made regulation a priority, the U.S. Class Is are poised for change. This report discusses potential upcoming regulation and legislation, historical comparisons in the industry, and the financial implications for stocks. We view rail stocks as being pressured from headline risk and lower rail multiples by half a turn.
EVALUATING INCREASED SCRUTINTY ON U.S RAIL
U.S. rails face increased regulatory scrutiny following a high-profile hazmat derailment and a historic rail merger. Reciprocal switching and rail safety are top of mind. We expect switching rules to be proposed by the end of the year based on our recent fireside chat with STB Chair Marty Oberman. Moreover, we believe this should have a negative impact on U.S. rail earnings beginning around 2025. This report offers annualized EPS impact estimates that have largely remained unquantified in commentary so far.
TAKEAWAYS ON NEW RULES AND SAFETY REGULATION
Our proprietary survey and discussions with management teams indicate that about one-third of U.S. rail carloads could be impacted, and competition could pressure pricing for eligible shippers. We discuss takeaways from Canada’s experiment with extended inter-switching to support our analysis. We expect U.S. Class I stocks to react negatively to an announcement ushering in reciprocal switching rules while acknowledging that financial impacts will take time to materialize.
On the safety side, the Railway Safety Act should have negligible capex implications, in our view, particularly compared to past bouts of safety regulation. Moreover, we expect minimal effect on the stocks.
TD COWEN PROPRETARY RAIL SURVEY
We conducted a proprietary rail survey to support our analysis on the potential impact of new rail legislation. Discussions with Class I management reinforced potential outcomes, implications for long-term growth, and the capex outlook. TD Cowen Washington Research Group offers perspective on congressional developments and an estimated timeline on the bills.
REGULATORY HEADWINDS TO BURDEN U.S RAIL
We believe reciprocal switching regulation has the potential to be a burden for the U.S. rail stocks. The devil will be in the details of any legislation.
We believe rail safety legislation that is gradually moving through Congress does not amount to significant negative implications for the Class Is. Hot box detector installation mandates should not be significant capex headwinds.
NEAR TERM CATALYSTS & WHAT TO WATCH
We will be looking for three things in the ruling:
1) Interchange radius
2) Whether the ruling offers blanket accessibility or concessions
3) Whether the ruling specifies a different mileage range on East vs. West to account for lower density on the Western network.
Other events to note are:
1) Updates on STB Docket No. EP 711 (Sub No. 1), which refers to reciprocal switching, including language on interchange radius and infrastructure development
2) Impacts on Canadian rails from new long-haul inter-switching rules
3) Congressional records on RSA debates during this year and in 2024.
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