Railroads Lay Track for Oil, Freight & Profit

Train-to-truck and crude oil shipments are growing like gangbusters in the railroad industry, and to keep up, railroads are pouring billions into brand-new infrastructure. But those extra tracks, yards, and terminals don't come cheap. To achieve real growth, railroads need enough money to not only maintain what they have, but keep expanding. Thus, investors seeking winners in the railroad sector should look for companies with the highest returns on their capital investments.

How railroads are reinvesting their cash
BNSF Railway, owned by Berkshire Hathaway (NYSE: BRK-B  ) , is spending a record $4.3 billion to maintain and expand its network, up 19.4% from capital expenditures in 2012. The company is the leader in capital investments in 2013, compared to six other North American railroads. 

BNSF is spending $800 million on "expansion capital," according to spokesman Steven Forsberg. That amount includes more than $200 million to expand track and rail yard capacity through North Dakota and eastern Montana, where railroads have experienced a boom in shipping crude from the Bakken formation. 

BNSF is also spending $1.1 billion on locomotive, freight car and other equipment, much of which will serve North Dakota. In addition, the company is completing its Logistics Park Kansas City. Right now, its cranes there can lift 500,000 truck containers and trailers annually, but that number will grow to 1.5 million containers at full capacity.

Union Pacific  (NYSE: UNP  ) invested a record $3.7 billion in 2012, and it expects to invest another $3.6 billion this year in capital improvements. Union Pacific planned to complete a total of 1,500 projects across its 32,000-mile network this year to help improve train operating efficiency, reduce motorist wait times at crossings, and enhance safety.

Canadian National Railway (NYSE: CNI  ) expects to spend $2 billion on capital programs in 2013, up from $1.73 billion in 2012. CN is building an intermodal terminal in Joliet, Ill., and completing its Calgary Logistics Park. CN will spend $200 million in 2013 for the acquisition of locomotives, intermodal equipment and cars.

Last May, Canadian Pacific Railway  (NYSE: CP  ) announced that it was increasing its 2013 capital budget 10% to $1.2 billion. The extra money came from a higher-than-anticipated cash-flow projection. The company upgraded track on the north main line between Winnipeg, Manitoba, and Edmonton, Alberta; and improved signaling systems on a mainline between Moose Jaw, Saskatchewan, and Chicago.

Measuring greatness
Railroads' return on invested capital is perhaps the best measure of whether managers are allocating their capital wisely. To calcuate this metric, divide a company's earnings by its total capital. Here are ROIC numbers for seven Class I Railroads:

Name 2011 Return On Invested Capital  2012  2013
Union Pacific  10.77  12.81  13.23
Canadian National  12.75  13.81  12.66
Canadian Pacific  12.03    9.93  14.35
BNSF Railway    8.49    9.36    8.28
CSX    8.41    8.24    8.33
Norfolk Southern     9.20     8.00    7.88
Kansas City Southern    5.54    6.93    5.69

Source: Morningstar, except BNSF Railway numbers, which are my calculations.

The top capitalists
The chart tells us that Union Pacific, Canadian National, and Canadian Pacific are really good managers of capital. Their most recent returns top 10%, which is outstanding for a capital-intensive business like railroads.
 
Canadian Pacific is really getting a big bang for the buck when it comes to investing in its business. Return on invested capital has improved to 14.25% from 9.93% in just the past year. Shareholders have to be pleased. Canadian Pacific shares are up 12% since earnings were announced Oct. 23, and up 43% year to date through Nov. 8.
 
The company's third-quarter earnings came in at $1.81 per share, up 39% year over year. The game changer for the quarter was the company's operating ratio falling to a record low of 65.9% -- an 820 basis point improvement over third-quarter 2012. Operating ratio is total expenses divided by total revenue.
 
Advice from an investment sage
As Warren Buffett's partner Charlie Munger said about returns on invested capital: 
Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return-even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result.
Railroads likely won't achieve 18% returns on invested capital, because they require so many maintenance costs over their vast networks.  But lower operating rations and higher revenues have helped top-performing railroads' returns on invested capital improve to more than 10%.
 
Track down these stocks
Investors are wise to own railroads in their stock portfolios. These railroads are highly sophisticated businesses with diverse franchises, vital to the U.S. economy, with a positive outlook for agriculture, automotive, crude-by-rail and intermodal traffic. The companies with the highest returns on invested capital should generate the highest stock appreciation -- and in this regard, Union Pacific, Canadian National and Canadian Pacific deserve kudos for their excellent management of capital investments.

Read/Post Comments (11) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 09, 2013, at 12:24 AM, banmate7 wrote:

    Very nice article. The Charlie Munger quote alone made this read worthwhile. This article motivated me to more thorough factor in ROIC, PEG, earnings growth rate, and desired rate of return in weighing value investments.

    Well done!

  • Report this Comment On November 09, 2013, at 9:39 AM, ScoopHoop wrote:

    Thank you banmate7. Morgan Housel turned me onto the Charlie Munger quote. I've been looking for stocks with high ROIC. Hershey has 23 ROIC, probably my highest returning stock in recent years. Railroads likely won't do that well, but a 10% return is pretty good. Let me know if you find any other stocks with higher than 18 ROIC.

  • Report this Comment On November 10, 2013, at 4:02 PM, banmate7 wrote:

    Scoop, I'm looking to fine tune how I do value investing. Up to now, I basically used historical PE, PEG, PB, cash flow, & balance sheets, graham #, etc. ROIC is a dimension I didn't consider before. I think ROIC will let me better evaluate choices in value investments.

    Up to now, my fairly simplistic analysis has done well. Here is an example of my CNI investment. The 1st is my basis, the rest are reinvested dividends.

    trade_date shares total_cost price/share

    5/14/2008 179.194 $10,009.13 $55.86

    7/1/2008 0.856 $40.57 $47.39

    10/2/2008 0.842 $39.18 $46.53

    1/2/2009 0.91 $34.25 $37.64

    4/1/2009 1.041 $36.48 $35.04

    7/1/2009 0.92 $39.87 $43.34

    10/1/2009 0.892 $43.50 $48.77

    1/4/2010 0.812 $44.65 $54.99

    4/1/2010 0.806 $49.30 $6117

    4/8/2010 0.809 $49.48 $61.16

    7/1/2010 0.839 $47.49 $56.60

    10/1/2010 0.767 $49.14 $64.07

    1/3/2011 0.757 $51.21 $67.65

    4/1/2011 0.832 $63.32 $76.11

    7/1/2011 0.803 $63.92 $79.60

    10/3/2011 0.908 $59.37 $65.39

    1/3/2012 0.764 $61.11 $79.99

    4/2/2012 0.91 $72.28 $79.43

    7/2/2012 0.843 $70.91 $84.12

    10/1/2012 0.83 $74.02 $89.18

    1/2/2013 0.79 $73.42 $92.94

    4/1/2013 0.832 $82.88 $99.62

    7/1/2013 0.817 $80.27 $98.25

    10/1/2013 0.804 $82.47 $102.57

    This is basically a 120% return. It's 12% a year off the top of my head. I'm going to try to see how this reckons in lieu of ROIC.

    I got into CNI because it's PE was below it's 15 year average. Also, I increased the estimated earnings growth because at the time, Buffett started buying BNI. All the rails went up, except CNI (by the way, I also bought TRN near the same time, with similar results).

    Anyway, I am looking at buying heavily into CAT, IBM, ORCL, MSFT, and GLW right now, as these seem cheap to fair value. I own all of these already, but am ready to go in again...but ROIC is going to factor large. I'll post what I come up with...but am also open to your thoughts here.

  • Report this Comment On November 11, 2013, at 4:08 PM, ScoopHoop wrote:

    You achieved excellent results in CNI. The 120% return is impressive. By the way CNI is the only transcontinental railroad in North American, connecting the Pacific and Atlantic oceans and the Gulf of Mexico. I don't like IBM, ORCL or MSFT. Their technologies can be replaced, although I can't predict when. CAT is interesting, its forward P/E has fallen to 14, but I don't like its high debt levels. I don't think any of those stocks are screaming buys. If you don't already own UNP, I would buy that for your portfolio. I last bought it at 149 per share, but still believe it's attractive at 155. Good job on TRN, I did not know about that stock, thanks for letting me know about it, TRN looks very interesting trading at 1.5 times book and strong earnings growth, but return on invested capital is meager at 4.06, probably because rail equipment is so expensive. You sound like you have a decent system for evaluating stocks, but be careful with technology that can be replaced. No one will replace CNI. It's impossible to acquire the land and start a railroad. There are only a handful of railroads, so I plan to own most of them eventually, but so far concentrating on UNP, CNI and CP.

  • Report this Comment On November 12, 2013, at 8:59 PM, banmate7 wrote:

    I want to illustrate my example in MSFT. I bought in 2006 when the PE & PEG were very compelling. The cash flow & balance sheets certainly were. And now that apply it backwards, the ROIC has been excellent then and now.

    Here is how I did. Again, the 1st investment is my basis, the rest are reinvested dividends:

    trade_date shares total_cost price/share

    05/08/2006 500.0 $11,831.95 $23.66

    09/14/2006 1.726 $45.00 $26.07

    12/14/2006 1.686 $50.17 $29.76

    03/08/2007 1.813 $50.34 $27.77

    06/14/2007 1.654 $50.52 $30.54

    09/13/2007 1.746 $50.69 $29.03

    12/13/2007 1.594 $55.95 $35.10

    03/13/2008 1.959 $56.12 $28.65

    06/12/2008 2.053 $56.34 $27.44

    09/11/2008 2.112 $56.57 $26.79

    12/11/2008 3.35 $67.12 $20.04

    03/12/2009 4.062 $67.56 $16.63

    06/18/2009 2.902 $68.09 $23.46

    09/10/2009 2.752 $68.47 $24.88

    12/10/2009 2.311 $68.82 $29.78

    03/11/2010 2.383 $69.12 $29.01

    06/10/2010 2.769 $69.43 $25.07

    09/09/2010 2.895 $69.79 $24.11

    12/09/2010 3.166 $86.36 $27.28

    03/10/2011 3.397 $86.87 $25.57

    06/09/2011 3.666 $87.41 $23.84

    09/08/2011 3.34 $88.00 $26.35

    12/08/2011 4.343 $110.67 $25.48

    03/08/2012 3.475 $111.54 $32.10

    06/14/2012 3.856 $112.23 $29.11

    09/13/2012 3.701 $113.00 $30.53

    12/13/2012 4.766 $130.80 $27.44

    03/14/2013 4.71 $131.90 $28.00

    06/13/2013 3.837 $132.98 $34.66

    09/12/2013 4.087 $133.87 $32.76

    total shares: 586.111

    total value: $21,897.11

    This is an 85% total gain, again beating the S&P500 30% return in this time period.

    I understand your point about technology. But MSFT has an Office franchise that remains a business moat. It will not be displaced so easily. Moreover, the cash flow & balance sheets mean MSFT can still keep attacking mobile, social, search, enterprise, & cloud markets...which they are.

    I'm a software engineer & see IBM, ORCL, and SAP also have similar moats. More importantly, these companies are at value & have the aforementioned cash flow & balance sheets. With their kind of cash, business development follows...as attested to by history.

    I totally get your point about an even deeper moat with railroads & their incontestable physical infrastructure. But, technology is not as pliable as some might think either. Channel relationships matter, as do financial & supply chain operations...as evidenced by non-profitable currently hot tech companies like SalesForce, WorkDay, and ServiceNow.

    MSFT & IBM right now are cheap. ORCL I'm debating, but in the long run...just like with IBM & MSFT...I expect them to continue powering enterprise computing, as well as some retail technology plays. These companies have considerable history & runway.

    Fingers crossed.

    It

  • Report this Comment On November 13, 2013, at 9:25 AM, ScoopHoop wrote:

    As a software engineer, you are in the driver's seat for understanding tech giants like MSFT, IBM and ORCL. I bought MSFT at 21 and 22 and 23 in 2008-09, but sold it at 28, to buy more railroad stocks and Hershey, which is another favorite of mine. I know Buffett has a huge position in IBM, and he's spent much of his life avoiding technology. The 200-day moving average for IBM is 192 and stock is at 183. Good luck on those trades. I haven't bought much stock in the past five months, although I did pick up about $6500 worth of BKE, a retailer with lots of cash and no debt, now have 604 shares, BKE has had a good year and typically pays a special dividend at year's end, last year it was $4.50 per share (I got $2,000 in one day!), I expect special dividend to be around $3.25 this year. Market seems a bit shaky, we may see a pullback this month. When I bought BKE, I bought it at 53, 49, 48 and 47, stock is now at 51.76

  • Report this Comment On November 13, 2013, at 9:36 AM, Mathman6577 wrote:

    Good article and analysis methods .... actually looking at numbers and not trading on perceptions.

  • Report this Comment On November 13, 2013, at 11:12 AM, ScoopHoop wrote:

    Thanks Mathman6577. I think that is the challenge for us, we have to be diligent to do our homework and stay away from imperceptible noise. I covered railroads for The Topeka Capital-Journal for 10 years from 1999 to 2009. Best prices for rail stocks was in 2009, they had already improved their operations, but the recession and financial crisis struck, all stocks tanked, I remember buying some shares of UNP at 48 per share in February-March 2009, not knowing it was near the bottom. Railroads laid off some folks but later called them back as the economy recovered.

  • Report this Comment On November 13, 2013, at 10:26 PM, banmate7 wrote:

    I want to share one last example on how I approach investing for the most part. Consider what I did here with Apple.

    Here is my 1st Apple position. The 1st investment is my basis, the rest are reinvested dividends.

    trade_date shares total_cost price/share

    11/10/2010 31.0 $9,807.43 $316.37

    08/16/2012 0.13 $82.15 $631.92

    11/15/2012 0.156 $82.49 $528.78

    02/14/2013 0.177 $82.91 $468.42

    05/16/2013 0.221 $95.96 $434.21

    08/15/2013 0.194 $96.64 $498.14

    total shares: 31.878

    total value: $16,596.77

    total return: 70%

    This significantly beats the S&P500 return of 43% during the same time period. I have 2nd position:

    trade_date shares total_cost price/share

    03/28/2011 15.0 $5,273.25 $351.55

    08/16/2012 0.062 $39.75 $641.13

    11/15/2012 0.075 $39.91 $532.13

    02/14/2013 0.085 $40.11 $471.88

    05/16/2013 0.107 $46.43 $433.93

    08/15/2013 0.094 $46.75 $497.34

    total shares: 15.423

    total value: $8,029.74

    total return: 52%

    This compares to 36% for the S&P500 during the same time period.

    Apply by the way has compelling PE, PEG, and PB metrics. The cash flow & balance sheets are simply immense. I'm obviously holding and will probably buy in again on a dip.

    Keep in mind I bought when the PE was typically below 10. It now has a blended PE=13. In contrast Google has a PE of 25. Apple warrants a PE between 16 - 20 as a premium blue chip. At a PE=18, it supports a price of $735.

    The markets should normalize to this. It's not a question of if, but rather of when. Value investing works, especially for a proven blue chip like Apple that has compelling value metrics...in which I will also now factor ROIC!

    All the best. Again, thanks for this excellent write up.

  • Report this Comment On December 06, 2013, at 8:07 PM, GirlsUnder30 wrote:

    banmate7

    I've read your list and it looks like you're still holding GTAT. At what price will you accumulate more?

  • Report this Comment On January 03, 2014, at 3:53 PM, banmate7 wrote:

    @GirlsUnder30

    I admit I didn't sell GTAT, in spite of deep misgivings. Irrational greed & some laziness happened. But rationally speaking, I agree with your analysis on GTAT, especially choppy earnings & growth, not least an Apple deal that actually adds liabilities.

    As luck would have it, the price stabilized around $8 - $9, a good situation given my $4.40 average price per share. I emphasize the term luck, because there's really nothing I consider financially compelling with GTAT. My hopes here remain in faith that GTAT will be competitive in recovering sapphire & solar markets.

    I'll accumulate more if it goes down to $7, definitely $6. I'm definitely not buying at these levels. I need a positive catalyst to accumulate more at these levels.

    2 quarters of consistent growth might be such a trigger. Witnessing SalesForce, WorkDay, & ServiceNow, I've realized growth, not profits, can drive long cycles of stock price increases. I just have to see it to believe it with GTAT.

    As we discussed before, I'd rather err on the side of some quantitative safety and lose some gains...as opposed to blow up catastrophically in the total absence of anything quantitatively compelling.

    Sorry for the long winded reply. But yeah, $6 - $7 will do it for me...or 2 qtrs of significant growth at higher levels.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2714003, ~/Articles/ArticleHandler.aspx, 9/19/2014 4:21:41 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement