Railroads are always worth looking at for those seeking good dividend growth prospects. But since no two railroads will have exactly the same dividend or growth potential, let's consider which ones are best for income seekers.
Dividend-paying railroad stocks
| Stock | Yield | Dividend/FCF | 10-Year ROE | G=ROE (1-D/FCF) |
|---|---|---|---|---|
| Union Pacific Corporation (UNP -0.94%) | 2.3% | 58% | 18.2% | 7.6% |
| CSX Corp. (CSX -0.85%) | 1.5% | 63% | 17.4% | 6.5% |
| Norfolk Southern Corp. (NSC -1.28%) | 2% | 65% | 15.4% | 5.4% |
| Kansas City Southern (KSU) | 1.3% | 44.1% | 10.2% | 5.7% |
| Canadian National Railway (CNI -0.82%) | 1.5% | 64.9% | 21.8% | 7.6% |
| Canadian Pacific Railway Limited (CP -0.97%) | 1% | 64.7% | 17% | 6% |
Data source: company presentations. Author's analysis.
Let's first review what a few of the numbers mean in the table above.
The third column shows the amount of free cash flow that was used to pay dividends in 2016. Here, a low number is better because it implies the company has, at least in theory, more financial firepower to grow its dividend. Kansas City Southern scores the best in this regard.
The fourth column shows 10-year average return on equity (ROE), which is how much net income a company generates from shareholder equity. Here, a higher number is better as it implies the company can keep growing its income and cash flows more. Canadian National Railway comes out top on this metric.
The fifth column is the theoretical growth rate of the company's dividend based on its free cash flow payout ratio. It's calculated as return on equity divided by the free cash flow payout ratio Canadian National Railway and Union Pacific Corporation come out on top.
Of course, if you're just looking for the highest current yield, Union Pacific is the winner. Is that the right answer, though? Should you just go ahead and buy them all and wait for some low but solid dividend growth in the future? Investing is never that simple.
Image source: Getty Images.
CSX and Norfolk Southern
Assuming a railroad's previous 10-year average ROE will be the same in the next decade is a risky exercise. On the other hand, risk and uncertainty imply upside potential.
Indeed, CSX and Norfolk Southern both have the opportunity to increase their ROE in future years. Operating margin at both companies has been relatively flat since 2012 -- a marked contrast to improvements at the other four railroads:
CSX Operating Margin (TTM) data by YCharts
One reason for their relative underperformance is their exposure to coal. At the start of 2012, both companies generated around 28% of revenue from coal, but that figure is down to around 18% in their most recent quarters: 
US Coal Rail Traffic data by YCharts
Here's why both companies can improve their ROE in the future:
- U.S. coal rail traffic has stabilized in 2017.
- President Trump has been active in rolling back regulations that would have financially burdened mines in the Appalachian Basin.
- CSX CEO Hunter Harrison has aggressive plans to increase operating margin and productivity through utilization of so-called "precision scheduled railroading."
- Norfolk Southern has plans to improve its operating margin ratio to above 35% "by 2020 or sooner."
Putting all these points together, there is reason to believe that operating margin and revenue could improve at both companies, and all things being equal, that usually means an increase in ROE and the ability to grow dividends.
Looking ahead
All told, while none of the railroad stocks offer a high yield, now or in the near future, they are relatively safe to invest in. Union Pacific stands out, but CSX and Norfolk Southern are noteworthy for their potential to step up earnings, cash flow, and dividend growth. Of the two, Norfolk Southern looks like the best bet.
CSX stock has priced in a lot of the expectations for operational improvements from Harrison's tenure, but Norfolk Southern also has growth prospects, and its current dividend yield makes it a slightly better prospect right now.
