Fitch Outlook: U.S. Freight Transports to Remain Healthy in 2006.

CHICAGO -- Following another exceptional year for the U.S. land-based freight transportation industry, Fitch expects a strong showing from the industry again in 2006. In 2005, continued heavy demand led to significant increases in freight railroad and trucking industry revenues and profits. Although risks of slower 2006 U.S. economic growth have risen somewhat as a result of higher energy costs, demand for the goods transported by the nation's railroads and trucks is expected to remain relatively strong next year. This, combined with efficiencies and cost controls put in place after the last recession, will help to support continued strength in operating cash flows, even if they are not at the same high levels seen over the past two years.

Demand

Demand for freight shipping has been very strong over the past two years. As the U.S. economy has recovered from the recession in the early part of this decade, heavy consumer demand has driven a significant increase in freight shipments of raw materials and finished goods, both imported and domestic. The pick-up in the global economy has also resulted in an increasing appetite for fuel, particularly coal and petroleum products, which are needed to power utilities and factories. This significant increase in demand has driven record volumes of freight and commodities onto U.S. highways and railroads.

U.S. economic growth is expected to slow somewhat in 2006, likely resulting in continued freight demand growth, but at a more moderate pace than seen in 2005. Fitch expects real gross domestic product (GDP) in the U.S. to grow by 2.8% in 2006, down from a full-year forecast of 3.6% for 2005 and actual growth of 4.2% in 2004. Already, year-over-year volume growth for certain commodities appears to be moderating somewhat, with rail carload figures for many shipments showing little or no growth in the third quarter, and long-haul less-than-truckload (LTL) volumes also relatively stable. On the railroad side, the exceptions have been intermodal and coal shipments, which have continued to show strong year-over-year growth. Intermodal strength has been fueled by continued growth in the stream of imported goods arriving into the U.S., particularly from China, while coal shipments have been driven by demand from utilities that have been struggling to rebuild low stockpiles. In the LTL trucking sector, regional short-haul demand has also shown continued growth as shippers look to trucking to help support just-in-time inventory management.

Raw material shipments will likely show the most moderation, as factory volumes stabilize. Overall shipments of automobiles and parts will likely remain flat compared with 2005; however, railroads and truckers with a greater exposure to the foreign transplant auto factories in the Southeast may continue to see some growth. The transport of construction materials may experience some regional strength, as communities along the hurricane ravaged Gulf Coast begin to rebuild. This could be of particular benefit to Norfolk Southern and CSX, the two major railroads operating in that area, as it is expected that many of the materials needed for the rebuilding will be shipped by rail. Truckers could also see a pick-up in demand in that region, as retail operations restock inventories and residents replace goods lost or damaged in the storm. Coal volumes should remain strong despite moderation in the economy, particularly if natural gas prices remain high. This will primarily benefit the railroads, as little coal is transported by truck. Intermodal volumes are also expected to be strong, driven by continued consumer demand for imported goods.

Pricing

The heavy demand for freight shipping has given railroads and truckers alike a level of pricing power not seen for years. This has been especially true for the railroads that spent much of the past 25 years with little or no pricing power. Heavy demand and restrained capacity growth have driven price increases that have grown significantly faster than corresponding volumes. Embedded in these price increases are fuel surcharges that have risen along with the cost of diesel fuel. With fuel prices recently reaching record highs, the portion of the carriers' revenues comprised of fuel surcharges has risen to the point that it has become an integral part of the overall pricing of freight shipping, with surcharges responsible for 30% to 50% of railroads' unit revenue increases. For some truckers, that percentage has been considerably higher, at times comprising all of the unit revenue increase.

Looking toward 2006, pricing is expected to remain strong but, like volumes, pricing growth will begin to moderate somewhat. As fuel surcharges have become a larger component of the pricing structure, shipping customers are paying more attention to the effect it is having on their overall shipping costs and will likely begin to more actively negotiate the surcharge along with the base rate. As a result, the distinction between base rates and surcharges may begin to blur. The continuation of a tight capacity environment, however, will likely mean that top line revenue growth will continue to outpace volume growth in both the trucking and rail sectors.

Operating Results

Continued top line growth, including fuel surcharges, and relatively modest capacity increases, should result in increased profitability and operating cash flow generation for both railroads and truckers. Operating expense growth should remain largely in-check, although fuel and labor cost increases could put some upward pressure on expenses. Labor cost control will likely be a larger issue for the long-haul truckload carriers that are offering higher wages as an incentive to draw and retain drivers due to tightness in the available labor pool. The Federal Government's new hours of service rules may also increase the truckload carriers' labor costs. Growth in fuel expenses should be largely covered by surcharges, although overall pricing growth may begin to moderate.

With revenue growth outpacing operating expenses, operating ratios should generally continue falling. This improvement in profitability is expected to translate into higher levels of operating cash flow in 2006. In turn, free cash flow is also expected to increase, although the rate of growth could be curtailed somewhat by higher levels of capital spending. In the railroad industry, several carriers, including CSX and Union Pacific, are in the midst of network improvement programs, which are expected to drive capital spending needs higher next year. Railroads are also making investments in new, more reliable locomotives and other infrastructure improvements, taking advantage of their strengthened financial position to make needed investments to increase their service performance. A number of trucking companies are also expected to spend more capital next year as they purchase new tractors ahead of the government's low-emission engine requirements that go into effect in 2007.

Cash Flow Outlook

Relatively strong free cash flow should provide many railroad and trucking companies with an opportunity to continue reducing leverage in 2006 by paying debt maturities with cash on hand rather than simply refinancing them. Some companies with particularly strong free cash flow may also find opportunities to reduce their debt loads beyond the maturities that come due in 2006. The extent of the opportunities will depend, however, on the structure and market pricing of each company's debt obligations. In some cases, the cost of the premiums required to pay down the debt early could outweigh the benefits of a reduced debt load and the associated reduction in interest expense.

The industry's financial performance over the past two years has left several railroads and trucking companies with more cash on hand than they have traditionally held. For example, Norfolk Southern ended the third quarter of 2005 with over $1 billion in cash and equivalents on its balance sheet. However, questions remain about how these companies will choose to deploy this cash. It is likely that those companies with dividends will continue to raise them, while at least some companies without dividends may choose to institute one. Share repurchases could also be a means of returning this cash to shareholders, as evidenced by recent announcements at both Yellow Roadway and Norfolk Southern.

Among the truckers, acquisitions could also be a way to deploy excess cash, particularly in the LTL sector, which has seen several consolidations over the past few years. The larger truckers, like Yellow Roadway and CNF, will likely continue to seek growth opportunities in international markets, particularly in Asia and Europe. Several of these companies also have logistics operations that will look for continued acquisition opportunities in that sector of the transportation business as well. Although the fragmented short line railroad sector will likely continue to consolidate, merger and acquisition activity among the Class I railroads is unlikely, due to stringent Surface Transportation Board (STB) rules that must be met for those railroads to merge. In addition, the Class I railroads have been focused on shedding most nonrail assets over the past several years, so it is unlikely that they would seek to acquire nonrail businesses.

Credit Implications

Fitch expects the railroad and trucking sectors to generally see credit improvement in 2006, as free cash flow increases and leverage is reduced. This could lead to outlook revisions or upgrades on some freight transportation issuers. Fitch will closely monitor the general economic environment for signs of strength or weakness, as the cyclical transportation industry typically sees its fortunes rise and fall in-step with the health of the economy. It is important to note, however, that many railroad and trucking companies are entering 2006 with a level of financial strength not seen for a number of years. Improved operating ratios, robust free cash flow generation and relatively good liquidity puts them in a significantly better position to ride out a fall in the economic cycle should a slowdown begin next year. As a result, even in a deteriorating economic environment, Fitch expects that the healthier railroad and trucking companies can continue meeting their cash obligations, while improving their credit profiles. Longer term, structural changes in demand and the ways transportation companies respond to that demand may reduce the cyclicality of the industry's financial performance, particularly in the rail sector.

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