Railroads Grow Faster Than The Economy

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Includes: BRK.B, CNI, CP, CSX, IYT, KSU, NSC, SPY, UNP
by: Michael Hooper

Summary

Low oil prices and a growing economy are benefiting railroads.

Transportation stocks have dramatically outperformed the S&P 500 this year.

Railroads are investing capital to reduce congestion and improve train speeds.

Low oil prices and a growing U.S. economy are benefiting the transportation sector. Transportation stocks were up more than 20% year-to-date, while the S&P 500 was up 10% through Nov. 7 YTD.

Valuation metrics for railroad stocks are at all-time highs, leading me to believe they are fully valued or even overvalued. But long term, I am very bullish on railroads.

The iShares Transportation Average ETF (BATS:IYT) was up 21.55% compared with the SPDR S&P 500 ETF (NYSEARCA:SPY) up 10.10% through Nov. 7.

Railroad volumes were up 7% for CSX Corp. (NYSE:CSX) in third quarter -- much higher than the 3.5% GDP growth for the same quarter. The manufacturing sector is growing in the United States, contributing to gains in shipment of metal ores and automobiles. Railroads are moving record levels of grain and intermodal containers and truck trailers.

The average quarterly diesel fuel price of $3.01 per gallon for Union Pacific in the third quarter 2014 was down 5% compared to the third quarter 2013. This helped Union Pacific achieve an operating ratio of 62.3% -- an all-time quarterly record.

Railroads are appealing as investments because they are transparent, sophisticated operations regulated by the government. They hire employees with the expectation they will stay with the company for the rest of their careers. I know many railroad employees who have worked for the same employer their entire lives. Since Warren Buffett purchased BNSF Railway for Berkshire Hathaway (NYSE:BRK.B) in 2010, rail stocks have doubled or tripled in value. Investors who followed Buffett -- like Bill Ackman with Canadian Pacific (NYSE:CP) -- have done very well.

Unfortunately, there are only six major railroads that are traded on the stock exchanges in the United States and Canada. With railroads buying stock back, the amount of stock available has gone down while the demand for rail stock appears to be up, driving prices of these stocks to new 52-week highs. Union Pacific (NYSE:UNP) was up 41.37% YTD through Nov. 7. Union Pacific repurchased more than 8.3 million shares in the third quarter 2014 at an average share price of $102.54 and an aggregate cost of $856 million. The stock recently hit $120 per share. It looks like management made a good investment.

Take a look at the following key metrics for railroads.

Investment

Average P/E over 11 years

Trailing 12 months P/E

Average Dividend Yield over past 11 years

Trailing 12 months Dividend Yield

Union Pacific

18.08

21.9

2.81

1.55

Norfolk Southern (NYSE:NSC)

14.52

17.6

2.02

1.97

CSX

15.15

19.2

1.64

1.75

Kansas City Southern (NYSE:KSU)

33.9

28.7

0.82

0.86

Canadian Pacific Railway

20.23

37.5

1.39

0.61

Canadian National Railway (NYSE:CNI)

15.43

22.3

1.51

1.26

S&P 500

16.47

18.6

1.91

2.1

Morningstar.com and Vectorgrader.com

Valuation
Over time value investors develop a habit of looking at certain metrics when valuing a company. When it comes to railroads, I have looked hard at the price/earnings ratio, quarterly earnings per share growth, dividend yield, payout ratio and return on invested capital. Ultimately, my chief concern is how much cash can my share of stock extract from the company over time. That means a rising dividend is essential to my investment thesis. Due to rising stock prices, the dividend yield -- stock price divided by annual dividend -- for rail stocks have fallen below their historic averages. For example, Union Pacific's typical yield is 2.81%, but has fallen to 1.55% for the trailing 12 months due to quickly rising stock price. Investors were impressed with UNP's 23% increase in earnings per share to $1.53 in the third quarter.

UNP's current annual dividend of $2.00 is up 3.57 times from its $0.56 annual dividend in 2009. Union Pacific's payout ratio is healthy at 33%. Union Pacific had 2.5% pricing increases in third quarter 2014, plus sales gains with new business hauling intermodal, frac sand and grain. Operating revenue was up 11%. Trade between Mexico and the United States is benefiting Union Pacific and its rival Kansas City Southern.

So far weather conditions in the Midwest have been good for harvesting grain. Farmers are expected to harvest a record corn and soybean crop. The record harvest should keep railroads busy hauling grain well into 2015.

I expect UNP management to raise the dividend at Union Pacific every year going forward, unless the economy changes for the worse. The unemployment rate fell recently to 5.8%. A year ago, the unemployment rate was 7.2%. Five years ago, it was 10%. With more people working, the U.S. economy should chug along ahead with steady gains for 2015 and beyond.

I've watched volume numbers for railroads for many years. There was a time volumes fell over 10% during the recession and financial crisis of 2008-09. Since then freight volumes have been growing 1% to 4% annually, usually in line with Gross Domestic Product gains for the U.S. economy.

Third quarter financial results show railroad volumes grew faster than the 3.5% GDP growth. Union Pacific's third quarter business volumes, as measured by total revenue carloads, increased 7% compared to 2013.

Norfolk Southern posted a 10% volume gain in intermodal, fueled by robust growth in both international and domestic markets.

Norfolk Southern reported third-quarter net income of $559 million, 16% higher than $482 million for the same period of 2013. Diluted earnings per share were $1.79, up 17% compared with $1.53 per diluted share in the same period last year.

Rail traffic
For the first 44 weeks of 2014, U.S. railroads reported cumulative volume of 12,830,740 carloads, up 3.6% from the same point last year, and 11,459,079 intermodal units, up 5.5% from last year. Total U.S. traffic for the first 44 weeks of 2014 was 24,289,819 carloads and intermodal units, up 4.5% from last year, according to the Association of American Railroads.

Rail traffic tends to be slowest in January and February. This year traffic picked up in March and has steadily made gains all year, with August setting records for intermodal activity. I believe the increase in intermodal will translate into a big holiday season.

The 140,000 miles of track owned by Class 1 railroads would be hard to replace. When investors talk about the moat, it's the barrier to entry. How could a competitor build a tunnel and track through the Rocky Mountains to compete with Union Pacific? Just can't be done. Railroads own so many hard assets.

Railroads are investing capital to increase velocity for customers. Train speeds have slowed down due to congestion.

Velocity is dependent on a number of things, including wait times at intersections. Sometimes single-line track should be double-line track. Railroads are adding sidings to these single-line tracks to increase capacity and reduce wait times. Managers for BNSF Railway and Canadian Pacific Railway are adding sidings in the Northern Transcon to improve traffic flow through North Dakota and the Twin Cities.

Railroads have gotten so flexible and dynamic that they are able to switch gears when one area of business is losing and devote capital to faster growing areas of business, including oil-by-rail.

CSX is actively working to improve planning with other railroads, especially in the critical Chicago Gateway. Says CSX Oscar X. Munoz, executive vice president and chief operating officer, "This is the area most in our control with the fastest cycle time. We are nearly complete with our winter preparations and, also very importantly, we've been holding ongoing dialogue with our customers to keep them up-to-date on our service recovery progress in order to better meet their continued volume growth."

Some capital improvement projects have sweeping changes for railroads and the environment.

Union Pacific's Tower 55 Rail Intersection at Fort Worth, Texas, is one of the nation's busiest rail intersections, handling more than 100 trains per day. A new $115 million public/private partnership has created a new intersection and improvements, designed to reduce congestion and increase trade and commerce in the fast growing markets in Texas. Trains will now move 10 mph faster. The improvement will reduce 93,000 tones of carbon dioxide emissions annually and save 100,000 hours of waiting by motorists and pedestrians.

Oil conundrum
I've studied oil prices for years. I expect fuel prices to remain reasonable in 2015 given the tremendous increase in domestic production. Big trucks are popular again. We may see an uptick in oil prices in the spring ahead of the heavy summer driving season.

Stock returns for railroad investors may not be as good in 2015 as they were in 2014, due to the overbuying in this sector. Nevertheless, the economics right now tend to favor railroads. I plan to hold my rail stocks even though I believe they are overvalued at the moment. Why? Because railroads have a strong outlook for the next 10 to 20 years. No other form of transportation will be able to haul heavy goods and commodities cheaper than railroads over long distances.

Conclusion
Low oil prices will help transportation companies like railroads achieve lower operating costs. The manufacturing sector is growing in the United States. A growing economy and improving operating efficiencies will lead to higher profits for railroads. Many SA bloggers (including myself) said rail stocks were fully valued in the third quarter, but the stocks went higher. UNP went from $98 per share on Oct. 13 to $118 per share on Nov. 7. It is likely UNP will achieve 15% to 17% annual earnings growth in 2015, but that appears to be priced into the stock already. Long term, these railroads will eventually return to their normal metrics of valuation. Reversion to the mean usually occurs during a recession, but that appears a long way off. The outstanding third quarter of 2014 shows the United States is the kingpin of economic growth in the world.

Disclosure: The author is long UNP, NSC, CP, CNI, BRK.B.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.