Rail Renaissance: Returns, Capital & Capacity

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

2. 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

3. Railroad PerformanceClass I Railroads Index 1981 = 100 Productivity Volume Revenue Price Source: Railroad Facts, AAR (Based on a design by R. Gallamore)

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 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

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

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

10. U.S. Railroad Intermodal Traffic(millions) 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) Coal Intermodal Source: Carload Waybill Statistics (includes non-Class I railroads)

12. Coal and Intermodal are the Top Sources of U.S. Freight Rail Revenue Intermodal and Coal as a % of Revenue* *Data for BNSF, CSX, KCS, NS, and UP Source: Railroad financial reports

13. U.S. Railroad Intermodal TrafficTrailers vs. Containers (millions) 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. Below capacity Near capacity At capacity Above capacity CS: Future Corridor Volumes Compared to Current Corridor Capacity (Cambridge/AAR) 2035 without improvements

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

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 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 (% 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 EquityClass 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 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; ‘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

30. ...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 (Miles) Data are for Class I railroads. Source: AAR

33. 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 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. 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