Rail Industry: Why I'm Interested in Regionals

After Buffett’s investments in a handful of major railroads – Union Pacific (UNP), Norfolk Southern (NSC), and most notably Burlington Northern Santa Fe (BNI) – the industry garnered plenty of attention. The attractive industry dynamics and a myopic focus on the major players makes me interested in the small number of publicly traded regional railroads – among them Kansas City Southern (KSU) and Genesee & Wyoming (GWR).

Why railroads? Foremost, it’s an industry with significant tangible barriers to entry, and it provides a vital economic service. Although fixed asset investment is substantial, I also believe that the general consensus underestimates the variability of the typical railroad’s cost structure – yes, there’s operating leverage there, but there is also room to reduce headcount as unit volumes decline. Below is a graph of quarter-over-quarter revenue growth compared to QoQ operating expense growth for two major carriers (Norfolk Southern and CSX), one larger regional (Kansas City Southern) and the short-line amalgamation G&W.

A fixed asset business is going to have scale, but there’s still a fair degree of correlation for those companies. For the quarterly dataset going back to the beginning of 2006, the slopes vary from 0.51 (NSC) to 0.87 (GWR), so some flexibility exists in aligning expenses with revenues.

Next is a list of several metrics used to compare the four railroads, focusing primarily on their track infrastructure. Although other equipment is needed to operate a railroad, the real economic asset I’d be buying is the network.

A few explanations: there’s a strong correlation between revenue per track mile to market value per track mile. I chose to use enterprise value in addition to market cap, since these rails all have some level of debt attached and the end results cluster around 2.5x revenue per track mile. Also, the capital spending necessary to maintain the track network is important, and for the larger and more continuous players, spending is substantially higher than for a fragmented short-line company like G&W.

One red flag that makes me tread with caution is that railroad stocks have generally seen a robust recovery since the March lows, though I’m wary of mentally anchoring to those prices. On the whole, the rail industry has several positives about it – so even if a cross-section of some stocks don’t show any great bargains, it’s an understandable industry with competitive advantages, and that means good returns can be obtained at the right price.

Disclosure: I don't own any stocks mentioned here.

Comments

[Alan Young]

A great deal of the rail business is in moving commodities like coal and grain. When commodity markets are down, rail business is down. That should give one pause.

2009 Oct 04 05:14 AM

[sligoo]

KSU is reported to be in negotiations with the Mexican authorities about access to a Pacific Ocean port to be used to transport goods to the USA bypassing California's high priced port fees. What info do you have?

2009 Oct 04 01:12 PM

[Uncle Larry]

KSU, like the rest of the Class 1s handles a mix of freight.

Most of GWR's shortlines each serve one or two industries, with most of the lines tied to paper or construction materials. There is no way in the world to compare GWR with the other railroads because there is little bridge traffic - the GWR lines are gatherers that pass the carloads off to common carriers. It is the GWRs job to keep the manufacturers happy
I have owned GWR stock for 10 years, CNI and CSX stock for 5 years and KSU bonds for 2 years because I know that each has its own little monopoly and they will continue to be a cheaper way to products or raw materials than trucks.

2009 Oct 04 07:35 PM

[1more4me]

Mr. Cullen, good info.
I think it's important to note that the "recovery" is just beginning. In that case- railroads get to take advantage of the recovery two fold- they take the raw materials one direction, and finished good in the other.
That little ol' R&R KSU- is certainly an overlooked opportunity! I've owned and traded it since before they sold off the Janus Funds.
Finally, it has long been setting the stage with the new tracks and ownership of KSU Mexico so it is poised to take great advantage from the growth of the Port of Lazaro Cardenas as it will probably continue to gain freight away from South Cali. That won't change until something is done about the Unions at the American ports!
May be overly optimistic- but I see 08 highs reached again by end of 2nd QTR 2010 if not sooner.

Green trades to all- PEACE

2009 Oct 06 10:25 AM