Confident in the resiliency of US capitalism, railroads have been one of my top picks for some time now. This industry provides the most efficient form of industrial transportation, and is well-positioned to reap substantial benefits from a full recovery. Since I published my bullish article on CSX (CSX) and Union Pacific (UNP) here, the stocks have gone up 15.2% and 11.2%, respectively, while the Dow Jones appreciated by only 4.3%. This outperformance has raised questions over how much is left to be squeezed from the value gap. While some of the opportunities have dissipated, growth remains very much on the table.
From a multiples perspective, CSX is the cheapest of its peers. The railroad trades at a respective 14.5x and 12.3x past and forward earnings, while Norfolk Southern (NSC) trades at a respective 15.2x and 13x past and forward earrings. Union Pacific is justifiably at a premium given its leading size, strong brand and successful track record (pun intended). When digging behind the fundamentals of each, we find little reason to doubt consistent growth.
At the third quarter earnings call, Norfolk Southern's CEO, Wick Moorman, noted strong results:
Continuing to build on the first half's momentum, Norfolk Southern produced excellent results in the third quarter. We achieved all-time highs for any quarter, in income from operations and earnings per share, and our third quarter operating ratio of 67.5% equaled our best ever performance. As you would expect, these third quarter results, coupled with the first 2 quarters which were also outstanding, led to across-the-board record results for the 9-month period, including all-time highs for revenues, income from operations, operating ratio, net income and earnings per share. Much of this was driven by continuing improvement in our service product, which helped to produce significant growth in revenues.
In particular, Intermodal continues to produce significant free cash flow. Highway conversions led to the segment growing 8% sequentially. Export coal, meanwhile, is up 23% sequentially, and remains a major catalyst as the US transitions into possibly full recovery. A plurality of the business comes from coal, and I anticipate a continuation of strong gains in the fourth quarter. Norfolk Southern is also attractive due to its sustainable competitive advantage. While it may not be the largest in the rail sector, its direct connection from the Appalachian and Illinois mines cannot be copied. Putting its money where its mouth is, Norfolk Southern is modeled to spend $2.2 of its $3B cash from operations on capital expenditure and, specifically, investments in freight cars. This showcases a level of confidence that limits downside.
Consensus estimates for Norfolk Southern's EPS are that it will grow by 34.2% to $5.34 in 2011, and then by 12.2% and 12.5% in the following two years. Assuming a multiple of 15.5x and a conservative 2012 EPS of $5.85, the rough intrinsic value of the stock is $90.68, implying 16.7% upside. If the multiple were to decline to 13x and 2012 EPS turns out to be 7.7% below the consensus, the stock would decline by 7.5%. Accordingly, better risk/reward exists elsewhere at the current moment.
CSX is one such railroad that provides greater upside with less downside. It achieved record third quarter EPS of $0.43, with revenues gaining 11% from solid results in all the major markets. The main problem, however, concerns margins. Investors are concerned about labor expenses and the renegotiating of contracts. Although some of these fears are fair, others are not. In regards to unions, it is very likely that matters will be settled in favor of management. Both the House Transportation Committee chairman and Harry Reid introduced legislation to prevent a shutdown. The "cooling off" period for railroads ends in less than one month, and with a still-uncertain macro environment, management should get aggressive and cut labor costs.
Consensus estimates for CSX's EPS are that it will grow by 24.4% to $1.68 in 2011 and then by 14.3% and 14.6% in the following two years. Assuming a multiple of 15.5x and a conservative 2012 EPS of $1.86, the rough intrinsic value of the stock is $28.83, implying 22.5% upside. The company is rated near a "strong buy" on the Street.