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Railroad stocks are the oldest stocks listed in the equity exchange markets. When Charles Dow started compiling the Dow components, railroads were the dominant stocks in the index. This was primarily due to the critical role railroads played in the development and growth of the U.S. economy. It was this iron-made network of tracks that connected West with the East, and North with the South.

Establishing a profitable railroad company requires significant amount of time and resources. Naturally, given the high initial costs of starting a business in this field, the existing railroad companies have almost monopoly positions in their routes. The trends in their railroad businesses are also easier to estimate, offering stabile positions regarding the long-term revenues and profits. Moreover, the long-term trend in this industry is upward. Favorable trends in international trade have boosted the profitability of these companies. Since the introduction of NAFTA, the trade between the U.S., Canada, and Mexico reached more than $1 trillion.

Rail transportation is probably the cheapest way for continental transfer of goods. It is claimed that rail freight can move a ton of goods for 500 miles on a single gallon of fuel. Given the higher fuel costs, I expect the demand for rail services to keep their momentum in 21st century.

Here is a brief analysis of 7 railroad stocks. I rate five of them as buy, and two of them as hold. I have analyzed these stocks from a fundamental perspective, adding my FED+ valuations and O-Metrix scores where applicable:

Company

Trailing P/E

Yield

Fair Value

O-Metrix

Union Pacific (NYSE:UNP)

15.11

2.52%

$114 - $152

5.68

Canadian National Railway (NYSE:CNI)

14.84

1.70%

$87 - $112

5.53

Norfolk Southern (NYSE:NSC)

13.76

2.44%

$92 - $123

6.32

CSX Corporation (NYSE:CSX)

12.35

2.40%

$31 - $39

7.79

Westinghouse Technologies (NYSE:WAB)

19.2

0.2%

$84 - $105

6.73

Canadian Pacific (NYSE:CP)

18.51

2.10%

$54 - $84

4.03

Kansas City Southern (NYSE:KSU)

23.88

0

$56 - $80

3.97

Data obtained from Finviz/Morningstar and is current as of November 25. You can download the O-Metrix calculator here.

The fair value is calculated according to the following formula (adding book value gives the upper boundary):

  • Fair Value = E0 + E1 / (1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value + {Book Value}

O-Metrix score is calculated as:

  • O-Metrix = 5 x (Dividend Yield + Expected EPS Growth) / PE Ratio

Buy Ideas

CSX offers the most value for the buck among its peers. Its trailing P/E ratio of 12.35 and forward P/E ratio of 10.36 is the lowest among this list. The company offers a yield of 2.4% which is also above the industry average.

CSX operates more than 21,000 miles of tracks across North America with access to 70 ports. The company is highly profitable with a gross margin of 70%, and a net profit margin of 16.45%. Based on 15% EPS growth estimate, my fair value range for CSX is $31 - $39. If the analysts’ estimates hold, CSX can be the best performer among the railroad companies. Capital Research Global Investors is the largest shareholder with a share ownership of near 10%.

Norfolk Southern is one of the highest cash generators in its business. Its year to date performance of 15% also suggests that investors have been pretty bullish on the stock so far.

Norfolk pays regular dividends. Its yield of 2.44% is also above the industry average. EPS increased by 45% in this year, and analysts expect an annualized EPS growth rate of 14% for the next 5 years. Based on this estimate, my fair value range for NSC is $92 - $123. Its O-metrix score of 6.32 is also above the industry average. Capital World Investors is the largest institutional shareholder with an ownership of 5%.

Union Pacific was among the best stocks to own in the last decade. It returned almost 14% in the last 5 years, which is 12 points higher than the market’s average annualized return of 2%.

Morningstar offers 4-star rating for UNP, suggesting that the company has more near-term growth potential. UNP also owns a quarter of the Mexican railroad Ferromex. Thus, it is one of the companies that has greatly benefited, and is expected to benefit from increasing trade between Mexico and the U.S. Analysts expect 13% EPs growth for the next 5 years. Based on this estimate, fair value range is $114 - $152. UNP has been an outperformer, and I expect it to outperform in the next 7 years, as well.

Canadian National Railway is among Bill Gates’ favorite stocks. Apparently, the technology guru sees more value in CNI than in his own company.

Canadian Railways operates a network of near 20,600 route miles in North America. The company is pretty profitable with a gross margin of 37% and net margin of 24%. The stock has recently multiple topped, suggesting a bearish pattern for the near-term. However, the long-term trend is upward. Since its dip of $8 in 2000, it increased by almost ten-fold, reaching $80 in November. Based on 14% EPS growth estimate, my fair value range for CNI is $87 - $111.

Westinghouse Air Brake Technologies is an alternative way to invest in the future of railroads in the U.S. The company does not directly operate rail tracks, but it provides technology-based products and services to these transit industries.

Westinghouse was able to boost its earnings by more than 50% in the last quarter. The stock does not offer a significant yield compared to its peers. However, based on 22% EPS growth estimate, it has an O-Metrix score of 6.73. While this estimate looks pretty bullish, given the 16% EPS growth in the last 5 years, it is attainable. Fair value range is $84 - $105.

Hold Ideas

Canadian Pacific Railways was a disappointment in this year. The negative return of -13% significantly lagged its peers in the industry. While the company is expected to benefit from the increasing trade between Canada and the U.S., the balance sheet has some red flags. The debt to equity ratio of 0.84 and current ratio of 0.71 are above the average in this business.

While the fundamental ratios are not as good as other railroad companies, Canadian Pacific has a strong backup from activist investor Bill Ackman. Bill Ackman’s Pershing Square hopped on the board of Canadian Pacific Railways, recently. In the last quarter, he initiated a new purchase of 4 million shares. Whether Ackman can turn around the sluggish performance of the company or not is a matter of time. Until we see strong signs of recovery, I rate Canadian Pacific as a hold.

Kansas City Southern was among the top performers in 2011, returning more than 30% since January. Since its dip of $15 at the peak of sub-prime crises, the stock returned more than 300%. Kansas is doing fine as a company. EPS increased by 11% in the last 5 years.

The reason I rate KSU as hold, but not buy, is about the high valuation of the company. Its fair value range of $56 - $80 indicates that it is okay to own the stock. However, at a trailing P/E ratio of 24, and forward P/E ratio of 18, the stock looks expensive compared to its peers. Analysts mean target price of $68 also imply limited upside potential in near-term.

Source: 5 Railroad Companies To Buy, 2 To Hold