The railroad sector has been plagued with many woes. From a stronger U.S. dollar to weaker oil prices hampering demand for the shipment of crude oil, declining coal demand and sluggish rail traffic, the railroad industry is currently braving multiple headwinds. Not unexpectedly, then, 2015 was an abysmal year for railroad stocks.
The Association of American Railroads (AAR) recently reported North American rail traffic volume for the first 14 weeks of 2016 was down 6.6% from the same point last year. This indicates the sector will likely continue to struggle this year unless fundamentals change.
Stock market indices tell a similar tale. The S&P 500 Railroads Sub-Index has posted a one-year loss of 22.4% while the Dow Jones U.S. Railroads Index has fallen nearly 27% for the same period, as of April 14, 2016.
The persistent weakness in the sector has, however, created attractive valuations with some key players trading at as much as 27% discount to their 2015 peaks. Despite challenging economic conditions, select railroad companies have reported respectable revenues and robust free cash flow, produced outstanding operating ratios and are expected to generate double-digit earnings per share growth, according to Morningstar equity research.
| Union Pacific Corp. | ||
| Ticker | UNP | |
| Current yield | 2.45% | |
| Forward P/E | 14.8 | |
| Price | US$89.63 | |
| Fair value | US$95 | |
| Data as of April 22, 2016 | ||
The largest public railroad company in North America, 
Union Pacific (UNP) operates in the western two thirds of the United States, hauling coal, industrial products, intermodal containers, agriculture goods, chemicals and automotive goods. It also owns about a quarter of Mexican railroad Ferromex (10% of its revenue).
"Management has successfully boosted profitability despite demand fluctuations [keeping] UP surprisingly nimble for a huge asset-based enterprise," said a Morningstar report, referring to the firm's ability to cut costs faster than sales decline during tough times and improving margins consistently.
UP generated an extraordinary US$3 billion in free cash flow in 2014 -- greater than 12% of sales -- or US$1.8 billion after paying dividends to shareholders. "The firm has tripled dividends per share from the start of 2010 through 2014, making the stock attractive to yield-seeking investors," said Morningstar sector director Keith Schoonmaker. In response to lower expectation for freight volume growth and average revenue per carload during 2016-17, however, he recently slashed the stock's fair value from US$110 to US$95, still above its current market price.
In the long run, though, Schoonmaker projected the rail will "attain a 62% operating ratio next year and 59% by 2018" -- a lower operating ratio reflects a higher margin on earnings before interest and taxes -- and asserted that "UP has improved profitability in times of plenty and times of need."
| Canadian Pacific Railway Ltd. | ||
| Ticker | CP | |
| Current yield | 0.74% | |
| Forward P/E | 14.8 | |
| Price | $189.30 | |
| Fair value | $198 | |
| Data as of April 22, 2016 | ||
Canadian Pacific Railway (CP) is a transcontinental railway operating across most of Canada and in the Midwestern and Northeastern United States. It hauls shipments of intermodal containers (21% of 2014 freight revenue), industrial and consumer products (32%), grain (23%), coal (10%), fertilizers (9%), automotive products (6%) and a diverse mix of other merchandise.
"CP earns two thirds of its revenue hauling somewhat resilient intermodal, metallurgical coal, grain and fertilizer and has low exposure to more cyclical automotive and forest products," said a Morningstar report, stressing that "demand will continue to recover and service will improve, and we project increased rates for most cargo."
The railroad behemoth is helmed by the legendary railroad leader Hunter Harrison, who was awarded Morningstar's CEO of the Year award for his radical transformation of the company during 2013. "The cadence of change has been breathtaking so far, and we expect CP to continue on its margin improvement trajectory for several more years as it rapidly closes in on the aggressive 60% mark," said Schoonmaker, who increased the stock's fair value from $179 to $198 after adjusting his expectations following the company's first-quarter earnings report.
CP enjoys a wide economic moat, or sustainable competitive advantage, which Schoonmaker said stems from its ability to "leverage cost advantage and efficient-scale competitive advantages to generate positive economic profits with near certainty 10 years from now, and more likely than not 20 years."
| Norfolk Southern Corp. | ||
| Ticker | NSC | |
| Current yield | 2.58% | |
| Forward P/E | 15.2 | |
| Price | US$91.33 | |
| Fair value | US$97 | |
| Data as of April 22, 2016 | ||
Norfolk Southern (NSC) is an US$11.6 billion railroad giant operating in the Eastern United States. The company hauls shipments of coal (21% of consolidated 2014 revenue), intermodal traffic (22%) and a diverse mix of automobile, agriculture, metal, chemical and forest products (each 7% to 16%).
"Norfolk Southern's five-year mean free cash flow and operating ratio are among the best in the railroad industry," said a Morningstar report. The company, whose long-term target payout ratio is projected to be 33%, has paid a higher dividend yield than other railroads during recent years, the report noted.
Schoonmaker asserted the firm delivers reliable returns, and has produced the highest margins among U.S. railroads since 2004. "Norfolk Southern is raising rates in accord with the value it provides, applying fuel surcharges, and (long run) increasing profitability through better operations," he said.
He recently reduced the stock's fair value estimate from US$102 to US$97 owing to lower projected carloads and revenue per carload during 2016. However, he forecasted the firm will be able to improve margins as it increases intermodal volume -- carloads typically related to consumer goods -- and makes even more efficient use of fuel and labour.
Norfolk Southern has remarkably increased intermodal volume, making it "the highest-volume segment (3.8 million units of the firm's 7.7 million total in 2015). The segment's 2015 revenue contributed 22% of total sales, exceeding coal (20.5%).
| CSX Corp. | ||
| Ticker | CSX | |
| Current yield | 2.62% | |
| Forward P/E | 14.0 | |
| Price | US$27.53 | |
| Fair value | US$33 | |
| Data as of April 22, 2016 | ||
CSX Corp. (CSX) is a freight transportation company operating in the Eastern United States. It transports shipments of coal products (23% of consolidated revenue), chemicals (17%), intermodal traffic (14%) and other merchandise.
"CSX's margin gains of the past decade are nothing short of astounding," said a Morningstar report. "Much-improved profitability is here to stay at CSX."
The report forecasted operating ratios of 69% in 2016 and 65% in 2019 as management continues to deftly adjust operations to plunging coal demand. While the company will feel the impact of plunging coal demand over the next several years, autos and intermodal growth, as well as continued improvement to its operating ratio, should help salvage earnings despite coal losses, assured Schoonmaker.
Taking into account the overall industry weakness, he reduced the stock's fair value to US$33 from US$37. However, despite forecast of further coal contraction and a weak 2016, Schoonmaker forecasted "population growth, auto recovery, homebuilding recovery and intermodal gains from the highway will fuel modest volume improvement."
A combination of powerful barriers to entry, cost advantage and efficient scale provides the company with a sustainable competitive advantage and will help generate positive economic profits for at least a decade and likely beyond, he added.
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