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

2. 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

3. 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

4. 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?

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

6. Rail Freight Volume
Major studies done in (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

7. 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)

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

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

10. 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

11. 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)

12. 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 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

13. 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

14. 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

15. 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

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

17. 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

18. 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%?

19. 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

20. 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

21. 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

22. 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

23. 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

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

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

26. 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.

27. 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?

28. 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

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

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

31. 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

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

33. 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.

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

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

36. 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…

37. 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

38. 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

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

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

41. 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

42. 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

43. 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

44. 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)

45. 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!

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

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