U.S. Railroads Make a Comeback (NSC, UNP)

Includes: NSC, UNP
by: Daniel Andres Jacome

2005 results for a handful of railroad companies blew 2004 numbers out of the water. Union Pacific Corp. (UNP), the nation's largest railroad, for example, reported 70 percent growth in 2005 net income to $1.03 billion with sales climbing 11 percent to $13.6 billion. No. 4 Norfolk Southern Corp (NSC) saw its net income rise 39 percent to a record $1.3 billion in 2005, while revenue rose 17 percent to $8.5 billion.

Growth has been driven by higher, volatile diesel costs (which has kneecapped the trucking industry, any railroad company's chief competitor) as well as voluminous cargo shipments from Asia, whose GDP figure is growing almost as fast as Pamela Anderson's ex-hubby list. And on the Street, shares are finally getting a much deserved oomph now that value investors -- bored by the chase-the-prom queen act -- are gradually turning to beat up wallflowers and/or large caps.

Despite these turnarounds, the industry is for the most part ignored by most analysts and portfolio managers. It's hard to get excited when the industry (intermodal rail freight) grew "just" 7 percent to 11.7 million containers and trailers in 2005, right? Wrong. The railroad industry doesn't stink -- maybe what stinks are the Street's lofty expectations. If the current growth and demand scenario sticks around, we think railroad stocks could get a nice lift in 2006.

Because railroads are more fuel efficient than truckers (whose headache has been compounded by a sharp drop in driver headcount), we don't think this proposition is by any means far-fetched. In fact, if fuel continues to behave as schizophrenically in 2006 as it did in 2005, we believe railroads could see a sharp increase in freight traffic as order & volume levels pick up. That said, we wouldn't pounce on railroad stocks of companies who couldn't effectively spread their costs across the supply chain and/or pass them down to customer.

The railroad business is notoriously capital intensive, so what we're telling our clients to do is pursue those companies with lower-than-average operating ratios, which is simply the percentage of sales that ends up going into capital expenditures (cap ex/total sales). One name we're really fond of is Northfolk Southern, which we briefly mentioned above.

Over the last few years, Northfolk has begun to pull in some fantastic free cash flow by whacking down its operating ratio to 11% of revs. Additionally, unlike some of its peers, Northfolk has not received an excessive amount of delay-related customer complaints. Currently, the stock is trading at 10x cash flow and 17x current earnings, which puts its current valuation at a discount to both its peer group and the S&P benchmark. How long can this last?

Not long, we think. In 2004, Northfolk dropped heavy dough on cap ex. In 2005, it began weeding out some operational bad worms. In 2006, we believe NSC will begin to harvest some of the fruit related to heavy capital spending -- there is a decent top and bottom line story here, but no one is seeing it.

We remind you of the risks that come with the territory: a sour economy, coal-related price shocks, poor customer service, high(er) supplier power, and mediocre capacity management could ALL cripple railroad stocks and send them spinning off the tracks, along with your hard-earned cash.

NSC 1-yr Chart

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