Pullback in Railroads Offers Short-Term Opportunity

Since 2004, railroads as a sector have dramatically outperformed the S&P 500 and other transportation stocks. Also, the sector regularly has 6-12% pullbacks based on the latest worry about economic growth, housing, financial crisis and last week slower exports due to a slowing global economy. There was also speculation that the sector was being targeted by short sellers who were guessing there was hedge fund liquidation going on in the stocks. Based on my experience in the sector, the strong fundamentals and continued pricing power will once again be demonstrated, and the stocks offer a short-term opportunity for appreciation.

When you look at a railroad company, it is an incredible collection of assets. It took 80-120 years to form the large railroads that now dominate America after decades of mergers and consolidation. They own billions in land, rights of way for their tracks, switching yards and capital intensive equipment. In today’s environment, all these assets are producing nice profits and generating good cash flow.

All of the four major railroads - Burlington Northern (BNI), CSX Railroad (CSX), Union Pacific (UNP) and Norfolk Southern (NSC) - pay 1-2% dividends, trade at a price to earnings ratio of 15-16, and have significant stock buybacks in place. Also, for the last few years, the companies have consistently increased their dividends and stock buybacks, while at the same time increasing their capital budget for future investments.

When I evaluate a sector for relative valuation, I favor enterprise value divided by revenue, rather than price to earnings (click to enlarge image):

The main reason that these stocks have been outperforming other transportation stocks is high fuel costs. While trains run on diesel fuel, they use much less than the equivalent in trucking. As long as fuel costs remain elevated, they have a significant cost advantage over trucking and can demand the pricing power they need to achieve 15% earnings growth while returning capital to shareholders. That is why after last week’s significant pullback of 8-12% in the stocks, the railroad sector offers a nice short-term opportunity.

Disclosure: Author holds positions in BNI , CSX, and UNP

Comments

[WEBISKING:]

I hammered BNI at77 but buying it at 95 or so is not a great deal .under 85 is closer to where to start layering in.I have been all over this stock and buying it at 100 is not wise

2008 Sep 10 01:03 PM

[bertil:]

Sure, but BNI hasn't been there since New Year.

2008 Sep 10 07:02 PM

[Kofi Bofah:]

I dumped BNI within the past year thinking the easy money had already been made. I still believe that the party is over. The dollar is strengthening, commodity prices are falling, and the global economy is weak. This does not bode well for exports, nor the pricing power of transporting coal, ag products, bauxite, etc.

2008 Sep 10 08:04 PM