Four railroad stocks steaming ahead

Despite economic and energy-related headwinds, leading railroad companies this year have reported impressive quarterly revenues, prodigious free cash flow, and are expected to generate profit over the next 10 years, according to Morningstar equity research. These stocks are currently regarded by analysts as fully valued, indicating investors looking to hitch a ride on railroad stocks may want to sit tight until a pullback creates attractive entry points.

The largest public railroad in North America, Union Pacific (UNP) operates in the western two-thirds of the U.S. The company rang up US$23 billion in revenue in 2018 by hauling coal, industrial products, intermodal containers, agriculture goods, chemicals, and automotive goods. It also owns about one fourth of Mexican railroad Ferromex, which accounts for 10% of its revenue.

“Union Pacific continues to improve its profitability, most recently by implementing principles of precision scheduled railroading beginning in late 2018,” says Morningstar report, noting that this is the surest path to the best operating ratio (OR), a key industry measure of profitability.

The wide moat railroad firm generated the bulk of its 2018 revenue through coal, intermodal, and industrial products. “Even though we believe coal is in a secular decline, cheap Powder River Basin coal is still a giant franchise for the rail,” says Morningstar sector director, Keith Schoonmaker, who projects energy, including coal, to produce US$4.6 billion of revenue this year.

Despite modest price increases over the last couple of years, UNP is expected to raise prices enough to outpace inflation over the long term. “We are impressed by progress made so far and project more record-setting margins in coming years,” says Schoonmaker, who puts the stock’s fair value at US$160 per share, and projects ROIC (13%-15%) to continue to outpace cost of capital (8.3%).

Canadian railroad behemoth, Canadian Pacific (CP) operates on 12,500 miles of track across Canada and in the midwestern and northeastern United States. In 2018, CP hauled shipments of grain (22% of freight revenue), intermodal containers (22%), energy products (crude and frac sand), chemicals, and plastics (17%), coal (9%), fertilizer and potash (10%), among other products.

The company has made some “astonishing changes” including closing three intermodal terminals and four hump yards, selling nonessential rail lines, replacing most of the leadership team, cutting costs and workforce, says a Morningstar equity report, noting the overhauling has transformed Canadian Pacific from the worst in class to tied for best.

As a company that transports a mix rich in bulk commodities such as grain, fertilizer, and metallurgical coal, CP is well positioned to benefit from continued demand, says Schoonmaker, who also believes service will improve and so will rates for most cargo.

Canadian Pacific’s wide economic moat is built on a cost advantage and efficient scale. The vast footprint of its system across Canada and the U.S., rights of way, and installed track coalesce to “form a nearly impenetrable barrier to entry,” says Schoonmaker, who recently upped the stock’s fair value from $315 to $323 and forecasts CP’s top line to grow about 7% this year, expanding at about a 4% increment per year thereafter.

Norfolk Southern (NSC) is an US$11.5 billion railroad operating across the eastern U.S. The firm transports shipments of coal (16% of consolidated 2018 revenue), intermodal traffic (25%), and a diverse mix of automobile, agriculture, metal, chemical, and forest products (each 7% to 16%).

Norfolk Southern has historically delivered steady returns. It generates the highest margins among U.S. railroads, and has outpaced its cost of capital for several years, says a Morningstar equity report. While the decline of high-margin coal loads creates a drag on earnings, Norfolk has offset that by increasing intermodal volume impressively. Intermodal is now the highest-volume segment (55% of 2018 carloads, 25% of revenue) handily outpacing coal (13% of carloads, 16% revenue), the report says.

The railroad behemoth is committed to raising rates, applying fuel surcharges, and increasing profitability through better operations. “Norfolk will be able to improve margins as it makes even more efficient use of fuel and labour, though reduced high-margin export coal in 2019 will likely present a challenge,” says Schoonmaker, who pegs the stock’s fair value at US$187.

The firm’s sustainable competitive advantage, he adds, stems from belief that rails will leverage cost advantage and efficient scale to generate positive economic profits with near certainty for 10 years, possibly 20 years, from now.

CSX Corp (CSX) runs a US$12 billion railroad operation in the eastern U.S., hauling shipments of coal products (18% of consolidated revenue), chemicals (19%), intermodal containers (16%), automotive cargo (10%) and other merchandise.

The new CEO James Foote has successfully replicated former CEO and railroad turnaround legend Hunter Harrison’s turnaround plans. During his brief time at CSX, Harrison implemented precision railroading and pared all assets, including human resources, real estate, sorting yards, motive power, and rolling stock. “Fewer assets can lead to greater velocity, and resulting improved service can open intermodal opportunities,” says a Morningstar equity report, noting that Foote, who took the helm after Harrison’s passing “has not missed a beat.”

CSX spans the densely populated eastern U.S., capturing about half of the rail volume in the region. Its rights of way and installed track form a nearly impenetrable barrier to entry, thus creating a sustainable competitive advantage. Additionally, the company’s costs and efficient scale lead to competitive advantages that will help “generate positive economic profits for the benefit of shareowners with near certainty [at least for the next] 10 years,” says Schoonmaker, who appraises the stock to be worth US$78.

As for profitability, CSX has managed to improve its operating ratio significantly, reaching a 60.3% OR in 2018, a year faster than expected. Schoonmaker projects OR to continue to improve, falling to 59% in 2019, and further to 56% by 2022.