Railroad operators have continued to gain ground since I last wrote about them in September. Robust auto shipments and significantly higher crude oil shipments from the Bakken and Eagle Ford offset coal and grain weakness in 2013.
But investors may be best served hanging onto these rails through the first quarter. Over the past ten years, major railroad operators CSX (CSX), Kansas City Southern (KSU) and Union Pacific (UNP) have all traded higher eight times.
Source: Seasonal Investor Database
Despite coal and grain headwinds, industry carload volume is 1.7% higher year-to-date through the first 51 weeks of 2013. The growth last year was driven by intermodal volume, which combines rail and truck shipments. That intermodal volume grew 4.5% in the period versus the prior year.
As we head into 2014, the big question facing the industry is whether natural gas prices will remain low and continue to eat power production market share away from coal. In the recent past, the shift to natural gas has created utility coal stockpiles to surge, reducing power producer demand. That's been a big hurdle for railroads given coal represents more than 40% of all rail traffic.
Railroaders also had to navigate a drop-off in grains, which are the second largest carload category. High prices ahead of the 2013 harvest caused a big fall-off in export activity. That fall-off, coupled with lackluster coal, created a tough environment for railroad operators because it offset much of the strength in auto, construction related shipments, and oil and gas frac sand.
But with coal and grain shipments facing much easier comparisons in 2014, railroad operators may enjoy a much better year in terms of volume and pricing power this year than last year.
If so, investors could find the first quarter's seasonal strength helps support shares in these three plays.
1. CSX Corp.
CSX hasn't been as affected by lower coal volume as its peers. The company got just 20% of its total volume from the commodity in 2012, versus 24% in 2006. It's also enjoyed the intermodal tailwind more than others, with the category accounting for 38% of all its shipments last year versus 30% in 2006. That mix and a tightening noose around costs have allowed CSX to boost its earnings per share a compounded 12% annually over that period. That earnings momentum is expected to continue next year, with CSX guiding investors to expect growth of 10%-15% in 2014. Importantly, CSX continues to manage its business more efficiently, projecting its operating ratio will continue to drop into the mid 60%'s over time. The company's east coast focus and less reliance on coal and grain, which represents just 6% of shipments, means CSX is more likely to benefit from an accelerating economy than a significant bounce back in coal and grain volume. But given the two categories still represent over a quarter of all rail carloads, a stabilization or recovery would still offer support this year.
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2. Kansas City Southern
Kansas City Southern has arguably benefited most from the carmakers shift to producing vehicles in Mexico. That production shift, which I covered back in 2011, has helped increase KSU's sales from cross-border activity to 20% of revenue. The company's sales were up 8% to a record $622 million in the third quarter. That translated into earnings per share growth of 16% year-over-year. Cross-border sales were up 16% from last year in the quarter and intermodal shipments climbed 17%. The company also called out improving grain shipments post harvest into the end of the third quarter, which suggests the company may have seen the worst in export shipments. More shipments helped grain revenue per carload improve to $1,796 from $1,689 last year in the quarter. Coupled with intermodal, better pricing and volume helped KSU's balance sheet improve, with cash growing to $96 million from $73 million and debt due in less than a year falling to $52 million from $60 million entering 2013. Given KSU's strong cross-border presence, which includes connecting to 12 Gulf of Mexico ports, one Pacific Ocean port, and a solid array of intermodal facilities, KSU should continue to enjoy growth as long as manufacturers move production south of the border.
3. Union Pacific
The third quarter was Union Pacific's best ever, producing record operating revenue and operating profit. Earnings per share grew 13% year-over-year in the quarter despite coal and grain headwinds. Industrial products, automotive, and chemicals were among the best carload categories during the third quarter. Those baskets more than offset weakness in coal, which accounts for 21% of revenue, and agriculture, which represents 15% of sales. But there were signs things may be improving for coal and grain, offering fourth quarter tailwinds. While agriculture volume slumped 4% in the quarter, sales only fell 2% as average rail car prices ticked up 2%. Similarly, a 10% increase in pricing helped UP's coal sales increase 2% despite a 7% drop in volume. That suggests a move back toward volume growth in those commodities could move the needle as it reduces the offset to auto, where pricing improved 9%, and industrial, where volume increased 9% thanks to construction growth. If so, Union Pacific may find it in the enviable position of leveraging that volume and pricing strength against recessionary driven cost cutting. That could mean Union Pacific maintains its peer-leading operating ratio of 64.8%.
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Overall, 2014 may prove an important year for all three operators. Coal remains the biggest wildcard, but given the industry appears to have navigated the headwind nicely over the past three years odds would seem to support the industry increasingly shifts from a head to a tailwind. That would be welcome news, especially if residential construction strength broadens to include commercial construction too. If that's the case, all three companies may be able to boost profits through the seasonally strong first quarter.