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Back to Part XV - The Lure of Precious Metals

By Mark Bern, CPA CFA

If you are joining the series for the first time, you may find it informative to refer to the first article in the series, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do.

Do major U.S. railroads have pricing power? According to a class action brought by a group of shippers, there is a question of just how much more pricing power is going to be allowed. Rail shippers are also asking Congress to step in to regulate freight rates again. I have been long Union Pacific (NYSE:UNP) for some time and have been enjoying the increasing trend in earnings and share price. I have to wonder just how much longer the ride will last. My assumption is that the rail companies will be able to drag legal battles out for several years and that Congress may be unwilling to consider legislation until after the November elections. Even then I doubt that both parties will agree on anything and that it will probably require a court decision after several appeals to get anything concrete. This is a case where I suspect that the justice system will create legislation due to inaction on the Hill. But that's just my opinion.

Based upon that opinion, though, a few rail companies still look good if the economy picks up again. Until that time, I expect that the rail companies will begin to face some headwinds. Notably, I expect that coal tonnage will continue to fall as natural gas becomes favored for multiple reasons, especially price. That may be temporary, as I do expect the price of natural gas to begins rising again once several facilities under construction begin operating and shipping liquefied natural gas overseas to markets where prices are much higher. Today in the U.S. the price of natural gas is low because it cannot be shipped easily overseas. That will change and with it the balance of fuel preferences may shift once again. We will need to keep our eye on how this situation evolves.

A second potential headwind is the near drought conditions in the heartlands where much of our nation's crops are grown. If farm output falls, so will tonnage of grains for export. This is another area to keep an eye on for the next few months.

With the economy in the U.S. slowing somewhat from an already anemic pace overall freight tonnage is apt to be negatively affected. But the long-term picture for increased tonnage should be strong once the economy gets back on sound footing. Then it will all come back to the courts again and how the rate climate evolves through the legal and legislative quagmires. Unless something ridiculous (completely possible) is enacted, rail freight still offers the best value for bulk shipments in the U.S. and I see no serious contenders to compete on that basis.

As I mentioned above, I have owned UNP for several years even though the company has fallen from my master list because of its lack of free cash flow. I am including UNP in this discussion because it remains a solid company and I also believe it will serve as a good contrast. The company is the largest rail company in the U.S. both in terms of track miles and revenues. It serves the western two-thirds of the U.S. The company is targeting a payout ratio of 30 percent, which should translate into additional increases in the dividend. UNP also has a strong track record of repurchasing stock (3.9 million share in the March quarter) and the board authorized number of shares for repurchase through 2014 of 23.9 additional shares means that the company could reduce shares outstanding by another five percent. Let's look at the metrics.

Metric

UNP

Industry Average

Grade

Dividend Yield

2.0%

1.8%

Pass

Debt-to-Capital Ratio

32.0%

40.4%

Pass

Payout Ratio

25.0%

22.0%

Neutral

5-Yr Average Annual Dividend Increase

23.3%

N/A

Pass

Free Cash Flow/Share

-$0.95

N/A

Fail

Net Profit Margin

16.8%

16.9%

Neutral

5-Yr Average Annual Growth in EPS

17.8%

9.4%

Pass

Return on Total Capital

13.1%

10.5%

Pass

5-Yr Average Annual Growth in Revenue

7.6%

3.6%

Pass

S&P Credit Rating

BBB+

N/A

Pass

One fail, two neutral rankings and seven passes. And the two neutral rankings are so close to passing that I believe neither raises any cause for concern. If you own UNP, it is a solid company with excellent long-term potential. However, I believe that the company's stock is somewhat over-valued at the moment. Unless the courts or Congress intervene in the rate-setting process, I have a five year price target of $180 on UNP which would provide an average annual total return of about 11.5 percent.

My favorite company in the rail industry is Canadian National (NYSE:CNI) for a couple of reasons. Firstly, I like the company's route system which spans Canada from east to west coasts and north-south all the way down through the U.S. to the Gulf of Mexico. Second, I like the greater likely stability of the loonie (Canadian dollar), the superior financial condition of Canada's banking sector and the growth potential of the resource-based economy relative to the U.S. dollar, U.S. banking system and the U.S. consumer-based economy. I also like that the company is not likely to be affected significantly by the class action activity in the U.S. Finally CNI's coal tonnage is more focused on the Asian market demand with a much healthier outlook. Let's look at the metrics.

Metric

CNI

Industry Average

Grade

Dividend Yield

1.6%

1.8%

Neutral

Debt-to-Capital Ratio

38.0%

40.4%

Pass

Payout Ratio

27.0%

22.0%

Neutral

5-Yr Average Annual Dividend Increase

18.0%

N/A

Pass

Free Cash Flow

$0.06

N/A

Pass

Net Profit Margin

24.3%

16.9%

Pass

5-Yr Average Annual Growth in EPS

10.2%

9.4%

Pass

Return on Total Capital

14.0%

10.5%

Pass

5-Yr Average Annual Growth in Revenue

9.1%

3.6%

Pass

S&P Credit Rating

A-

N/A

Pass

The company rates eight passes and only two neutral rankings, both related to the dividend which is slightly below the industry average. I expect that management will be able to manage dividend growth and the payout ratio in a manner that will make shareholders happy. My five-year price target for CNI is $130 which works out to an average annual total return of about 11.2 percent.

I know what people are going to say so I will attempt to address it here. I realize that UNP's free cash flow is positive unless credit markets freeze up. The same does not apply to CSX Corporation (NYSE:CSX) or Norfolk Southern (NYSE:NSC). Each of these two companies has negative free cash flow when including capital spending, dividends and interest payments on debt alone, not including the debt coming due over the next five years. CNI and UNP both have about $2.5 billion in debt coming due over the next five years. The difference is that CNI has the cash flow to pay that debt without additional borrowing to do so while UNP does not. UNP must be able to refinance much of that debt in order to maintain its dividend, without even considering stock repurchases.

Any one of these four companies may be a solid investment as long as the economy continues to recover and the financial credit market does not freeze up like it did in 2008. While most will argue that a repeat of that situation is highly unlikely, I will remain unconvinced until the sovereign debt crisis and banking solvency issues in Europe are solidly behind us. I don't believe that the counter-parties that insure U.S. exposure to eurozone financial ties will be solvent if the European banking system begins to crumble. The counter-parties are generally either other large U.S. financial institutions or the very European financial institutions that would be going under. I do not pretend to understand every nuance of the situation but my experience background and training do afford me the ability to recognize smoke and mirror assurances that should not be relied upon in a crisis situation. I may sound paranoid, but really I just consider myself very cautious. If individual readers take a different view of the situation their opinions and mine will differ and that is not a bad thing. The market accepts all types of opinions and reflects the aggregate. Thus, I understand why am feeling a little lonely.

If I were to remove the requirement of positive free cash flow, both CSX and NSC would be on the list. So, I have decided to provide the metrics for both companies just for comparison's sake for those who are interested.

Metric

CSX

Industry Average

Grade

Dividend Yield

2.5%

1.8%

Pass

Debt-to-Capital Ratio

51.4%

40.4%

Fail

Payout Ratio

26.0%

22.0%

Neutral

5-Yr Average Annual Dividend Increase

32.6%

N/A

Pass

Free Cash Flow

-$1.33

N/A

Fail

Net Profit Margin

15.5%

16.9%

Neutral

5-Yr Average Annual Growth in EPS

17.7%

9.4%

Pass

Return on Total Capital

12.0%

10.5%

Pass

5-Yr Average Annual Growth in Revenue

9.0%

3.6%

Pass

S&P Credit Rating

BBB

N/A

Pass

Metric

NSC

Industry Average

Grade

Dividend Yield

2.5%

1.8%

Pass

Debt-to-Capital Ratio

43.0%

40.4%

Neutral

Payout Ratio

34.0%

22.0%

Neutral

5-Yr Average Annual Dividend Increase

19.8%

N/A

Pass

Free Cash Flow

-$2.47

N/A

Fail

Net Profit Margin

16.6%

16.9%

Neutral

5-Yr Average Annual Growth in EPS

8.0%

9.4%

Neutral

Return on Total Capital

12.0%

10.5%

Pass

5-Yr Average Annual Growth in Revenue

7.4%

3.6%

Pass

S&P Credit Rating

BBB+

N/A

Pass

My reasons for eliminating other companies in the industry are as follows: Rail America (NYSE:RA) and Genessee & Wyoming (NYSE:GWR) pay no dividend, Kansas City Southern (KSA) doesn't have enough dividend history and Canadian Pacific (NYSE:CP) has experienced more earnings volatility that I prefer relative to the other choices available.

That concludes my assessment of the railroad industry. I hope you have found it interesting and informative. As always I welcome comments and will attempt to answer any questions. The exchange of information is always welcome and it is how we all become better informed investors.

Disclosure: I am long UNP.

Source: The Dividend Investors' Guide: Part XVI - Near Monopoly In Railroads