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Investing In North American Railroad Stocks - Playing The Macro Recovery In The US

|Includes: CP, Union Pacific Corporation (UNP)

Key Investment Themes: With a share of 40%+ of the freight traffic movement in North America, railroad stocks are a good way to play the economic recovery of the region. Given the increasing competitiveness of US manufacturing vs. imports from Asia (esp. as costs rise in China), within the railroad space I would recommend exposure to manufacturing hubs such as the Midwest and Southern US.

Stricter environmental regulations and more importantly substitution from cheaper natural gas have and will continue to be a drag on coal volumes transported by railroads (a very high margin category). Also, while export coal volume held up well over the past few quarters (due to flooding in Australia), I expect it to come under pressure as mining in Australia resumes. While it might be argued that with sell-side estimates coming down, the coal story has been priced-in, I would advise investors to limit exposure to companies which have high exposure to coal given the lack of visibility into upcoming EPA regulations (which would impact domestic coal volumes) and export coal prospects.

Lastly, I prefer US railroad stocks over Canadian names as they have greater scope for operational leverage owing to their larger scale and availability of excess capacity in the high margin segments such as intermodal (incremental margins while using excess capacity are significantly higher vs. on new capacity). Also, Canadian names have an overhang from compensation related issues.

Top Picks: BUY - Union Pacific (NYSE: UNP)/ SELL - Canadian Pacific Railway (TSX: CP)

Union Pacific (NYSE: UNP): My positive stance on shares of Union Pacific is driven by the company's well diversified (compared to other Class 1 rails) product mix which enables the company to benefit from improvements in the broader economy (vs. risk growth in specific sub-sectors). More importantly, compared to most other Class 1 rails UNP has the lowest exposure to coal (~20% vs. 30%+ for CSX and NSC). Within coal, UNP has a greater mix of western coal, which is much cleaner than eastern coal and hence coal volumes for the company are at limited risk of substitution.

Compared to peers the company has the largest $ amount of legacy contracts coming up for re-pricing. Given recent successes at re-pricing, I expect meaningful rev upside. Further, the company has been fast improving operational performance (with more room for improvement). Lastly, the company has exposure to fast growing mineral categories such as frac sands for shale oil which the markets seem to be ignoring today.

At ~13.6x forward P/E the stock is trading at a discount to its peers, historical multiples for Class-1 rails (~14-15x) and 10-yr avg of 14.5x P/E. With a large number of upcoming catalysts and solid FCF conversion, multiples should expand and I expect the stock to trade at a premium to peers and historical averages. As such, my price target is $125 (16% upside), which is based on a 15.5x P/E.

Canadian Pacific Railway (TSX: CP): The overhang from issues of shareholder activism (from Pershing Capital) would be a major drag on management focus esp. at a time when the company's performance significantly lags its peers. There is a total lack of visibility on how this battle plays out and I believe that there are significant risks from either side winning - current mgmt. has a poor track record and the new proposed CEO might lead to attrition of key consumers. Further, CP has limited avenues for operational improvements (esp. in the short-medium term) given its small size (hence lack of scale) and the nature of its railroads (sharper curves, steeper gradient, older yards) - facts which have been reiterated by the company management recently.

Despite these issues, the stock trades at a premium valuation of 17.6x P/E. This multiple is at a significant premium to the railroad peer group's average trading multiple of ~14-15x P/E and the company's historical trading range. As such, given the weaker prospects, I would value shares of CP at 14x P/E and based on consensus EPS expectations my price target is $60, which represents a 20% downside potential.

As such, while shorting shares of Canadian Pacific, investors should be cognizant of a tail risk that shares might drastically increase in price depending on how the proxy battle plays out and investors might want to hedge their shorts using out-of-the-money options.

Risks and Uncertainties: Pace of economic recovery in North America, situation in Europe and geo-political risks causing multiple revisions for the markets, impact to overall railroad freight traffic from maritime transportation - opening of Arctic routes and expedition of widening of the Panama Canal, loss of consumers, governmental regulations, derailments of trains, acts of god or terrorist activities impacting installed infrastructure, changes in benchmark rate

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.