Providence And Worcester Is The Next Canadian Pacific

May.10.13 | About: Providence and (PWX)

Company overview

The Providence and Worcester Railroad Company (NASDAQ:PWX) is a regional freight railroad operating in Massachusetts, Rhode Island, Connecticut and New York. The company transports a wide variety of commodities for its approximately 160 customers.

Ticker: PWX
Exchange: NASDAQ
Country: USA
Sector: Transportation
Industry: Railroad
Price: $15.91
Shares outstanding: 4,841,955
Dividend yield: 1%
Insider ownership: 28%
52 week high/low: $16.93/$12
Market cap: $77 million
Debt: None
Revenue: $29.96 million
Net income: $3.54 million
Click to enlarge

Source: SEC filings, ttm

Industry outlook

The outlook is positive given the following:

  • Strong pricing power

  • Strong shipment growth (commodities, chemicals, autos, intermodal - PWX strengths)

  • Competitive cost vs. trucking

  • High barriers to entry

Near term risks include:

  • Weakness in selected products. The weakness last year in coal shipments should be viewed as part of a secular decline (albeit a long term one) however this should affect PWX less than peers since coal accounts for only 2% of fiscal 2012 revenues. The recent rebound in coal shipments noted by Union Pacific and Burlington Northern Santa Fe is encouraging. The weakness in agricultural products due to last year's drought should diminish since not every year is a drought year.

  • Volatile fuel prices (offset to some extent by surcharges)

If it appears the weaknesses really are strengths, it is because this is one of the strongest industries in the market.

Investment thesis

PWX is a relatively smaller (market cap, miles of track) and weaker (stock performance, operating ratio) competitor and failed to participate in the industry and economic recovery due to a high cost structure (largely due to expensive union contracts) and a CEO with a stranglehold on the board. As a result the stock trades at a low valuation despite numerous and significant positive factors.

A strong activist investor would help maximize shareholder value by working with management and the board to reduce costs and improve corporate governance.

Ticker 1 year return (%)
PWX 0.36
GWR 64.73
UNP 40.24
CNI 27.33
CSX 20.5
NSC 18.26
CP 77.85
KSU 49.6
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Source: Bloomberg

Book value is the more appropriate valuation metric rather than P/E or P/CF because earnings and cash flow are low due to the high cost structure.

Ticker P/B
PWX 1.0
GWR 2.4
UNP 3.6
CNI 3.9
CSX 2.8
NSC 2.4
CP 4.2
KSU 3.8
Click to enlarge

Low valuation given financial strength/assets:

  • P/B of 1x vs. peer group average of 3x

  • No debt (rare in this industry)

  • Multiple assets on balance sheet (especially railroad property and equipment) carried at cost and not replacement or acquisition value

  • Railroad track maintenance credits which may be used to offset taxes

  • Valuation floor (discussed below)

  • Stable dividend history

  • Paid off all long-term debt last year

  • Strong industry fundamentals

Competitive advantages:

  • Diversified product/customer mix less exposed to weaker areas like coal

  • Strategic position in Northeast/geographic dominance

  • Competitive advantage with multiple connections to Class 1 railroads

Operational improvements:

  • Acquiring new customers

  • Expanding service over all four Class 1 connections

  • Continuing to develop ports in cooperation with local, state and federal governments

  • Improving infrastructure which will lead to better operational performance

  • Working with partners to increase efficiency and traffic volume

  • Expanding commuter service

  • Winning recent repair work bid

Re the valuation floor, numerous acquisitions and activist campaigns in the industry over the past several years (Ackman at Canadian Pacific, Buffet at Burlington Northern Santa Fe, TCI and 3G Capital at CSX) should mitigate any further valuation decline.

Below are five key areas of improvement along with recommendations which should help narrow the significant discount to intrinsic value.

Problem 1: High operating ratio. The high cost structure due to expensive union contracts is one of the major reasons for the undervaluation. PWX's operating ratio of 92% is significantly higher than the industry average of 75% due almost entirely to salaries and benefits which represent 56% of PWX operating revenue compared to 29% at its closest peer Genesee & Wyoming.

Source: Individual company SEC filings

Source: SEC Filings

The activist campaign by Mr. Ackman and his efforts to lower the high operating ratio created tremendous shareholder value. The relatively poor performance at Canadian Pacific prior to his involvement and the phenomenal performance since clearly speaks for itself. Another activist investor could have similar results at PWX.

The upcoming negotiation of the UTU trainmen contract in October 2013 represents a significant opportunity to bring the high operating ratio more in line with the industry average. This new contract can be a model to be used in the negotiations for the clerical and maintenance workers in the next few years. The unions should be willing to work with management on this for the following reasons:

First, no one (including the unions) wants a strike given what happened after the Canadian Pacific strike.

Second, by bringing costs down, there is a greater chance of earning money for the union profit sharing plan, which they have not participated in for the past two years due to poor company performance.

Problem 2: Corporate governance. First, although the large common stock position of CEO Robert Eder is encouraging, his ownership of a majority of the preferred shares is a great concern. He owns 500 out of 640 preferred shares, which enables him to elect two-thirds of the board. He should immediately convert all of his preferred into common to allow for a truly democratic board election.

Second, the combined CEO and chairman role should be split. Mr. Eder can still contribute as a "regular" board member while removing a significant conflict of interest.

Problem 3: Failure to properly monetize existing assets. There are several assets on the balance sheet that are not being fully valued.

First, the feasibility of a sale-leaseback for the corporate headquarters should be explored.

Second, non-essential company owned land alongside railroad lines, including easements, should be sold.

Third, the waterfront development at South Quay in East Providence, Rhode Island should be sold. This property is a distraction from running a railroad and would surely be more valuable to a real estate developer. Furthermore, this property should command a higher sale price given its location (waterfront, near 195), recent improvements (vehicular access, access to highway) and development potential (zoning for offices, hotels, restaurants, shops, marinas, apartments).

Proceeds from real estate sales should be returned to shareholders via a special dividend.

Problem 4: Exposure to volatile fuel costs. PWX should start hedging or raise surcharges even more. In the airline industry, everyone is affected by the same fuel costs (just like the railroad industry) yet Southwest was able to operate at a much lower cost structure for years simply because they hedged.

Going forward

PWX should address the concerns mentioned above in the short term. The long term goal should be to eventually sell to a larger player like Genesee & Wyoming, which has a history of successfully integrating short line railroads like PWX (see their acquisition of RailAmerica and Arizona Eastern Railway). PWX will earn a higher multiple after the implementation of these recommendations and once the current initiatives (mentioned above in the operational improvements section) improve the bottom line.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.