These 4 Railroad Stocks All Merit 'Strong Buys'

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 |  Includes: CSX, KSU, NSC, UNP
by: Takeover Analyst

If you bought railroads since the economic recession, you would have doubled your investment by now. With some of the leading brands, like Union Pacific (NYSE:UNP), near their 52-week highs, those same investors are naturally wondering whether its time to sell. My answer is an emphatic "no". Railroads may have lost much of their glitter after the Gilded Age, but they are still indisputably the cheapest and most efficient mode of good transportation. They are an essential piece to the US industrial backbone and thus well positioned to appreciate from a macro recovery.

While some critics have voiced concern about the impact that EPA regulations will have on coal shipping, I find that railroads have taken meaningful steps to diversify. Union Pacific is turning 150 and is rated a "buy" on the Street. Here's why:

If you take a logarithmic regression of EPS over the past few years, you extrapolate 2016 EPS to be $9.64. Assuming a multiple of 16.5x, the stock will hit $159.08. This estimate is incredibly bearish in light of the fact that $9.28 EPS is expected in 2013 and 15% growth is expected thereafter.

If we take the consensus estimates, 2016 EPS turns out to be $14.10. At a 16.5x multiple, the future value of the stock is $232.69. A future value range of $159.08 - $232.69 is highly compelling from risk/reward given that the stock is only worth $119.31. Put differently, Union Pacific is highly safe. At a 10% discount rate on consensus estimates, the price target is $144.48. This means a 25% margin of safety.

Despite its century-and-a-half birthday, Union Pacific has gotten less media attention than CSX (NASDAQ:CSX) right now. CSX is much smaller than its peer, which is a regrettable circumstance in light of the industry's high barriers to entry. The railroad has nevertheless delivered impressive momentum in its own right. Growth is nearing the double-digits, and CSX beat consensus by 13.2% in the first quarter. The dividend yield of 2.5% is reasonable and the stock will hit $28.56 by 2013 under a conservative $2.04 2013 EPS and 14x multiple assumption.

CSX is also cheaper than peers on a multiples basis. It trades at a respective 12.8x and 10.8x past and forward earnings versus 16.5x and 12.9x for Union Pacific (which merits a premium due to its size), 22.4x and 16.7x for Kansas City (NYSE:KSU), and 12.4x and 10.9x for Norfolk Southern (NYSE:NSC).

This is not to say that the more "expensive peers" are not worth buying. By contrast, I recommend broad diversification in the industry. While EPS growth is expected to be slower than CSX and Union Pacific's, the firm has a price target of $82.87 on top of an industry-leading 2.6% dividend yield. Moreover, the PEG ratio stands at 0.88, which indicates that the market is not properly factoring future growth prospects. The beta of 1.06 also indicates that Norfolk is pretty stable compared to its larger peers. On a liquidity basis, the company is less tied up in inventory than peers with a 1.1 quick ratio.

In my DCF model, I assume (1) 15.5% per annum growth over the next 6 years and (2) 2.5% into perpetuity, (3) consistent operating metrics, and (4) an 8.5% discount rate. Based on these assumptions, I find that the intrinsic value of the firm is in-line with the consensus $82.87 consensus.

Kansas City is also worth a look. The firm is the smallest of the four railroads highlighted in this article, but it still has bullish prospects. MSN Money's StockScouter rates the company an 8 out of 10 and this is backed by better-than-expected performance. The last four quarters have beaten expectations by an average of 4.9% and shareholder value has been rewarded with more than 25% appreciation. Accordingly, though the company trades at 22.4x past earnings, double-digit growth prospects will be the foundation for continued value creation.

Author's note: all ratings are sourced from FINVIZ.com.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CSX, UNP, KSU, NSC over the next 72 hours.

Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.