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Rediscovering the value of rail

01 May 2007

IF THERE had been any remaining doubts among investors about the financial health of the US rail industry, they would surely have been dispelled last month when Berkshire Hathaway revealed that it had taken substantial shareholdings in three Class I railroads.A spokesperson confirmed on April 9 that the investment group led by the so-called 'Oracle of Omaha' Warren Buffet had acquired 10?9% of BNSF Railway, valued at more than $3?2bn, and stakes worth around $700m in two other major railroads. A week later, UK hedge fund TCI Fund Management filed to buy shares in CSX worth more than $500m.The railway industry is particularly capital-intensive, and the major US railroads have been struggling for many years to earn high enough returns to meet their full cost of capital. But a quarter century after the deregulation of the industry through the Staggers Act, three of the seven US and Canadian Class Is reported that they had achieved the benchmark, with two others expecting to do so imminently.As we have reported before in these pages, the long-term trends are very positive. Growing intermodal business, driven by the tidal wave of Asian imports, strong coal traffic for power generation, and the impact of increased costs on the domestic road haulage industry have enabled the rail operators to increase rates, boosting returns and funding much-needed capacity expansion projects. Rail's share of the US freight market is back above 40% in terms of tonne-km, compared with less than 15% for much of Western Europe.Further globalisation of trade and increased containerisation are expected to continue driving up the demand for freight transport in Asia, Europe and the Americas (p264). In the US alone, freight tonne-km are forecast to grow by 50% over the next 25 years. At the same time increasing environmental regulation and a greater focus on energy consumption look set to benefit rail above other modes.With railways and suppliers around the world looking to raise private-sector finance for major projects, ranging from high speed lines in Europe, North and South America and China to high-capacity freight routes across Asia, last month's manoeuvrings on Wall Street may well help to strengthen market sentiment. On April 18 a report for the California High Speed Rail Authority confirmed that 'the private sector can, and likely will, play a big role' in financing that $10bn project. But if we are to learn anything from the rail industry's roller-coaster ride over the past half-century, it is that big investors will only back well-managed businesses, putting their funds into well-planned projects with realistic prospects for a good rate of return.