Weakness In Rail Traffic - Economic Or Secular?

Includes: BRK.A, CSX, KSU, NSC, UNP
by: Valuentum

Norfolk Southern (NYSE:NSC), one of the largest U.S. rail companies, announced that its third-quarter results will not be as good as expected (click here for its dividend analysis). Earnings per share for the period will be in the range of $1.18 to $1.25, significantly lower than the consensus expectation of $1.63. The major reason for the decline appears to be reduced coal shipments, where volume will fall 13%, leading to overall volume declines of 2%. CFO John Rahtbone considers the U.S. grain market as another contributor to weakness. The firm also expects lower fuel surcharge revenues to negatively impact results by $25 million to $30 million due to an unfavorable lag effect (or about $80 million in total from the same period a year ago). Norfolk will report third-quarter results Oct. 23.

Union Pacific's (NYSE:UNP) CFO Rob Knight also mentioned weakness in coal and industrial production, which is being offset by strength from autos and chemicals. Still, unlike Norfolk Southern, Union Pacific expects shipments to remain elevated on a year-over-year basis. For an in-depth look at Union Pacific's intrinsic value, please take a look here. Although it appears industrial production isn't great, we're bearish on the coal sector in general, thanks to the rise of cheaper, cleaner natural gas and the implications of negative political sentiment. We've seen some pretty bullish news out of the homebuilding sector and out of many retailers, so weakness in rails, tech infrastructure spending, and some global bellwethers -- FedEx (NYSE:FDX), Intel (NASDAQ:INTC) -- aren't causing us to give up on the U.S. economy at this time.

We typically place a greater emphasis on rails as an indicator of economic activity, but if coal is in a secular decline, translating their performance to the broader economy may lose its informative value. Norfolk, for example, is among the most exposed to the fossil fuel (see chart below), but it shouldn't impact Kansas City Southern (NYSE:KSU) or Canadian National (NYSEARCA:CN) nearly as much. We also suspect Burlington Northern Santa Fe (NYSE:BRK.A) could be negatively impacted.

Click to enlarge image.

Still, it doesn't look great for CSX (NYSE:CSX) or Union Pacific either. Massive migration to natural gas could have a long-lasting impact on the industry, but we think the transportation firms will figure out new ways to replace the lost volume. Natural gas can also be shipped via rail, and we think demand for it will increase given recent price declines (but not as much to offset the coal declines). Housing should also benefit the rails, as lumber and other large construction materials are often transported via rail.

Regardless, we aren't fans of any name in the rail space at current levels. We will continue to wait to see if investors overly punish the sector in the coming weeks, providing us with an attractive investment opportunity in the portfolio of our Best Ideas Newsletter (please view the links on our left sidebar for more information).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.