Railroad Service Providers Are Generally Overvalued From A Free Cash Flow Perspective

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Includes: CNI, CP, CSX, KSU, NSC, UNP
by: Pim Keulen
Summary

Railroad Service Providers typically have high returning annual capital expenditure.

High capital expenditure reduces free cash flow available for dividends and buybacks.

From a free cash flow perspective, railroad service providers are overvalued.

Three out of six stocks will become interesting after a modest market correction.

Investors in railroad service providers have not been blessed with a great return on their investment so far this year. A short scout around shows that all major railroad service providers are down for the year. Union Pacific (NYSE:UNP) is down 15.1%, Canadian National Railway (NYSE:CNI) is down 12.8%, CSX Corp (NASDAQ:CSX) is down just 4.9%, Norfolk Southern (NYSE:NSC) is down 16.2%, Canadian Pacific Railway (NYSE:CP) is down 12.4% and Kansas City Southern (NYSE:KSU) posted the largest decline of 22.1%.

The poor performance of railroad service providers comes after the very profitable year in 2014. However, several reports and news events were published over the past three weeks pointing out some cracks in rail road service providers' growth potential. For example, Kansas City Southern pulled its 2015 guidance, Union Pacific stated that coal shipments were down 25% in the second quarter and the Association of American Railroads reported that oil shipments decreased 14% in the second quarter as oil company cut back domestic shipments.

All three reports and news events mentioned above took place in a timeframe of just one week, namely between May 14 and May 21. Not surprisingly, investors have become a bit more cautious with respect to railroad service providers' growth potential and their stock market valuation. In a recent article named "Union Pacific: Evidence That An Even Bigger Correction Is Near", I already warned that Union Pacific was likely to fall below $102 per share and the stock eventually did.

Following my recent article covering Union Pacific, I will evaluate the valuation of the major railroad service providers named in this article from a free cash flow point of view. In my opinion, a free cash flow is the best way to evaluate these companies because of their capital expensive business. It is nice if company X earns $1 billion in operational cash flow. But if all this money has to be reinvested in new assets, there is no money left to pay dividends to shareholders or to repurchase the company's own shares.

First let's find out the differences between the companies with a quick and dirty overview of their 2014 operational cash flow (in the table OCF), capital expenditure (in the table CapEx) and free cash flow (in the table FCF) to market capitalization ratio (in the table MC). The results are shown in the table 1 below.

OCF CapEx FCF MC FCF/MC
UNP $7,385 $4,249 $3,136 $87,300 27.8x
CNI $3,580 $1,736 $1,844 $47,220 25.6x
CSX $3,343 $2,387 $956 $33,350 34.9x
NSC $2,852 $2,118 $734 $27,570 37.5x
CP $1,735 $951 $784 $27,030 34.5x
KSU $906 $970 n/a $10,030 n/a

Table 1: Overview of 2014's free cash flow to market capitalization

It is interesting to see that capital expenditures have a significant impact on the free cash flow to market capitalization ratio. For example. Norfolk Southern reinvested almost 75% of its operational free cash flow in 2014. Railroad service providers in general are very capital expensive, as these companies need to invest in properties, infrastructure and equipment like locomotives and train wagons.

The results of the comparison between the six companies tells me that Union Pacific and Canadian National Railway are trading at significantly lower free cash flow to market capitalization ratios than CSX Corp, Norfolk Southern, Canadian Pacific Railway and Kansas City Southern. Additionally, I will focus on company specific growth potential and conditions.

It is interesting to see that capital expenditures have a significant impact on the free cash flow to market capitalization ratio. For example. Norfolk Southern reinvested almost 75% of its operational free cash flow in 2014. Railroad service providers in general are very capital expensive, as these companies need to invest in properties, infrastructure and equipment like locomotives and train wagons.

Union Pacific

In my previous article covering Union Pacific, I calculated Union Pacific's average free cash flow growth rate. In the period 2011-2015 (see graph 1 below), Union Pacific's free cash flow is likely to grow at an average growth rate of 10% per year. Therefore, I assumed average free cash flow growth in the next five years as well. Based on this assumption, I calculated Union Pacific's fair value at $102 per share.

Graph 1: Cash flow analyses Union Pacific 2011-2015 (est.)

Recently, Union Pacific warned that coal shipments were down significantly in the second quarter. Combined with a worse overall sentiment, my initial assumption of 10% free cash flow growth in the next five years might be a bit to steep. In case I adjust my growth rates downwards to 9%, 7,65% and 1.8%, Union Pacific's fair value is just $91 per share.

Despite the disappointing performance in the first quarter of this year (see Q1 report), Union Pacific should be able to increase earnings per share strongly compared to last year. However, increased capital expenses moderate the improved operational performance. Considering my adjusted DCF valuation, I find that Union Pacific is slightly overvalued at this point.

Conclusion: Union Pacific is slightly overvalued.

Canadian National Railway

Canadian National Railway trades at the lowest free cash flow to market capitalization ratio of all six railroad service providers mentioned in this article. This indicates that Canadian National Railway is the cheapest stock out there from a trailing free cash flow perspective. The company's average free cash flow growth rate in the period 2011-2015 is 8.7%, quite impressive as well.

Graph 2: Cash flow analyses Canadian National Railway 2011-2015 (est.)

Like Union Pacific, Canadian National Railway has reported strong growth numbers and a low free cash flow to market capitalization ratio. However, Canadian National Railway's capital program in 2015 will be quite extensive compared to Union Pacific. Recently, the company announced an increase of its already large capital program to C$2.7 billion (US$2.0 billion), an increase of 17.7% compared to last year's capital expenses.

The company undoubtedly delivered strong results in the first quarter (see Q1 report). Revenue increased with 15%, driven by grain and fertilizers (up 24%), forest products (up 23%), automotive (up 23%) and metals and minerals (up 22%). However, Canadian National Railway's free cash flow is likely to grow very modest because of the company's extensive capital program. Because of the slowing free cash flow growth, I consider this stock overvalued from a free cash flow perspective as well.

Conclusion: Canadian National Railway is slightly overvalued.

CSX Corp

CSX Corp is the best stock market performer among railroad service providers with just a drop of 4.9% of its share price year-to-date. However, the company is also among railroad service providers with a free cash flow to market capitalization ratio that exceeds 30. From this perspective, CSX Corp really needs high growth potential in order to justify its current valuation. However, I find that CSX Corp's actual performance does not look promising (see graph 3).

Graph 3: Cash flow analyses CSX Corp 2011-2015 (est.)

Looking at graph 3 above, it is evident that CSX Corp's high level of capital expenditure in 2014 was not a one-time event. Further, the company also face headwinds in the coal markets. Combined with flat cash flow from operations in the period 2011-2015 (est.) and a high free cash flow to market capitalization ratio, CSX Corp does not look like an attractive investment at this point.

Conclusion: CSX Corp is overvalued.

Norfolk Southern

Apart from Kansas City Southern's negative free cash flow, Norfolk Southern trades at the highest free cash flow to market capitalization ratio. Looking at the company's financial performance in the period 2011-2015, this comes not as a surprise. Norfolk Southern's free cash flow decreased 4.9% on average in this period (see table 4 below).

Graph 4: Cash flow analyses Norfolk Southern 2011-2015 (est.)

Unlike its industry peers, the decline of Norfolk Southern's free cash flow was caused by a decline of operational cash flows. In other words, the company's operations earned less cash while capital expenses were stable. Based on this poor operational performance and the company's high free cash flow to market capitalization ratio, it is fair to say that Norfolk Southern is not a solid investment.

Conclusion: Norfolk Southern is overvalued.

Canadian Pacific Railway

The second Canadian railroad service provider is Canadian Pacific Railway. This stock ranked third in my initial free cash flow to market capitalization analyses. Looking at the company's financial performance in graph 5 below, it is obvious that this company delivered the strongest free cash flow growth in the period 2011-2015 of all railroad service providers in this article. Free cash flow growth was mainly driven by strong operational cash flow growth.

Graph 5: Cash flow analyses Canadian Pacific Railway 2011-2015 (est.)

From a growth perspective, Canadian Pacific Railway might be an interesting stock to own. However, keep in mind that this stock trades at 34.5 times last year's free cash flow. Compared to Union Pacific (27.8x free cash flow) and Canadian National Railway (25.6x free cash flow) it is fair to say that Canadian Pacific Railway's growth is already priced in.

Despite lower free cash flow to market capitalization ratios and decent growth potential, I already concluded that Union Pacific and Canadian National Railway are slightly overvalued. Canadian Pacific Railway is growing at a faster pace than these two stocks, but does also trade at a premium of 34% compared to the other Canadian railroad service provider. Therefore, I consider this stock slightly overvalued as well.

Conclusion: Canadian Pacific Railway is slightly overvalued.

Kansas City Southern

Kansas City Southern did not report a positive free cash flow in 2014 at all due to very high capital expenses and operational lease expenses. For this year, the company's guidance does not look any better. As I mentioned earlier, the company pulled its guidance for this year. As a result, I do not expect positive free cash flow in 2015 (see graph 6 below).

Graph 6: Cash flow analyses Kansas City Southern 2011-2015 (est.)

This article describes Kansas City Southern's operational and financial struggles perfectly. For example, Kansas City Southern depends heavily on coal shipments. Union Pacific warned coal shipments were down in the second quarter. Based on Kansas City Southern's historical performance, poor guidance for 2015 and operational struggles, I consider this stock the least attractive railroad service provider.

Conclusion: Kansas City Southern is significantly overvalued.

Overall conclusion

Railroad service providers operate a very capital expensive business. Therefore, a large portion of their operational cash flow needs to be reinvested in properties, plants and equipments. As this sector has a very high level op capital spending, I consider the free cash flow to market capitalization an important tool to analyze these companies' valuation. In this article, I provided an overall analyses of free cash flow to market capitalization ratios and considered the companies' growth rates in the period 2011-2015 (est.).

Looking at the results, I consider three stocks slightly overvalued at this point, namely Union Pacific, Canadian National Railway and Canadian Pacific Railway. Not surprisingly, these three stocks rank one to three in my free cash flow to market capitalization analyses. Further, all three offer decent free cash flow growth potential. However, their stock price has run up too fast. For example, take my adjusted DCF valuation of Union Pacific into account. However, Union Pacific, Canadian National Railway and Canadian Pacific Railway may become interesting investments after a modest stock market correction.

Unlike the three stocks mentioned above, I do not consider CSX Corp, Norfolk Southern and Kansas City Southern potential investments after the modest stock market correction. All three stocks trade at high free cash flow to market capitalization ratios and offer less growth potential compared to the other three railroad service providers. Therefore, CSX Corp, Norfolk Southern and Kansas City Southern are not interesting investments from a free cash flow perspective. Not even after a modest correction.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.