Rail Renaissance: Returns, Capital & Capacity 2010 Midwest Regional & Short Line Railroad Summer Conference AB HATCH abh18@mindspring.com 155 W68th St Suite 1117 NYC 10023 www.abhatchconsulting.com July 13, 2010

Strengths Challenges Opportunities Threats Rail Assessment Strengths Challenges Strong secular growth Favorable market structure Supply constraints Solid barriers to entry Limited alternatives Capital intensity Capacity bottlenecks Port congestion Reliability vs. trucks Opportunities Threats Pricing Volume Growth Service levels / productivity Modal shift Consolidation? Economic malaise Rising capital requirements Regulation Maritime trade flows 2

Railroad Performance Class I Railroads Index 1981 = 100 Productivity Volume Revenue It is possible that the measure of Productivity, ton-miles per constant dollar expense, is distorted by the GDP-Deflator inadequately putting the expenses in constant dollars. Transportation expenses are probably more-affected by huge changes in fuel prices than the overall domestic economy. Other measures of productivity, such as ton-miles per employee, per gallon of fuel, and per mile of roadway are all still increasing. Price Source: Railroad Facts, AAR (Based on a design by R. Gallamore) 3

Street influence on RRs – and Why that affects ALL stakeholders Battle for cash Management’s reactions to pressures Investors, competitors, regulators, politicians, labor – oh, yes, and customers Rare Industry: Short term decisions (current economic outlook)/long term consequences (40+ year life of a locomotive) Remember 2004! (?) – rails unprepared for volume; embargoes Which “bucket” (Capex, share repo, DPS) will they place their chips?

Simple Math Rates Returns Capital Expenditures Capacity Service ARE ALL CONNECTED! Virtuous Circle (’03-07) or Disinvestment?

Rail Freight Volume Major studies done in 2005-07 (ie; at the cyclical peak): DOT, Global Insight, Cambridge Systematics/AAR New Studies being undertaken – due late 2010 Visibility coming off of all-time lows (“no solid feel for H2/10”) Government role both supportive (PPPs, etc) and a threat (re-reg, coal) Major intermediate-to-longer term variables for coal, autos, paper, housing, retail, and trade sourcing Emissions a two-edged sword (coal flattens, intermodal growth accelerates) GDP has the highest correlation – by far

Future Growth Potential Oil, Carbon, Infrastructure & Efficiency Intermodal – International and Domestic Grain – the world’s breadbasket Coal? Exports The Manifest/Carload “Problem” MSW (garbage), perishables, others Point-to-point vs. Hub & Spoke (or Southwest vs. United)

Grain Traffic Major U.S. and Canadian railroads Source: AAR Railroad Time Indicators, February edition, page 12

Intermodal Growth Drivers Domestic and International Globalization Trade Railroad Cost Advantages Share Recovery From Highway Truckload Issues

U.S. Railroad Intermodal Traffic (millions) 2001 Cost of Capital = 10.2%. ROI = 6.85% Source: Association of American Railroads’ Weekly Railroad Traffic Year 09e week 52 is estimated

Long-run Railroad Intermodal Revenue Growth Has Outpaced Coal (Short-run has not) 2002 Intermodal Units up 4.6% for U.S., 5.9% for U.S. & Canada 2002 Coal Carloads down 3.4% for U.S., down 3.8% for U.S. & Canada Source: AAR Weekly Railroad Traffic Coal Intermodal Source: Carload Waybill Statistics (includes non-Class I railroads)

Intermodal and Coal as a % of Revenue* Coal and Intermodal are the Top Sources of U.S. Freight Rail Revenue Rail intermodal transportation — the movement of truck trailers or containers by rail and at least one other mode of transportation, usually trucks or steamships — has been the fastest growing major segment of the U.S. freight railroad industry for many years. 2006 intermodal volume (12.3 million units) was 301% higher than 1980– that’s a unit every 2.5 seconds. 12.0 million in 2007. In 2003, for the first time ever, intermodal accounted for more revenue than coal, traditionally the most important rail commodity. In 2007, intermodal = 22.1% of revenue; coal = 21.9% for the 5 US-based Class I railroads combined (=BNSF, CSX, KCS, NS, and UP) Intermodal combines the door-to-door convenience of trucks with the long- haul economy of railroads. Intermodal growth driven largely (but by no means entirely) by international trade, especially with China. Around 60% of rail intermodal movements are imports or exports. Intermodal and Coal as a % of Revenue* *Data for BNSF, CSX, KCS, NS, and UP Source: Railroad financial reports

U.S. Railroad Intermodal Traffic Trailers vs. Containers (millions) 2001 Cost of Capital = 10.2%. ROI = 6.85% Source: Association of American Railroads’ Railroad Facts Year 09e week 52 is estimated

Domestic Intermodal The real growth opportunity is the age-old goal of taking trucks off of the highway Driving down the LOH (requires very tight service standards) Corridor development (see NS’ “Crescent”); truck partnerships (see JBHunt) Fuel price, carbon footprint, infrastructre shortages and congestion, driver shortages (CSA 2010) Trailer (TOFC/”Piggyback”) the gateway drug” for containerization Opportunities in unitized carload as well

DOT: Future Demand for Freight Transportation Will Continue to Grow Billions of Tons of Freight Transported in the U.S. p – U.S. DOT projection

CS: Future Corridor Volumes Compared to Current Corridor Capacity (Cambridge/AAR) 2035 without improvements Below capacity Near capacity At capacity Above capacity

Carbon Footprint– from cocktail chatter to decision point 2003 – 221/F500 report on carbon; 409/F500 in ’09 Green supply chains enforcement by Wal-Mart (from $2B transport spend to $4B+ by ’11); GE, P&G, etc…. Anticipating future EPA regs and emissions law

S0 -What is the growth rate? Great studies done – in 2007 Is there a “Great Re-set”? (paper, autos, retail, coal) Or do we look past 2035 and simply add a few “lost” years? (the emerging consensus save for the coal question) AAR new assumptions suggest coal is flat from DOT projections while the rest reaches 2025 targets despite Great Recession impact (ie; future intermodal/carload growth is higher than recent studies…) Will the government policy help to increase modal share by 10%?

Rail Intermediate term volume prospects ABOVE GDP ABOVE GDP Intermodal – Domestic (++) Intermodal - International Agricultural products Export Coal Ethanol GDP-GROWTH Autos Lumber Chemicals (+?) Aggregates Metals BELOW GDP Paper Auto Parts (?) UNCERTAIN Domestic Coal 19 19

Growth is Expensive Huge Capex - $40B in the last 5 years in the US – through the Great Recession! AND: Comeback of the share repo/DPS? EPS beat the Street consistently, yet: Uneven returns in the Modern Age Recent improving trend line Threats to ROIC threaten capacity

Regulatory Review/Discussion Staggers (1980) and predecessor Acts Freedom to set rates Freedom to sell/abandon low density track (growth of short line industry) Freedom to exit passenger business Impetus to cut costs, divest massive non-rail holdings & become “pure” rail plays

The Staggers Act: An American Success Story This chart shows how the industry has performed since 1981: Productivity (white line = revenue ton-miles per constant dollar operating expense) is up 144%. RR productivity improvement has been among the highest of all U.S. industries. (Drop since 2005 mainly due to big increase in fuel costs that increased total rail expenses.) Volume (green line, = revenue ton-miles) is up 95%. Revenue (inflation-adjusted operating revenue, red line) is down 4%. And rail prices or rates (yellow line, = inflation-adjusted revenue per ton-mile) are down 49%, even after an increase in average rates since 2005. However, despite the severe harm regulation caused and the huge benefits since Staggers passed, some shippers and their allies want to again give regulators wide control over crucial areas of rail operations. Their proposals would result in sharply lower rail revenues and earnings. RRs would be unable to cover their costs and meet the transportation needs of our nation. Ultimately, under reregulation, the only realistic alternative to wholesale disinvestment of our nation’s rail network would be for the government to step in and subsidize railroads on a massive scale. Productivity decline due mainly to fuel price volatility. (Index 1981 = 100) Productivity Volume Staggers Act Passed Oct. 1980 Revenue Price Source: AAR

Railroads: The Leader in Freight Transportation Railroads have around a 43% share of all freight ton-miles, more than any other transportation mode. The rail ton-mile share has been trending slightly upward over the past 15 years, after falling steadily for decades.  However, largely because they are so efficient, in return for hauling 43% of freight ton-miles, railroads receive only around 10% of intercity freight revenue. (% of Ton-Miles) Railroads Trucks Water Pipeline Pipeline excludes natural gas. Source: U.S. DOT

Finally, Railroads Making Decent Money... Net Income Source: AAR

Railroad Return on Equity Class I Railroads n.m. n.m. = not meaningful (negative value) Source: Railroad Facts, AAR

RR CoC vs. ROIC – RR Stocks have done well but… they still trade at a discount to all stocks 2001 Cost of Capital = 10.2%. ROI = 6.85% Effective with the 2006 proceeding, the method for calculating the cost of equity was changed from a Discounted Cash Flow method to a Capital Asset Pricing Model. Effective with the 2008 proceeding, the method for calculating the cost of equity was changed from a Capital Asset Pricing Model to a simple average of the Capital Asset Pricing Model and a Multi-Stage Discounted Cash Flow model. 2008 cost of capital calculated by the AAR is 11.9%, but the STB has not decided. The ROI calculation is preliminary and excludes one of the smaller railroads. NS will probably be the only railroad that has an ROI that exceeds the cost of capital. Source: Surface Transportation Board Note: Cost of equity estimation method changed by Board effective 2006 and 2008.

Rail Regulatory Risk? STILL Biggest Uncertainty in 2010 Safety Bill done/UTU influence S2889 (“STB Reauthorization Act”, formerly the “Competition” Bill AKA“M-A-D”) + Anti-Trust And yet, STB makes it 3-straight shipper “wins” Cost of Capital Revision shock (no replacement costs mandate – a “study”) Mandated STB, CTA “Reviews” AAR/RAC/ASLRRA have great “D” but hard to score on defense Compromise or fight? Quid pro quo in the future? Rocky & The Dark Star – new horror movie?

Other DC Issues S2889 not fatal, would be a long time before changes manifest themselves; compromise could lead to future monies, for example: ($500B)Transportation Bill (SAFTEA-LU 2) already behind schedule, under extension – could have increased monies for intermodal - and yet potential truck size (TSW) threats Rail is not a particularly partisan issue (more regional) Administration – supports a 10% modal shift toward rail

Rail Capacity and Capex Rail Capacity is extremely fungible Heavier/faster track, double track., sidings; Larger cars (avg size: ’80 79tons; ‘90 88.2 ’08 110.5) Unitization, shuttle trains Denser systems (2001 8.9mm RTMs/mi; ’08 11.6) IT – planning, signaling, communications (PTC?) Unitization Equipment in storage (down to the dregs) T&E employees System Velocity

(Ton-Miles Per Mile of Railroad) ...And Tighter Capacity (Ton-Miles Per Mile of Railroad) Up 31% Source: AAR

High Density* Rail Miles Have Increased (Miles) 72% 30% of Class I Network *Track with freight density of at least 20 million gross ton-miles. Excludes way and yard switching tracks. Source: AAR

Second, Third, and Fourth Main-Line Miles Have Increased Data are for Class I railroads. Source: AAR

Reflects two years following SP/UP merger. UP was Average density of Class A main lines has continued to grow even as total mileage has increased Reflects two years following SP/UP merger. UP was conforming SP reporting to its own standards. During this time, miles were reported but density could not be determined for the entire system and so remained unreported. Class A main lines have > 20,000,000 gross tons annually; Class B main lines have >5,000,000 gross tons annually but < 20,000,000.

Railroad Capital Spending ($ billions, constant 2008 dollars) Data are for Class I railroads. Source: AAR

Class I Railroad Capital Spending vs. Net Income (Current Dollars) Capital Spending Net Income Source: Association of American Railroads

Rail Service Cycles Is the recent improvement in the metrics sustainable? Systemic? Is it a product of huge capex injection and IT? Or, is it merely a product of lower volumes/less stress on the network…

Capacity Constraints The revival of passenger railroading (the vast majority of which is on freight network) HSR (and HrSR) TIH/NIH issues TSA and secuirity NIMBY – see the CN and its tortured purchase of the EJ&E; efforts on MSW

New Passenger Service Must Compete With Freight Growth Different rail corridors differ in their traffic density and their change in density over time, and individual railroads differ in the degree to which their capacity is constrained overall. Still – at least until the current recession - there is no question that there was significantly less room to spare on the U.S. rail network today than there was even a couple of years ago. Millions of Revenue Ton-Miles Per Mile of Road Owned Data are for Class I railroads. Source: AAR

Double the Freight on Same Amount of Fuel! (Index 1980=100) Volume = revenue ton-miles. Source: AAR

Record Re-Investments RRs Still Making Record Re-Investments Net Income RR Spending Per Mile Source: AAR

Current Issues Rails in the Recovery After the Rereg Fight what? Partnership with government? The Green mantle New “Golden Age”? PE &Infrastructure funds – back for good? Service

Key Class1 Issues in Recession ‘10 Re-regulation Bigger Threat than Ever Rates (versus Volumes) The Recovery (Pace & Durability) Service – The Key to the Future! Green Ramifications – positive/negative Stimulus, TIGER 1&2, MAP21, ATRK, “HSR” & HrSR - (ONERail) PTC-”unfunded”- and unknown -mandate

Service will be the Key to the Next Cycle Service at all time highs $40B spend in last 5 years (service ought to be better!) Putting increased traffic back on at current velocity means: Higher asset utilization, more market share gains, greater operating leverage (perfect circle affects all stakeholders) Implications for equipment fleets

Threats to the Renaissance Cyclical vs. secular argument New Congress –impacting labor & shippers Mandated Reviews – STB, Canada Rereg – the MAD answer Emissions impact shakeout (coal down, intermodal up, ethanol?) Execution: service Execution: merger (unlikely) Activist hedge funds? (unlikely) Liquidity? (proven not to be a direct issue in Q408)

Warren’s $44B “all-in” bet Advantages of going private? (capex cycle) Influence in DC “Robber Baron” vs. “Sage” Bets not (just) on economy – rereg, coal, western intermodal Bought on the cheap!

RR/Investor Issues Summary-3Rs3Cs Recovery? The Re-Set Re-Regulation Capital Needs Capital Cooperation Cash Flow

Developing website www.abhatchconsulting.com TopShipper Survey RailTrends 2010 September 28-29