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Railroad industry is characterized by significant barriers to entry, making it an attractive investment area for savvy investors. Ever since Buffet acquired Burlington Northern Santa Fe, the industry has featured prominently on the radar of the investor community. In this article, I will analyze 5 big names from the sector by performing a fundamentals based valuation analysis. The companies selected for analysis are Canadian National Railway (NYSE:CNI), Canadian Pacific Railway (NYSE:CP), CSX Corp (NYSE:CSX), Norfolk Southern Corp (NYSE:NSC) and Union Pacific (NYSE:UNP).

The table that follows presents basic information about the subject companies. UNP is the largest company in the group with a market capitalization of $73 billion. At the other end of the spectrum, CP is the smallest on the list with a market capitalization of $22 billion. The companies have performed well over the past year with CP and UNP leading the way. CNI and UNP have almost doubled in value during the previous 5 year period. Additionally, all the companies selected are dividend payers with NSC providing the highest dividend yield of 2.6%.

Company Basics

CNI

CP

CSX

NSC

UNP

Market Cap (Billion)

42.41

21.8

25.69

24.48

73.09

Debt to Equity Ratio

85%

119%

104%

122%

129%

Stock Performance 5 Yr

91%

85%

15%

21%

101%

Stock Performance 1 Yr

23%

74%

20%

18%

43%

Dividend Yield

1.7%

1.1%

2.4%

2.6%

1.8%

Growth Rates:

The analysis began with an evaluation of the historical growth rates in revenue, income, EPS, book value, and the projected future growth rates. These are summarized in the table shown below:

Growth Rates

CNI

CP

CSX

NSC

UNP

Revenue

10 Year

5%

5%

4%

5%

6%

5 Year

5%

4%

3%

3%

5%

1 Year

10%

10%

0%

-1%

7%

Income

10 Year

10%

2%

22%

13%

10%

5 Year

4%

-13%

7%

4%

16%

1 Year

9%

-15%

2%

-9%

20%

EPS

10 Year

13%

1%

25%

15%

11%

5 Year

8%

-14%

12%

8%

19%

1 Year

13%

-16%

7%

-1%

23%

Book Value

10 Year

-3%

1%

-2%

-2%

-1%

5 Year

-3%

2%

-5%

-4%

-2%

1 Year

-4%

1%

-4%

-6%

-3%

Growth Projections

Next Year

13%

24%

14%

14%

14%

Next 5 Year

11%

18%

11%

10%

14%

An analysis of the growth rates reveals that NSC has been a laggard in this group with declining revenue growth in the past 1 year. CSX also reported a flat revenue growth. Coming to book values, CP was the only firm on the list which generated a positive growth. However, CP's EPS fell by 16% last year. Conversely, UNP grew its EPS by 23% last year. Going forward, CP and UNP are expected to grow at a faster pace than the competition. The other companies are projected to increase their earnings at an annual rate of 10%-11%.

Margins

After analyzing the growth rates, the next step was the evaluation of gross and operating margins of the 5 firms. The results are presented in the table below. CSX and UNP have either maintained or increased their gross margins. The remaining 3 companies have reported 200 to 300 basis point declines over the past decade. Coming to operating margins, CP appears to be the laggard with declining margins which are significantly below its peers. CNI has the best margins in the group.

Margins

Averages

CNI

CP

CSX

NSC

UNP

Gross Margins

10 Year

72%

61%

64%

65%

64%

5 Year

72%

62%

68%

64%

66%

Last Year

70%

58%

64%

63%

67%

TTM

69%

59%

64%

63%

67%

Operating Margins

10 Year

35%

23%

22%

26%

22%

5 Year

35%

20%

27%

28%

28%

Last Year

37%

17%

29%

28%

32%

TTM

37%

18%

30%

28%

33%

Profitability:

To evaluate the profitability of the 5 firms, return on invested capital and return on assets were selected as the metric. The historical ratios are shown below.

Profitability

Averages

CNI

CP

CSX

NSC

UNP

ROIC

10 Year

2%

3%

3%

3%

3%

5 Year

2%

3%

3%

3%

2%

Last Year

2%

3%

3%

3%

2%

TTM

2%

3%

3%

3%

2%

ROA

10 Year

24%

13%

12%

14%

13%

5 Year

25%

12%

14%

16%

16%

Last Year

27%

9%

16%

16%

19%

TTM

25%

10%

16%

16%

19%

There is not much which separates the 5 firms in terms of ROIC with ROIC ranging from 2% to 3%. CNI again shines when it comes to ROA with a healthy ratio of 25%. CP has historically generated the least ROA among its peer group.

Valuation:

Having developed a good idea about the fundamentals of the 5 companies, the next step was to perform relative valuation. The multiples used in the analysis were based on historical analysis of individual company and industry multiples. The table below presents the valuation analysis results.

Valuation

CNI

CP

CSX

NSC

UNP

Next Yr Est

$6.91

$7.80

$2.02

$6.40

$10.89

EPS Growth Rate

11.5%

18.3%

11.0%

10.4%

14.3%

Future EPS (5 Yr)

$10.10

$14.05

$2.84

$9.49

$18.55

Expected P/E

14.1

16

13.2

13.2

15

Price 5 Yrs Out

$142.39

$224.73

$37.43

$125.31

$278.32

Unlevered Beta

0.99

0.99

0.99

0.99

0.99

D/E Ratio

17%

22%

37%

35%

13%

Current Tax Rate

35%

35%

35%

35%

35%

Levered Beta

1.10

1.13

1.23

1.21

1.08

Risk Free Rate

2.3%

2.3%

2.3%

2.3%

2.3%

Risk Premium

6.00%

6.00%

6.00%

6.00%

6.00%

Size Premium

-0.36%

-0.36%

-0.36%

-0.36%

-0.36%

Cost of Equity

8.5%

8.7%

9.2%

9.2%

8.3%

Fair Value

$94.84

$148.29

$24.06

$80.82

$186.40

Current Price

$99.82

$124.76

$25.14

$77.70

$156.59

% Overvalued

5%

-19%

4%

-4%

-19%

As shown in the table above, CP and UNP trade at a significant discount to their respective fair values and present attractive buying opportunities at current levels. CNI and CSX are modestly overvalued and should be avoided at current prices. In fact, considering that I expect a modest correction in the S&P500 from current levels, I would sell my position in CNI and CSX and look for better buying opportunities later. Of the group, UNP would be my preferred vehicle to gain an exposure to the sector at these prices.

(Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision.)

Source: Railroads: 2 To Buy, 2 To Sell, 1 To Hold