Since its inception, intermodal was the railroads’ avenue for growth, but it hasn’t been growing lately.
Intermodal was never one of the more profitable revenue segments for the railroads, but it was important to the industry because it provided an avenue for volume growth, enabling railroad volumes to move with, or occasionally exceed, GDP growth rates rather than underperform them. Intermodal’s advantages were numerous: It took trucks off the road, was more fuel-efficient and was cheaper than moving products by truck, saving shippers 10-15%. Those factors, combined with intermodal being a relatively nascent transportation method, enabled intermodal volume to grow ~2x GDP, on average, for most of its history.
Until recently, intermodal was a seemingly undisputed secular growth story. But with very little intermodal growth since 2015, including a 4.9% year-over-year drop in U.S. intermodal unit volume year-to-date, it is in dispute now.
Is intermodal over as a growth story? I believe that is a question of whether recent industry trends will persist or reverse. I argue both sides below.
Figure 1: Rail intermodal volume grew faster than the economy for most of its history
Figure 2: Lately, market share has shifted back to truck
Figure 3: A growth area? 2019 intermodal volume is 1.7% above 2015, a meager CAGR of 0.4%
It’s over: Intermodal is no longer a growth area, and it won’t be again.
Intermodal networks are not railroads’ top investment priority. The railroad stocks are not trading at or near all-time highs because the volumes have been good – they haven’t been. Rather, it’s because the railroads are posting steep improvements in cash flow and margins, handling lower volumes more profitably.
Intermodal has never been among the railroads’ most profitable segments; at best, intermodal profitability is in the middle of the pack, if not toward the back. The reason is simple – over-the-road trucking is always a competitive alternative. Some lanes are more competitive than others, but trucking is always a competitive threat. There’s not a viable alternative for much of the railroads’ book of business, so those less-competitive, higher-margin segments will be the areas that railroads put capital toward, provided it’s not a segment in secular decline, like coal.
What better example is needed than the Class I railroads de-marketing intermodal lanes? CSX de-marketing 15% of its intermodal business over the past two years and decommissioning its North Baltimore, Ohio terminal, as an intermodal hub were the most visible examples, but there was also de-marketing activity at Union Pacific and Norfolk Southern.
The railroads are unwilling to price intermodal in a way to attract highway freight
To me, the most striking recent railroad comment came from Jim Foote, CEO of CSX, when he was asked if the railroad would be willing to cut rates to attract more freight from trucking. He was dismissive of that suggestion, citing strong service levels and essentially asking why intermodal rates need to be below truckload rates at all (compared to the traditional 10-15% discount to trucking) since the service is so good. I do not believe CSX is alone among the Class I railroads in this thought process. If the railroads are no longer willing to price 10-15% below trucking rates, then that breaks down the bargain that made intermodal grow faster than the market in the first place; it was always a lower-quality service than trucking in exchange for a lower price. Sometimes that lower quality manifests in one extra transit day, other times in a less time-definite service, but why would a shipper choose intermodal if they have no financial incentive to do so?
East Coast ports are taking share from West Coast ports – and it’s not (just) about the tariffs
Clearly, the East Coast ports have taken share and that’s a negative for intermodal volume because about three-quarters of the U.S. population lives within 500 miles of the East Coast – that’s a one-day truck move, and a length of haul in which intermodal struggles to compete. That shift is permanent because it is not just about the tariffs but about numerous other factors that will be long-lasting.
Manufacturing production has gradually shifted from China to Southeast Asia because of inflation in Chinese wages and production in Southeast Asia tends to go westbound all-water through the Suez Canal to the U.S. East Coast. Meanwhile, the expansion of the Panama Canal and the massive expansion/dredging taking place at virtually all East Coast ports, including raising the Bayonne (New Jersey) Bridge, have all made the East Coast ports more competitive, accommodating larger vessels than they have historically.
Plus, the state of California is doing everything it can to make its ports more expensive in the name of being environmentally conscious. The overarching idea is that moving freight in the water is far cheaper per mile than moving it over land, so all-water routes make economic sense.
Figure 4: East Coast port share growth is bad news for intermodal
Most truck traffic is just not convertible to intermodal
There is a reason that approximately two-thirds of intermodal traffic travels in just seven dense lanes; intermodal only works in long-hauls over dense corridors anchored by large cities. The economics quickly break down if the haul is too short (less than 500 miles) or if the dray on either end is too far (more than 100 miles). Intermodal is also best suited for freight that is less time-sensitive. With that in mind, the 14% to 15% market share that intermodal has in origin-destination pairs longer than 500 miles grossly understates the penetration of the addressable market, which is maturing.
Figure 5: Is your origin-destination pair not near the cities on the top of this list? Then it’s probably not an intermodal load.
Intermodal remains a growth area – the recent lack of growth is temporary.
The current Class I railroad strategies can’t last forever. Lately, they have been engaged in a game of operating ratio (OR) limbo – how low their ORs go? The operating ratios of the Hunter Harrison-led Class I railroads have forced the other publicly traded Class I management teams to take a more aggressive approach on margins and capital expenditures. In intermodal, that has meant walking away from less profitable business and re-pricing remaining business higher, both antithetical to volume growth.
But that can’t go on forever as the U.S. Class I railroads’ margins will likely reach an equilibrium point (perhaps that is an OR in the mid- or low-50s) where volume growth again becomes a requirement to grow earnings and see further share price appreciation.
For a preview of how that might play out, look to Canadian National Railway and Canadian Pacific Railway, which have seemingly left the OR-improvement era and are now on to the era of finding ways to grow volume to have “GDP-plus” traffic growth. The U.S. railroads will have to take a similar tack as the Canadians, as only so many costs can be taken out without severely impairing service levels and a railroad can raise prices only so much without becoming more heavily regulated. Intermodal will then have to fill in as an avenue for growth.
The weak truck market is temporary
It’s hard to grow intermodal volume in the truck market that gave us the biggest truckload bankruptcy in history, but the current truckload market is the exception, not the rule. For instance, Hub Group lamented that truckload carriers have been so desperate to keep trucks filled that truck rates have been pressured to the point of being at parity (or even below) truckload rates in key corridors that have historically been intermodal-dominant lanes, such as Los Angeles-to-Dallas.
The current market weakness can’t last forever; the current truck market is weak because carriers purchased too many pieces of equipment during the latest strong market combined with carriers having a little more luck finding drivers following pay increases. Despite this year’s trends, the longer-term industry dynamics haven’t changed. Fuel prices are likely to rise over time, regulations will place increasingly strict constraints on driving time, there are aging driver demographic challenges, and there is the potential for the national drug and alcohol clearinghouse to take large numbers of drivers out of the industry.
Figure 6: A weak truck market has made the highway competitive in long-haul lanes, which is temporary/unusual.
Food will be the next big intermodal growth area
The counterpoint to intermodal’s maturation is that refrigerated transportation is done almost entirely by truck with very little intermodal penetration. Tiger Cool Express, to my knowledge, has a fleet of 735 refrigerated containers, a blip compared to the dry domestic containers in the marketplace. Much of the food that is consumed is grown in the western U.S. and consumed in the eastern U.S.; lettuce grown in California becomes salad in Chicago or New York – 2,000 or 3,000 miles away. When intermodal service is “truck-like,” that works despite the extra challenges associated with refrigerated containers and the potential for perishability. For a more robust pitch on this topic, see the Tiger Cool Express website.
Intermodal is more environmentally friendly
Perceived environmental impact is already having a major impact on the portfolio management industry with the rise of environmental, social and governance (ESG) investing, which involves constructing portfolios that meet a certain threshold for social good. It’s also possible that under a new administration, businesses will run into a tax on their carbon footprints, or something of that nature. And shippers want to boast about the steps they have taken for the environment. That is to say nothing of the savings associated with burning less diesel – intermodal is about twice as fuel-efficient as trucking; therefore shippers are charged only about half the fuel surcharge. While clearly most truckload freight is not competitive with intermodal, a market share of 14% to 15% in the greater-than-500-mile length of haul only needs to move to the low 20s for it to be a growth area for several more years.
The winning side of the debate will depend on future railroad strategies and behavior
It was easier for me to make the points in the first half of this article – that intermodal’s status as a secular growth story has at least been diminished, if not demolished. But, I believe it is too soon to make that assertion with any certainty, and it could well be the case that recency bias puts me, for now, in the camp of not expecting much intermodal volume growth near-term. One could make the claim that a perfect storm of recent events has impaired intermodal’s market share. Ultimately, the question of whether intermodal will resume as a growth area depends on the railroads’ behavior, the railroad marketplace and railroad regulations. Will the railroads reach a point at which their operating ratios flatten out, necessitating a growth avenue? Or will regulators and a relatively uncompetitive market continue to allow railroads’ operating ratios to march ever lower, making intermodal volume growth an afterthought?