Inside Freight: Takeaways from STB Hearings on Cost of Capital

STB HEARINGS. Yesterday, the STB held public hearings on the Board’s previously announced proposal to revise its calculation of the rail industry’s cost of capital (CoC). The hearings lasted 4 hours and included testimony from the U.S. Class I rails, the DOT and FRA, industry lawyers, lobbyists, and private investors.

BACKGROUND: In August, the STB proposed switching to a CAPM calculation for the cost of equity vs. the existing DCF methodology. For ’05, this would imply a 7.5% CoC vs. 12.2% using a DCF. This is important because a lower CoC implies a lower revenue adequacy threshold for the rails in STB rate cases. Using the current DCF method allows the railroads a higher CoC and thus higher rail rates. Switching to a CAPM and a lower CoC implies relatively lower future rail rates.

KEY TAKEAWAYS: (1) The hearings focused on the merits of CAPM vs. DCF or a combination of the two; (2) Speakers also debated the proposed inputs (specifically the market risk premium) and many argued for a higher cost of equity and implied CoC; (3) BNI and UNP noted a CoC in the low double-digits, while KSU argued for a higher company-specific CoC rather than being subject to the industry avg. of the Big 4 U.S. rails; and (4) The Board seems likely to review the merits of historic vs. replacement costs.

FINAL DECISION LIKELY SEVERAL MONTHS AWAY. Based on comments from the Board members yesterday, it seems like the STB may now favor a CoC based on a combination of the CAPM and DCF calculations. At the end of the day, we expect the STB to arrive at a CoC somewhere between the current DCF and the proposed CAPM numbers. We do not expect a final decision for several months.

REGULATORY NOISE LIKELY TO CONTINUE. While there were positive developments for the rails yesterday, we expect continued noise from the STB and Congress in ’08. Combined with ongoing macro concerns, our sense is the rail stocks could face continued pressure, and we would recommend buying the group on pullbacks.

INVESTMENT CONCLUSION: All things considered, yesterday’s STB hearings were likely more positive for the railroads than we anticipated. Based on the hearings we now expect some form of upward revisions to the final cost of capital adopted by the STB (likely somewhere between the current DCF and the proposed CAPM calculations highlighted in Exhibit 1). However, with likely changes to the original proposals, we believe a final STB decision is now likely several months away. As a point of reference, the STB issued its final decision on simplified rate case procedures this September, nearly nine months after holding public hearings on its proposals. Also coming out of yesterday, we now strongly believe the STB will examine historic versus replacement costs which would be a clear positive for the rails. However, the timing or potential ruling on this issue remains very uncertain given the difficulty in calculating a fair “replacement” value for a railroad.

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