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Reuters reported on Monday that investors who drove railroad shares down about 12 percent in the past month may be underestimating the extent to which they haul less-cyclical freight and the extent of their inroads against trucking companies. Fundamentals favored by the market lately with respect to railroads suggest Canadian National Railway Co. (CNI) may be most worthy of consideration, with Canadian Pacific Railway Company (CP) and Norfolk Southern Corp. (NSC) close behind and of particular interest to value aficionados.

With railroads so heavily tied to fixed capital, this hardly seems like an industry that would have much appeal to modern investors. Even relative to other cyclical companies, it might seem hard for rail firms to generate much growth. After all, we can't expect carriers to build new routes as easily as the typical manufacturer might build a new factory.

Actually, though, there's considerable room for these firms to flourish as additional shipping demand for items like coal, grain and goods involved in global trade boosts the amount of cargo that moves along track networks. Also, hauling capacity can increase through more efficient scheduling and train operation. In addition, carriers always strive to improve in terms of cost efficiency.

Putting aside the group's recent struggles on Wall Street, the sector has looked good over a longer perspective. Over the past 52 weeks, average share price performance ranked high relative to other industries — in the 83rd percentile.

While the capital-intense nature of this business does not necessarily reduce its overall appeal, our review of the data suggests it may have some impact in assessing the relative merits of individual railroad stocks.

We have often seen that return on capital in all its variations — return on assets, return on investment and return on equity — tends to be helpful assessing the prospects for share-price performance. But in the Railroad industry, which includes not just the carriers but also equipment-makers whose fortunes rise and fall in tandem with the operators, returns in general tend to be low — industry average returns on investment over the trailing 12 months and past five years were 6.08 and 3.14 respectively, versus 12.08 and 9.95 for the S&P 500 — and not especially helpful in choosing individual stocks from the group.

Among the 14 railroad stocks priced above $1 in our database on July 29, 2005, those that were in the top half in terms of share price performance from that time through Aug. 7, 2006 have a median trailing 12-month return on investment of 3.95 percent, versus 6.93 percent for the lower-tier performers. Another often-respected asset-based fundamental statistic, asset turnover, was similarly ineffective with nearly equal tallies for both the better and lesser groupings.

On the margin

Interestingly, margin, which has not always been useful in isolation — i.e., when considered without reference to turnover and return on capital — turned out to be highly relevant to assessing future railroad share price performance, as demonstrated in Table A.

Table A

Median data
as of
7/29/05
Rank, share price performance
7/29/05 - 8/7/06
Top half Bottom half
gross margin
TTM
37.06% 31.57%
operating margin
TTM
16.73% 9.63%
pretax margin
TTM
13.22% 8.18%
net margin
TTM
8.10% 4.22%
Notes:

TTM = Trailing 12 Months, MRQ = Most recent Quarter

Table B shows that it was also associated with future share price performance over a six-month time frame.

Table B

Median data
as of
1/27/06
Rank, share price performance
1/27/06 - 8/7/06
Top half Bottom half
gross margin
TTM
40.25% 36.20%
operating margin
TTM
18.24% 12.52%
pretax margin
TTM
14.22% 9.67%
net margin
TTM
9.77% 6.87%
Notes:
TTM = Trailing 12 Months, MRQ = Most recent Quarter

Given the heavy maintenance burden and the limited ability of carriers to scrimp in this area — poor maintenance will make it harder to maintain the service levels needed to keep customers from defecting to truckers — it seems Wall Street is most keen to reward those companies that address these weaknesses most effectively through cost efficiencies and pricing.

Tables C, D, E and F identify railroads presently in the top five based on trailing 12-month gross margin, operating margin, pretax margin and net margin.

Table C — Highest Railroad Gross Margins

Gross Margin
CSX Corporation (CSX) 65.85
Pioneer Railcorp (PRRR) 58.33
Canadian National Railway (CNI) 51.41
Canadian Pacific Railway (CP) 45.54
Providence & Worcester (PWX) 44.31
Notes:
Based on Trailing 12 Months

Table D — Highest Railroad Operating Margins

Operating Margin
Canadian National (CNI) 37.59
Norfolk Southern (NSC) 25.8
Florida East Coast (FLA) 24.78
Canadian Pacific Railway (CP) 23.32
Burlington No. Santa Fe
(BNI)
23.04
Notes:
Based on Trailing 12 Months

Table E — Highest Railroad Pretax Margins

Pretax Margin
Genesee & Wyoming (GWR) 58.38
Canadian National (CNI) 33.84
Florida East Coast (FLA) 22.81
Norfolk Southern (NSC) 21.96
Guangshen Rail. [ADR]
(GSH)
21.87
Notes:
Based on Trailing 12 Months

Table F — Highest Railroad Net Margins

Net Margin
Genesee & Wyoming (GWR) 35.49
Canadian National (CNI) 25.8
Guangshen Rail. [ADR]
(GSH)
18.69
Canadian Pacific (CP) 18.34
Norfolk Southern (NSC) 14.75
Notes:
Based on Trailing 12 Months

Canadian National is noteworthy based on its top-five ranking in all four margin categories. Canadian Pacific and Norfolk Southern rank well in three out of four areas.

Value plays

Considering the un-sexy nature of railroading, at least relative to so many other things that attract investment community notice nowadays, it should come as no surprise to learn that these stocks tend, on balance, to be modestly valued. Industry average trailing 12-month price/earnings (P/E) and price/sales ratios stand at 13.07 and 1.93 respectively, versus 19.15 and 2.65 for the S&P 500.

But over the past 12- and six-month periods, those value measures have not been helpful in making individual selections among the railroad group.

Tables G and H show that "forward" P/E and price to cash flow have been more useful.

Table G

Median data
as of
7/29/05
Rank, share price performance
7/29/05 - 8/7/06
Top half Bottom half
price/earnings
(curr. yr. est.)
15.09 20.56
Price/cash flow
TTM
10.38 12.18
Notes:
TTM = Trailing 12 Months

Table H

Median data
as of
1/27/06
Rank, share price performance
1/27/06 - 8/7/06
Top half Bottom half
price/earnings
(curr. yr. est.)
16.08 22.34
Price/cash flow
TTM
11.30 14.22
Notes:
TTM = Trailing 12 Months

Tables I and J show which railroads presently rate best under each of these metrics.

Table I — Lowest Railroad P/Es

P/E based on
Est. Curr. Yr. EPS
FreightCar America (RAIL) 6.09
Greenbrier Companies
(GBX)
10.95
Norfolk Southern (NSC) 12.35
RailAmerica, Inc.
(RRA)
13.25
Burlington No. Santa Fe (BNI) 13.57
Notes:
Based on estimated current-year EPS

Table J — Lowest Railroad price/cash flow ratios

Price/Cash Flow
Pioneer Railcorp
<(a href="http://seekingalpha.com/by/symbol/prrr">PRRR)
3.8
RailAmerica, Inc. (RRA) 5.79
Genesee & Wyoming (GWR) 5.84
Canadian Pacific Railway(CP) 6.47
Kansas City Southern (KSU) 6.68
Notes:
Based on Trailing 12 Months

For the most part, value plays tend to skew towards the suppliers, as opposed to the carriers. But two among the latter that do make the value lists stand out by virtue of their also appearing on multiple margin listings: Canadian Pacific and Norfolk Southern.

In addition, Genesee & Wyoming Inc. merits attention based on its appearance on a value list and on two margin lists, while Burlington Northern Santa Fe Corp. makes one list for each category. (Pioneer Railcorp also looks good in terms of the numbers, but with a market capitalization of only $15 million, its stock may not be sufficiently liquid for most investors.)

A longer view

The factors considered above are noteworthy because of the apparent duration of their impact, periods of six and 12 months.

This isn't necessarily the final word on railroad stock selection. Factors such as estimate revision, analyst upgrades and downgrades, price-performance indicators and so forth, ought not be ignored. But our study has shown their impact to be durable enough to impact share price performance for six months or longer.

At the time of publication, Marc H. Gerstein did not own shares of any of the aforementioned companies. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the Reuters.com investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by Reuters.com.

Source: Lots of Value Riding the Railroad