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The rail industry is looking undervalued right now with low multiples and steady growth. Many bears have argued that, with the coal market weak, railroads are unlikely to have the superior bargaining power that they did in the past. Certainly, railroads have struggled from weak coal demand but I believe in the longer-term coal is heading for recovery. With high barriers to entry and access to key export markets, railroads are stable and will grow in accordance with macro trends. Since I am bullish on both the economy and the industry's fundamentals, I recommend diversifying across Union Pacific (UNP), Norfolk Southern (NSC), and CSX (CSX). Below, I review the fundamentals of each company and the latest news.

Union Pacific

Union Pacific is the largest global railroad and has a century and a half worth of experience. Management is top-notch, earnings have been consistent, and the market, accordingly, assigns the stock a premium. The firm may trade at a 15.8x multiple, but it is still forecasted for 14.4% annual EPS growth over the next 5 years. That means 2016 EPS of around $14.15, which, at a 16x multiple, translated to a future stock value of $226.40. Discounting backwards by 10%, Union Pacific should be worth $140.58 right now. This is not an incredible value discount but it is reasonable enough when you consider that your holdings may nearly double in half a decade!

Fundamentally, Union Pacific is also one of the strongest businesses in the United States. Second quarter results were phenomenal with net income rising 28% under higher prices and fuel surcharges. In fact, price hikes in four of the six lines offset weak demand in agriculture and coal. Put differently, even a 17% decline in quarterly coal volume could not stop this railroad!

As I predicted earlier, Union Pacific knows not only knows how to, but can and will, substitute weak demand in one segment with high demand in another. If management can continue to control costs as it has in the recent past, the upside is tremendous. Another area to be optimistic about is the company's $400M second phase capital construction in Santa Terasa. Greater expansion will further improve pricing power and thus margins. The European debt crisis and slow macro growth may compromise near-term share appreciation, but the long-term looks bright with the company taking the necessary steps to hedge against uncertainty.

Norfolk Southern

Like Union Pacific, Norfolk also delivered impressive performance in the second quarter. Diluted EPS of $1.60 represented a 3% y-o-y gain while operating expenses fell 3%. A 200 basis point improvement in the operating ratio further illustrate how Norfolk is on the right course.

Management has been able to keep costs low through increasing asset velocity and reducing equipment use. This directly lowered the cost of wages while improving cutover service. In fact, the company's composite service index remained at 83%, which is excellent. Fortunately, management is also showing a greater commitment to returning free cash flow to shareholders with an 18% per share increase on the 2011 dividend distribution. $850M worth of share buybacks in 1H12 further limited any downside that there would have been for the stock.

Going forward, there are several areas that shareholder should be optimistic about. Intermodal and merchandise networks gained 4% and 9%, which indicates improving economic conditions. In merchandise, 3 out of 5 business units (paper, chemicals, and automotive) yielded all-time records. To address weak coal markets, management reduced transportation crews by 14% -- 200 bps more than the volume decline to yield positive operating leverage. At a respective 12.9x and 11.4x past and forward earnings with a forecast for 13.5% annual EPS growth over the next half decade, Norfolk is a very compelling "strong buy".

CSX

CSX has become the most popular railroad stock on the market, as evidenced by its greater volume. It is also the cheapest on a multiples basis with a respective 12.8x and 11x past and forward earnings. The dividend yield of 2.5% also helps to offset some of the heightened volatility. Like for Union Pacific and Norfolk, I also recommend buying shares.

Whereas Union Pacific's tracks cover all of the region west of Michigan down to Mississippi, CSX covers veering to the East. The latter's tracks are generally denser and, in some cases, this leads to unnecessary costs and, in other cases, this leads to more intricate deals. At a valuation of $11.9B, I believe the firm is a possible takeover target. Antitrust regulators may have some problems with any arrangement, but there is a strong case to be made about industry value creation from wider nation-wide connections.

It certainly wouldn't be the first takeover in the industry. Rail was built through a series of acquisitions. This is because the revenue synergies from connecting various lines tends to be more significant than M&A activity in other industries. Several years ago, for example, CSX and Norfolk Southern received approval from the Surface Transportation Board to buy Conrail in a multi-billion dollar deal. At the time, the deal was revolutionary. Takeovers aside, CSX has delivered strong performance in its own right and is thus recommended as both a growth and value investment.

Source: CSX A Possible Takeover Target, Buy Alongside Union Pacific, Norfolk