Amid Rail Stock Weakness, UBS Likes Defensive Names

Investors’ concerns about the economy have been taking their toll on North America’s largest railroads, but the industry’s structural improvements may continue to provide pricing and earnings growth.

Shares of the big six Class One rails (Burlington, CN, CP, CSX, Norfolk and Union Pacific) have fallen 9.9% since the market turned downward in July, according to Fadi Chamoun at UBS Securities. With the exception of Union Pacific Corp. (NYSE: UNP), which has fallen only 0.9%, the group has underperformed the S&P 500, the analyst told clients in a note.

A survey of railroad customers done by UBS suggests average price increases (before fuel charges) of 7.2% in 2008. As a result of this strength, improving productivity and moderate cost inflation, Mr. Chamoun is forecasting average earnings per share growth of 13.3% for the big six next year.

He is recommending investors stay overweight in the sector, but that they be more selective and choose defensive names given the risk of slowing volumes. Union Pacific and Canadian National Railway Co. (NYSE: CNI) were highlighted as two companies with “improving fortunes.” Mr. Chamoun rates both of their shares a “buy” with price targets of US$145 and C$69, respectively.

“While this [CN Rail] may seem like an odd pick given the company’s high exposure to U.S. housing, we note that CN Rail is poised to see a recovery in volumes due to contribution from a new container terminal in Prince Rupert, strong demand for bulk commodities (coal, potash and grain) and high exposure to the Western Canadian resource based economy,” the analyst wrote.