1 Railroad Stock Poised to Deliver

North America's Class I railroads run a predictable and straightforward business, but the same can't be said of their stock price. Companies such as Norfolk Southern (NYSE: NSC  ) have been in freefall recently, with shares falling more than 12% in a week. Investors are nervous about weakness in the global economic recovery generally, but most specifically about the decline of the railroads' most important revenue driver. Despite these fears, however, railroads enjoy insurmountable barriers to entry and a bright future as trade recovers. Recent weakness might just present a great buying opportunity.

Freight falters
Intermodal cargo is an important revenue source for railroads, but it leaves them sensitive to weak consumer demand. In September, two reports came out from the New York and Philadelphia Federal Reserve banks indicating that manufacturing output was down in those regions, continuing a national trend. Depressed manufacturing means fewer industrial inputs are being shipped to factories, fewer finished goods are being shipped to consumers, and lower revenue is resulting for transporters.

Markets got a reminder of this weakness when freight shipping and logistics operator FedEx (NYSE: FDX  ) cut guidance, projecting that global trade will remain weaker than anticipated. CEO Fred Smith confirmed that declining industrial activity, as well as a slump in Chinese growth, would hurt the company's earnings. The company also predicted that the Federal Reserve's estimates for economic growth in 2012 and 2013 are too optimistic. FedEx, as one of the world's largest movers of goods, has great data on global demand for products, and a gloomy outlook from the company could foretell tough times ahead for freight transporters.

King Coal dethroned
The day after FedEx's announcement, Norfolk Southern slashed its own earnings guidance, specifically blaming low volumes of coal. Coal shipments are critical for many railroads: Norfolk Southern and CSX (NYSE: CSX  ) are particularly dependent, with Appalachian coal providing more than 30% of revenue.

Coal is primarily used for electricity generation, and its weight makes railroads the most viable way of transporting it. This has been a windfall for the rail industry, but coal has always been among the most environmentally harmful energy sources, a reality that has led successive administrations to pass tough new rules regulating the burning of coal for electricity. Utilities such as Duke Energy (NYSE: DUK  ) have fought such regulations for years, because coal has historically been the cheapest energy source. No more.

The advent of hydrofracturing, a process for extracting gas from shale formations, has allowed for record production, soaring supply, and plunging prices for natural gas. Natural gas is now not only the cleanest hydrocarbon but also the cheapest. Coal stalwarts are responding: Duke Energy will retire the Dan River coal station, for example, and replace its capacity with a new natural gas facility. Industry analysts don't expect another coal plant to ever be built in the United States, and railroads will need to face that reality.

Keep chugging along
The common thread in these challenges to railroads, however, is that they were both foreseeable. Slow economic recovery and the decline of coal have been years in the making, and investors should have already priced these dangers into railroad stocks.

I haven't been an owner of railroad shares for some time now, simply because I thought the market wasn't correctly pricing in these short-term troubles. Norfolk Southern's announcement changed all that. With most railroads down hundreds of basis points over the past week, I think it's time to reconsider.

American railroads' advantages are considerable. Compared with trucking, railroads enjoy a fourfold advantage in fuel efficiency and lower labor costs per ton, making them much more competitive for long distances and heavy goods such as commodities. Strong property rights make it next to impossible for potential competitors to put together the rights-of-way required to enter the railroad market, giving railroads a monopoly in their geographies.

And railroads will not be short of business opportunities. Despite the decline of American coal usage, China is expected to drastically increase its coal import and consumption. Coal terminals are under construction on the West Coast, and railroads may soon be shipping massive volumes of coal for export. In other sectors, rising global populations will trigger demand for the bulk agricultural products that American railroads move, and rising incomes will drive intermodal traffic higher. It's safe to say that when global trade recovers, so will railroads.

My favorite railroad today is Canadian National (NYSE: CNI  ) . It's more expensive than some competitors: It trades for 14 times forward earnings, compared with less than 10 times forward earnings for Norfolk Southern or CSX. However, with a product mix low in coal (under 10%), a favorable geography providing access to West Coast ports, and some of the highest operational metrics in the industry, I'm willing to pay up for quality.

Of course, any investment in railroads is tightly geared toward the energy markets, as the railroads are so exposed to energy prices for both revenue and costs. One Motley Fool analyst believes that the era of cheap natural gas could end as soon as 2014, and he's identified one stock you need to own before then. This report is free, but it's available for only a limited time, so get your copy today.

Fool contributor Daniel Ferry has no position in any of the companies mentioned above. Motley Fool newsletter services have recommended buying shares of Canadian National Railway and FedEx. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.
 


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  • Report this Comment On September 24, 2012, at 10:39 AM, Rail2012 wrote:

    Coal has always been King for railroads. The loss of that market will strain their revenues for a while, but other markets will grow out of the use of natural gas. Question is, will the railroads explore the use of natural gas to run their loco's?

  • Report this Comment On September 25, 2012, at 12:53 AM, Edamits wrote:

    There will be a ripple effect with the suppression of King Coal and the subtitution of natural gas. Natural gas is tranported thru pipelines. There will be an increase in the building of pipes which will probably from offshore production. Therefore there will be layoffs in the railroad industry in Pennsylvania, West Virginia, western Virginia and the north central coal region. President Obama with Chief Justice Roberts endorsement will tax coal out of existance. Coal is dead. Mergers in the railroad system will cause a massive downside in employment. President Obama will reintroduce the ninty-nine weeks of unemployment to support the unemployed coal miners and railroad workers.

  • Report this Comment On September 28, 2012, at 1:03 PM, clbjblk wrote:

    Norfolk Southern if I am mistaken which is highly possible seem like a little while back they made some news about a contract where they get there fuel from to go up and down the tracks with. If I recall they struck a deal to buy fuel from the billion dollar chicken food company who is partners with Mafshfield and SYNTROLEUM along with Tyson foods, they formed a company called Dynamic Fuels.

    Now this is kind of interesting because Dynamic Fuels started this company for Mr Green Peace, you know bio fuels and then Obama forced the USA NAVY which is the largest buyer if fuel in the world and they have to buy there fuel made from chicken grease and then make it into bio fuels for our NAVY AND THE CONTRACTS WHICH THE TAX PAYER PAYS FOR THIS FUEL AND I AM NOT TALKING ABOUT A LITTLE BIT OF FUEL THOSE AIRCRAFT SHIPS AND DESTROYERS AND ALL THE JET FUEL THEY USE COMES FROM THERE BIGGEST PARTNER TYSON FOODS HAS SOME CHICKENS NOW AND THOSE OTHER TWO CIMPANIES ARE JUST ALONG FOR THE RIDE. THEN OBAMA COMES TO OKLAHOMA AND SAYS NO KEYSTONE PIPELINE BUT HE DOES NOT TELL YOU THAT THE ONE COMPANY NAMED SYNTROLEUM WAS JUST DOWN THE ROAD SELLIG FUEL TO THE NAVY AND GUESS WHO GOT IN FOR THE RIDE I BELIEVE YOUR LITTLE RAILROAD CUT A DEAL LIKE THE NAVY HUNDREDS OF THOUSANDS OF GALLONS OF FUEL FOR TWO BIG USERS NOW THAT THE TAX PAYER HAS BEEN PAYING FOR AND AT A PRICE OBAMA FORGOT TO MENTION WHICH IS PUBLIC RECORD AND I HEARD IT IS AN OUTRAGIOUS PRICE BUT YOU GET YOU GREEN PEACE MERITS FOR BUYING THAT FUEL. IN THE NAVY'S CASE THEY HAD TO PAY 5 TO 6 TIMES MORE FOR A GALLON CAUSE OBAMA SAID SO AND THIS HELPED HIS GOOD FRIEND CHINA GET CANADA TO GET A REAL GOOD CHANCE OF A PIPELINE TO GO TO THE WEST COAST AND PUT THAT FUEL ON SUPER TANKERS WHEN IT SHOULD BE GOING TO THE USA REFINERIES IN TEXAS TO KEEP OUR FUEL PRICE DOWN BUT HE DID NOT BRING THAT UP IN HIS SHOVEL READY JOBS FOR AMERICANS TO GET JOBS HE OWES CHINA FAVORS SO HOW MUCH DOES THE NAVY PAY FOR FUEL AND THEY CAN PUT CHICKEN EMBLEMS ON THE FRONT OF OUR SHIPS IT COULD SAY CHIKENS MIGHT NOT FLY OR SWIM BUT OUR NAVY PAYS 5 TO 6 TIMES MORE A GALLON THAT THE TAX PAYER PAYS SO THEY GET CLEANER FUEL . BUT THE BIG SAVINGS IS IF YOU DO NOT HAVE A JOB YOU DO NOT NEED GAS IT COST TO MUCH ,TAKE THE OBAMA TRAIN AND VOTE ON THE WAY. GUESS WHERE ALL THE BIKES COME FROM NO GAS NEEDED AND A CHINA STICKER ON THEM, WHICH WILL BE GOOD FOR HIS HEALTH PLAN. SOLYNDRA WAS ONLY 500 BILLION AND THEY WENT TO CHINA AFTER BANKRUPTCY BUT OBAMA LOOKED GOOD ON THOSE PRE ELECTION COMMERCILES AND NOW EVERY BODY HAS FORGOT ABOUT THEM AND THEY WILL FORGET ABOUT THE KEYSTONE PIPELINE. WHICH WOULD BE BUILT BY NOW BUT HE OWES CHINA BIG TIME . SO YOUR RAIL ROAD IS PROBABLY A GOOD PICK .DO YOUR HOMEWORK AND TELL US JUST HOW MUCH THAT NAVY FUEL IS THAT GETS SHOVED DOWN THERE THROAT THAT WE PAY FOR. YOU CAN DELAY THIS COMMENT BUT THAT WOULD FIT WITH THE GAG ORDER OBAMA ALREADY HAS ON THE NO BUDGET OR NO KEYSTONE DEAL WITH THE SENATE , I THINK HE IS GOING TO CUT A DEAL WITH IRAN FOR A REAL ALTERNATIVE FUEL AND HAVE SOME CHICKEN ON THIS FINE WEEKEND THAT WOULD BE REAL PATRIOTIC. I made sure you know the truth like a fool should do before touting a stock that you are already paying for. JUST THINK YOUR WESTPOT TOUT IS GETTING CLOSER AND WILL BE WORTH MORE IF START PUTTING ON THE NATGAS PIPELINE. WHY DO YOU THINK WARREN RAILROAD WILL BE A BAD STOCK WHEN THE TRACKS IN THE BAKKEN FIELDS ARE DONE HE ALREDY HAS A BACK HAUL AND THEN HIS SECRETARY GETS A RAISE KENYA BELIEVE THAT .EVERYBODY IN THE WHITE HOUSE SHOULD SHOULD HAVE THERE MOTHER IN LAW ON THE THIRD FLOOR OF THE WHITE HOUSE THEN THEY CAN ALWAYS SAY WHATS FOR SUPPER AND SHE SAY'S CHICKEN ALA MEANS ANYWAY YOU LIKE IT .

  • Report this Comment On September 28, 2012, at 3:51 PM, lowmaple wrote:

    Rail2012 Canadian National was working with Westport already to look into building Nat gas engines which is good for Rails and oh goody also pipelines.

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