We all know Warren Buffett is fond of the railroads. His purchase of Burlington Northern four years ago is paying off handsomely. Forbes Magazine in March reported he was still "bullish as ever" on the railroad industry, mainly due to the economic advantages of transporting crude.
With several railroad companies to choose from, we will compare and contrast to see why Union Pacific (NYSE:UNP), despite the higher valuation, is the clear leader.
The four largest publicly-traded railroad companies by market cap are:
- Union Pacific: $88.5B
- Norfolk Southern (NYSE:NSC): $30.68B
- CSX Corp. (NYSE:CSX): $29.8B
- Kansas City Southern (NYSE:KSU): $11.8B
At a Trailing Twelve Month P/E ratio of 34.3, and this year's estimated P/E of 22.9, KSU is trading at a significantly higher valuation than the others. The PEG ratio of 2.30 is also higher, and market cap is much smaller. Because of this, we will eliminate this one and focus on the other three.
Union Pacific Corporation, through its subsidiary, Union Pacific Railroad Company, provides rail transportation services in the United States. Its network includes 32,000 route miles that travel through 23 states in the western U.S.
Norfolk Southern, together with its subsidiaries, is engaged in the rail transportation of raw materials, intermediate products, and finished goods. As of December 31, 2013, it operated approximately 20,000 miles of road in 22 states and the District of Columbia.
CSX Corporation, together with its subsidiaries, provides rail-based transportation services in the United States and Canada. It offers traditional rail services, and transports intermodal containers and trailers. Its network covers the Eastern U.S., with more than 21,000 miles of track in 23 states, Washington D.C., Ontario and Quebec.
Let's compare these three companies using the following metrics:
Right away, UNP emerges as an outlier with price to earnings ratios, while NSC and CSX are closer together at the 16.5 to 17.0 range (Trailing Twelve).
For the price-to-book and price-to-sales, UNP is also a clearly higher value than CSX and NSC. Additionally, that gap has widened over the last few weeks.
The market is giving UNP a higher valuation than the other two. Let's find out if it is justified:
Above, we see that recent revenue growth for all three has been slowing, but NSC is actually negative YoY at -1.79%, while on the opposite end, UNP is more stable and a healthy 6.58%.
Recent earnings growth is similar, with NSC -17.0% and CSX -11.1%, while UNP is +17.24%. This a significant difference.
Cash flow growth is also higher for UNP:
While admittedly variable, UNP has been more stable and has been improving, while CSX and NSC have been decreasing.
It is clear that UNP is doing a much better job of improving operating and profit margins consistently. While all three are healthy, UNP is steadily moving higher, while CSX and NSC are stable and/or decreasing.
UNP is once again moving higher relative to the other two on all three metrics. For the all-important ROIC figure, it is 50% higher than the other two.
Here's what we know: UNP is trading at a higher valuation based on P/E, P/B, and P/S. But, UNP is heads and shoulders above the other two in profitability and growth.
If we expand our horizon, and look over the past 10 years, the P/E ratio of UNP has been relatively stable or coming down, while the earnings per share have been increasing at a steady pace.
As for CSX and NSC, this also looks strong, but UNP is still separating itself from the others.
On the surface, it looks like UNP is justified in having a valuation based on its profitability margins and growth rate. But lets take it one step further by making a very big assumption: over long periods of time, earnings drive stock prices, and P/E ratios revert back to an average P/E of 15. This should unfairly punish UNP with a higher P/E, and help CSX and NSC. But when you add back in the expected earnings growth and dividend yield, we attempt to calculate a reasonable return expectation for each stock per year over the next 5 years. To be clear, this uses analysts future earnings growth forecasts.
Using a formula often used on broad stock markets, [(1+earnings growth)*(normal P/E/actual P/E)^1/# of years)] -1) + dividend yield% = annual return projection, let's do a calculation:
UNP: [(1+14.75%)*(15.00/19.98)^1/5)]-1.0 + 1.86% = 10.2%
CSX:[(1+9.50%)*(15.00/16.53)^1/5)]-1.0 + 2.02% = 9.4%
NSC: [(1+10.06%)*(15.00/17.07)^1/5)]-1.0 + 2.19% = 9.4%
Based on these big assumptions, even if each company reverts back to an average P/E of 15, UNP would still outperform the others.
Additionally, investors should be happy with those returns for any of the three. It appears Warren Buffett is right about being bullish on the railroads.
Railroads tend to be more economically sensitive and perform better in the early to middle stages of the business cycle. We are no longer there. If the projected and real growth is based primarily on shipping crude (debatable), as Warren Buffett suggests, then the railroads might become more correlated to oil prices, and more difficult to predict.
Weather is a factor that affects deliveries, fuel costs, and freight contents, and cannot be predicted.
As the chart below indicates, UNP has tracked closely with the Railroad Index, while CSX and NSC have lagged behind. A reversion in either way back together is possible.
On a technical basis, relative strength for all three is very strong, and they are all in an uptrend. This normally signals a continued move higher.
In conclusion, Warren Buffett was correct when it was reported he was "more bullish than ever" on the railroads. These three railroads looked poised to do well over the next few years using several different metrics.
The standout railroad and one deserving of investment dollars is undoubtedly Union Pacific. It is the largest and most dominant. It has a diverse revenue mix and has solid growth in each region. In addition to good earnings growth, current and projected, it has a solid balance sheet, reasonable debt, and almost $2B in cash. It pays a 1.86% dividend, has grown the dividend by 27% per year over the past 5 years, and has a payout ratio < 40%.
At this time, UNP is the railroad stock most deserving of investment with an above-average chance of outperforming.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in UNP over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.