Investing in Railroads: Transporting the Economy into 2008

 |  Includes: BNI, CSX
by: Wall Street Strategies

With the calendar now on 2008, we take a look back at the year that was for the railroad industry and explore what the future may hold. For the railroad industry, 2007 was a year of great expansion, both in terms of equity prices and capacity for various entities. The Dow Jones Railroad Index finished 2007 relatively flat. However, in July the index took a nosedive as concerns about pricing power and lower volumes came into focus. Since bottoming out in late summer, the index finished the year up 16%, compared to the S&P 500, which was up approximately 7% in the same time period.

In the third quarter of 2007, railroad stocks came under pressure due to increasing worries over the pace of economic growth, specifically with respect to expectations for the fourth quarter (which is expected to see GDP growth of a modest 1.5%). The drastic drop likely pressured the amount that the industry reinvested as did higher diesel fuel costs, which are up 76.5% year over year, and a lagging fuel surcharge program. At the beginning of 2008, those same macroeconomic jitters have remained intact, but given the strong pricing characteristics in the railroad industry, we continue to have a bullish bias towards this sector.

With all of the talk about the economy falling off a cliff as a result of the dismal state of the U.S. housing and credit markets, statistics out of the Association of American Railroads fail to flesh out these doomsday developments. Annualized total carloads through December 15 were only down 2.4% year over year, with estimated ton-miles being lower by a mere 0.9% to 1.695 trillion. For each quarter of 2006, the industry experienced record shipment and revenue tallies. During 2007, quarterly revenue and volume records were still being set in many commodities, with agriculture, chemical, and coal shipments headlining the list.

The fundamental aspects of the industry continue to look strong moving into 2008, and save for a pricing re-regulation of the industry, pricing power should remain in place. Amid complaints from large customers that prices have increased too much, the pricing power of the railroad industry has come into play. Congress is considering setting prices for the industry. Despite of all the talk about higher fuel prices, the fact remains, it is still cheaper to transport goods via railroads than it is by way of trucking companies.

The industry continues to invest a great deal of capital into expanding its capacity and improving operating efficiency. Adding capacity is not accomplished overnight, it is a multi-year endeavor for all of the parties involved. Since the economic rebound, which began in 2002, the industry has expanded its network enough to be able to handle the peak season which typically begins in August and continues through the end of the year. Moving forward, the additional investment will likely have a minimal effect on the day to day operations of individual companies and benefit operating margin and the bottom line as the additional capacity will allow for more efficient operations. Additionally, if demand remains strong and continues to grow, the pricing power the industry enjoys will not be pressured. Conversely, a dramatic drop in demand will cool down capital investment for the sector.

Congress appears to be having trouble deciding how it wants to handle the future of the railroad industry. There is currently legislation in both the House and the Senate that would offer tax incentives for capital investments to expand an individual company's railroad network. But, at the same time, as previously noted, Congress is considering re-regulating the pricing structure in the industry. The tax incentives would be a HUGE positive for the industry, both in the near and long term as the investments would have a meaningful bottom line effect immediately as well as preparing the industry for the future expected growth. The re-regulation would have an adverse effect on the bottom line as it would put a cap on pricing and revenue growth and erase most, if not all, of the pricing and capacity advances the industry has made over the last two decades.

Our favorite investment recommendations in the railroad industry are CSX Corp. (NASDAQ:CSX) and Burlington Northern Santa Fe (BNI). CSX is our favorite on the East Coast through its extensive railroad network with regards to intermodal shipments and coal. BNI is our favorite on the West Coast and feel that the exposure to the coal rich Powder River Basin in Wyoming and Montana will continue to benefit the Company. Additionally, we favor BNI as we believe the Company has more room for revenue and earnings growth than its larger Western rival Union Pacific Corporation (NYSE:UNP).

The share price of both BNI and CSX has traded relatively flat for the last three months given macro induced volatility of the broad markets. CSX trades with a trailing twelve month price to earnings ratio of 16.65 times compared to the industry average of 16.72 times earnings, and an estimated forward PE ratio of 15.06 times. BNI trades with a trailing twelve month PE ratio of 16.43 times, and an estimated forward PE ratio of 14.18 times. Both companies have strong revenue growth characteristics and sport two of the largest pricing gains through the first three quarters of 2007. However, for the first half of 2008, we are modeling for volumes to be flat to down slightly year over year. By the second half of 2008, the Fed's actions should smooth out the credit crisis, economic growth should accelerate, and we should see a surge in business. Additionally, the companies will see easier year over year comparisons than in 2007. BNI reports fourth quarter and full year earnings on January 29, while CSX reports fourth quarter and full year earnings on January 22.

Disclosure: none

David Silver is a Research Analyst for Wall Street Strategies covering companies in the Transports, Autos, and Beverage sectors. He is routinely invited to appear on business oriented television and radio shows including Fox News, Fox Business News, the Business News Network of Canada, WCBS Radio, and the Wall Street Journal Radio.