Railroads have soared since I first promoted them here. And they have continued to do well in 2012, despite worse-than-expected economic forecasts. The Street rates both CSX Corporation (CSX) and Union Pacific (UNP) a "strong buy", while rating Norfolk Southern (NSC) a "buy". Based on my multiples analysis and DCF model, I find that CSX - while riskier than Union Pacific - is the most undervalued.
From a multiples perspective, CSX is the cheapest of the three. It trades at a respective 13.5x and 10.4x past and forward earnings, while Union Pacific and Norfolk Southern trade at a respective 12.3x and 10.7x forward earnings. The last of these offers both the highest dividend yield at 2.6% and the lowest volatility at a beta of 1.1.
At the third quarter earnings call, Union Pacific's Chairman & CEO, Jim Young, noted excellent performance:
"As you can see, we finished 2011 with an all-time record quarter, achieving a quarterly earnings milestone of $1.99 per share, that's a 28% increase compared to 2010. Our outstanding fourth quarter results demonstrate the capabilities of this diverse franchise and contributed to the most profitable year in Union Pacific's 150-year history.
Record top and bottom line results achieved historic marks and generated record financial returns and investments. Rob will provide the details here in the financials in a minute. We remain focused on delivering safe, efficient, high-quality service that generates value for our customers and translates into record financial returns for our shareholders. These efforts were recognized with best ever 2011 marks in customer satisfaction and employee safety".
With such a strong operational track record, Union Pacific is arguably the best positioned to gain from investor entry when the economy picks up. Its business mix is less exposed to coal than the other railroads, which is a plus right now in terms of safety, given uncertainty in the industrial economy. When volumes dropped in 2009, management impressively addressed what it could control by mitigating its cost base. Consequentially, the firm generated more than $1.8B worth of free cash flow and is trending towards greater and greater margins. Union Pacific has done specifically well in containing labor costs, such as by replacing retirees at lower wages. With high barriers to entry, Union Pacific will be the main rail beneficiary of the positive impact that free trade agreements have on intermodal traffic.
Consensus estimates for Union Pacific's EPS forecast that it will grow by 20.2% to $8.08 in 2012 and then by 14.9% and 14.0% more in the following two years. Of the 26 revisions to estimates, 25 have gone up for a net change of 3.7%. Assuming a multiple of 15.5x and a conservative 2013 EPS of $9.23, the rough intrinsic value of the stock is $143.07, implying 25.2% upside.
Turning to CSX, we find a company that has greater upside, but at greater risk. Fourth quarter EPS of $0.43 was a penny below consensus. Export coal contracts have also been a core strength with regards to stability. With that said, free cash flow may decline by around $1B until 2013 as cash holdings decline, with debt relatively constant. During the same time period, however, ROE may expand by 420 bps to around 25.4%. These figures are roughly in-line with those provided by Deutsche Bank.
Consensus estimates for CSX's EPS forecast that it will grow by 13.8% to $1.90 in 2012 and then by 14.2% and 14.3% more in the following two years. Of the 20 revisions to estimates, 17 have gone down for a net change of -1.3%. Modeling a CAGR of 14.1% for EPS over the next three years and then discounting backwards by a WACC of 9% yields a fair value figure of $31.41, implying 39.3% upside for CSX.