My Top Rail Stocks For 2017

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Includes: CNI, CP, CSX, GWR, KSU, NSC, UNP
by: James Sands

Summary

My top rail stocks for 2017 include Canadian Pacific, Kansas City Southern and Union Pacific.

I expect increased volatility during 2017; this past week was a prime example of it with Kansas City Southern.

In the event market weakness occurs, Canadian National or Genesee & Wyoming could become more appealing.

In my opinion, CSX and Norfolk Southern currently trade at the highest premiums, offering little upside unless revenues and profits improve further from current estimates.

Source: Google Images

For 2017, my top rail stock picks are Canadian Pacific (NYSE:CP), Kansas City Southern (NYSE:KSU) and Union Pacific (NYSE:UNP). Performance for all rail stocks during 2016 was quite well, with both Canadian Pacific and Kansas City Southern lagging peer performance.

Part of the appeal is related to the fact that these two rail stocks did not witness as strong of a return to pre-2015 levels like others, including CSX (NYSE:CSX), Norfolk Southern (NYSE:NSC), Canadian National (NYSE:CNI) and Union Pacific, have. In the case of CSX and Norfolk Southern, both have eclipsed previous all-time highs in January 2017.

There are a few ways that I am keeping tabs on rail stock peers. First, I am tracking rail traffic and keeping an eye on the correlation between seaport traffic and container trends. Second, I am keeping tabs on the fundamental snapshot as it relates to valuation - specifically, P/E and EV/EBITDA. And lastly, I am paying attention to the technical trends as displayed by 50- and 200-day moving averages relative to stock prices.

Source: Class I weekly carloads and intermodal units carried and personal database

Overall rail traffic performance has improved substantially from the March/April bottom in year-over-year, YOY performance. For individual rail operators, improvement has varied as Canadian National witnessed carloads carried positive YOY results as early as September. Many other Class Is did not witness positive results until later in the year, Genesee & Wyoming (NYSE:GWR) included.

From a valuation perspective, multiples for rail stocks have fluctuated over the past few years. This is to be expected and is the case for any industry during contraction and growth cycles of the business. Leading up to 2014, most rail stocks traded above 20 times earnings and between 11 and 14 times EBITDA. CSX and Norfolk Southern were exceptions trading at discounts.

But during 2015, these valuation multiples contracted substantially as rail stocks entered a downturn from the previous growth cycle. During this period, rail stock traded 13 to 18 times earnings and between 7 and 10 times EBITDA.

Today, expectations are for a return to growth for both rail traffic and revenues and earnings per share, EPS. As such, rail stocks have already risen substantially during 2016 to reflect higher valuation multiples.

Between 2014 and today, there were excellent buying opportunities for each rail stock. From a technical perspective, volatility increased substantially to the downside during 2015 and early 2016. This was a significant change versus the period between 2012 and 2014, with exceptions being Kansas City Southern due to concession issues, and CSX and Norfolk Southern during 2012 winter issues.

I view today's prospects for the rail industry as favorable. Gross domestic product, GDP, is expected to marginally improve, led by industrial production growth. Combined with sustained consumer demand in the U.S., rail traffic is positioned to witness marginal improvement. With the possibility of energy prices increasing and tightening occurring in the truckload market, rail stocks could also benefit from increased pricing.

But there is uncertainty surrounding President-elect Donald Trump's focus on the North America Free Trade Agreement, NAFTA, as well as overall foreign trade policy. A lot has changed over the past 30 years as global manufacturing has shifted to most continents and supply chains have adjusted accordingly.

Some are hopeful that tax reforms and infrastructure spending will provide mechanisms for stimulating jobs and further economic activity. But the net effects from these policies is not clear. As a result, investors should be prepared for further volatility on a weekly basis for rail stocks.

Canadian Pacific

Source: Canadian Pacific weekly carloads and intermodal units carried and personal database

Canadian Pacific, like its peers, witnessed strong improvement in both carloads and intermodal units carried during the fourth quarter of 2016. Much of the improvement was derived by intermodal units carried, which has been positive now for five consecutive months since August.

Fundamentally, Canadian Pacific has traded at 20 to 24 times earnings prior to 2015, with an EV/EBITDA range of 11 to 15 times. The company has the second lowest operating ratio, OR, to Canadian National and is a leader for profitability. With 2017 offering a return to growth, the market could easily attribute a P/E multiple of 20 times earnings. Canadian Pacific's valuation is at 19.5 times earnings today.

Looking out to 2017 estimates, this would translate to a stock price of $240 per share, a 24 percent premium from today's price, just below $195. In addition to the 2017 estimate, the company is trading at a discount of 8 percent versus full 2016 earnings estimates. Canadian Pacific is only one of two rail stocks trading with this steep of a discount for 2016.

Source: Yahoo! Finance and personal database

As mentioned above, Canadian Pacific witnessed much less stock price volatility to the downside between 2012 and 2014. It was only until the latter half of 2015 through the first quarter of 2016 that the company witnessed extreme deviations from its 50- and 200-day moving averages.

From a technical level, Canadian Pacific is at a much better price-point versus most every other rail stock. The company does have the highest levered capital structure versus its peers and the highest debt/EBITDA ratio as well. Additionally, Canadian Pacific provides a significant amount of exports to the U.S., so the company is mired in uncertainty regarding U.S. foreign trade policy changes, especially as it relates to the North America Free Trade Agreement, NAFTA.

The same could be said for Canadian National, but the gap between the two from a valuation perspective for the next year has widened, leaving Canadian Pacific as the more appealing opportunity today.

Kansas City Southern

Source: Kansas City Southern weekly carloads and intermodal units carried and personal database

Kansas City Southern led all Class Is with only a -2 percent decline in carloads and intermodal units carried for 2016. For both carloads and intermodal units carried, performance was stronger for Kansas City Southern's Mexico rail traffic, while the U.S. side was moderately negative.

Fundamentally, Kansas City Southern had traded between 23 and 31 times earnings prior to 2015 and 12 to 18 times EBITDA. Kansas City Southern has witnessed strong improvement in its OR and ranks fourth behind Union Pacific and the Canadian rails. Like Canadian Pacific, Kansas City Southern could be ascribed a P/E ratio at 20 times earnings as the market improves. This is at a slightly higher multiple than today's 18.2 times earnings.

Out to 2017, this would translate to a stock price of $103.50 per share, a 23 percent premium from today's price, just below $84. Also like Canadian Pacific, Kansas City Southern is trading at an 8.5 percent discount based on 2016 earnings estimates with a P/E multiple at 20 times.

Source: Yahoo! Finance and personal database

Kansas City Southern has witnessed less stock price volatility to the downside prior to the second half of 2015, with the exception being during late 2013 and early 2014. Kansas City Southern has had greater volatility due to its exposure to Mexico. During 2013 and 2014, there were concerns surrounding the company's concession and its longevity due to Mexico reform policies.

Today, volatility to the downside has continued since Donald Trump was elected president. There will likely be further volatility in the near term as the market continues to digest the ramifications of the relationship between the U.S. and Mexico. Investors should remember that Kansas City Southern's revenues from Mexico are close to 50 percent.

With political uncertainty on the horizon, investors should be prepared in the event further downside stock price volatility returns. Additionally, higher energy costs in Mexico could begin to impact the company's OR. Either way, the stock may offer double-digit upside for 2017. The expected return may decrease, so investors should consider a patient approach. If the stock moves down aggressively, strong returns can be achieved by year-end.

Union Pacific

Source: Union Pacific weekly carloads and intermodal units carried and personal database

Union Pacific was the sole Class I to witness only one month of positive YOY for carloads and intermodal units carried; and it was the last month of the year for 2016. Union Pacific also witnessed some of the strongest declines during March and April; improvement during the back-half of 2016 was gradual.

Fundamentally, Union Pacific has traded 16 to 21 times earnings prior to 2015 and eight to 11 times EBITDA. Union Pacific has the third strongest OR behind only the Canadian rails. As the largest Class I rail in North America by total operating revenues, Union Pacific could be attributed a P/E multiple at 20 times earnings moving forward. This would be at a level just below today's 21 times earnings.

Through 2017, this would translate to a stock price of $112 per share, a premium of approximately 8.5 percent from today's price, just above $103. Unlike Canadian Pacific and Kansas City Southern, Union Pacific is not trading at a discount today based upon 2016 year-end estimates.

Source: Yahoo! Finance and personal database

Union Pacific was the poster-child for ideal stock price performance and negative volatility prior to 2015 and early 2016. Interestingly, Union Pacific was one of the earlier rail stocks to witness stronger declines, starting in March of 2015.

Union Pacific has displayed a much stronger trading pattern as the most recent stock price activity has deviated nearly 15 percent higher from the 200-day moving average. Kansas City Southern remains negative, while Canadian Pacific has been only marginally positive.

While Kansas City Southern is more exposed to Mexico, investors should remember that Union Pacific generated greater than $2 billion in revenue in the Mexico geography during 2015. This is about two times that of Kansas City Southern. Union Pacific has exclusive access to five ports of entry with Mexico.

Both Canadian National and Genesee & Wyoming have witnessed appreciation as of late. Compared to the previous three rail stocks I would be a little more patient for a better price. Taking a similar approach as the highlighted rail stocks, Canadian National is trading with a seven percent discount, and Genesee & Wyoming is trading with a six percent discount.

For those long or looking to add or initiate positions in CSX and Norfolk Southern, I do not see much upside for 2017. Both rail stocks are trading 21 times earnings today, directly in line with Union Pacific. When comparing fundamentals, it just does not pencil out; I would value them slightly below at 19 times earnings. I, of course, could be completely wrong, but it would take a much more robust increase in rail traffic, in my opinion, for these two to have more upside. Pricing could also be a sleeper leading to greater profits.

Using the same estimates for 2017, CSX would be fairly valued at $38 per share, offering one percent upside from today's price. Norfolk Southern would be fairly valued at $116 per share, offering four percent upside from today's price. In most cases, CSX and Norfolk Southern are expected to grow earnings at or below peers, with their ORs and other fundamental metrics, they should continue to trade discounted as they have in the past.

Source: Yahoo! Finance and personal database

The technical picture may be a better way for investors to glean some insights as to the comparable performance for rail stocks. Clearly, CSX is at all-time highs as the stock price has eclipsed the recent 2014 and 2015 price levels.

Source: Yahoo! Finance and personal database

The same can be said for Norfolk Southern with new stock price at all-time highs above the previous 2014 levels.

In conclusion, Canadian Pacific, Kansas City Southern and Union Pacific are my top picks for 2017. All three are not without risk, and today's prices could become more volatile in the near term. Based on long-term prospects, however, I would be most comfortable owning one of these three; maybe more so with Canadian Pacific or Union Pacific over Kansas City Southern during the next few years.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CP, KSU, UNP over 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.