Can U.S. Railroads Prosper in Spite of Coal?

Many of the U.S.-based publicly traded railroads are suffering from extremely tough operating conditions, and there's only one culprit: coal. Due to a variety of factors including depressed natural gas prices and a broader national desire for cleaner sources of energy, railroads are shipping significantly reduced levels of coal and realizing lower prices to boot. This has brought down bottom lines across the industry, and it makes investing in railroads an iffy proposition.

Are any domestic railroads that are worth buying despite coal's drag on profitability, or would investors be better served remaining on the sidelines until coal fundamentals improve?

Coal in the cross-hairs
The recent results from a slew of large railroads such as Norfolk Southern (NYSE: NSC  ) , and CSX (NASDAQ: CSX  ) reveal that coal is sandbagging their profits.

Norfolk Southern relies on coal for approximately 22% of its operating revenue, and the company's sluggish results exemplify the dour situation facing coal.

Coal revenues dropped 17% in both the most recent quarter and the first six months of the year for Norfolk Southern, offsetting strength in the company's General Merchandise and Intermodal segments. Overall, Norfolk Southern's quarterly revenue fell 3% year over year, despite coal being the only operating segment to see a decline in revenue during the quarter.

For its part, CSX is holding steady. The company's second-quarter revenues were flat year-over-year, while diluted earnings per share managed a 6% increase.

Coal is very important for CSX as well, however, as it accounts for one quarter of the company's revenue. Over the first six months, CSX has seen its coal volume and revenue drop 8% and 9%, respectively.

Going forward, CSX is not overly optimistic about coal as it has noted the pronounced global oversupply as a likely headwind in future quarters. As a result, CSX investors should monitor the company's coal results closely.

A clear outperformer
Union Pacific  (NYSE: UNP  ) , meanwhile, is not only hanging on through this tough environment -- it's thriving. The company's fiscal second quarter produced record diluted earnings per share, operating revenue, and operating income. In all, operating revenue and diluted EPS climbed 5% and 13%, respectively.

Most surprisingly, though, Union Pacific grew freight revenue in four of its six segments. This included coal, which saw a freight revenue increase 12% in the second quarter. Second-quarter volumes actually fell 1%, which means that Union Pacific boasts exemplary pricing power.

Union Pacific's uniquely reliable performance has earned its shares a noticeable premium to those of its industry peers. Whereas Norfolk Southern and CSX trade for 13 times trailing earnings, Union Pacific changes hands for 17 times trailing earnings. Investors shouldn't let this well-deserved multiple scare them away from the stock.

Should investors ride the rails?
There's no denying the impact coal is having on the nation's railroads, and no guarantee that the current unfriendly economics of coal will reverse anytime soon.  That said, as natural gas experiences rising demand, its price probably won't stay this low forever.

At the same time, these railroads have demonstrated a remarkable ability to remain strongly profitable and reward shareholders, even with coal bringing down their results.

Therefore, while further share price gains may not materialize in the short term, these stocks should reward shareholders with resilient profits and strong dividends provided you keep a long-term perspective.

In that light, the compelling dividends and reasonable valuations make the railroad industry intriguing. Each of these stocks deserves a closer look for long-term Fools, with Union Pacific earning highest praise among the three.

Railroads aren't the only promising prospective pick on our radar. The Motley Fool's chief investment officer has selected his No. 1 stock for this year. Find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2013." Just click here to access the report and find out the name of this under-the-radar company.

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9/30/2016 4:00 PM
CSX $30.50 Up +0.51 +1.70%
CSX CAPS Rating: *****
NSC $97.06 Up +1.91 +2.01%
Norfolk Southern CAPS Rating: *****
UNP $97.53 Up +1.57 +1.64%
Union Pacific CAPS Rating: *****