Why Railroads Look Attractive Despite Current Valuation

The premium on railroad stocks is justified as the economy continues to improve.

Feb 4, 2014 at 12:16PM

Union Pacific (NYSE:UNP) shares rose sharply last Thursday after the railroad company reported solid fourth-quarter results. A day before, another railroad company, Norfolk Southern (NYSE:NSC), saw a sharp rise in its shares after posting better than expected fourth-quarter earnings. CSX Corporation (NASDAQ:CSX), meanwhile, tumbled two weeks ago after investors were disappointed with the company's results for the fourth quarter. Still, all three railroad stocks were among the best performers in the S&P 500 in 2013. Last year's rally has meant that railroad stocks are now trading at a premium to their 10-year average. Is the premium justified, though, given the declining coal volumes?

Railroad companies report Q4 results
Union Pacific announced its financial results for the fourth quarter, beating Street estimates. The company posted net income of $1.17 billion, or $2.55 per share; this was up from the $1.04 billion, or $2.19 per share, that was reported for the same period in the previous year. While the 13% increase in earnings was impressive, what was more impressive was the fact that the company registered overall volume growth for the first time in six quarters even as coal shipments remained weak and crude oil volume dropped 22% on a year-over-year basis.

Norfolk Southern also reported its quarterly results earlier in the week, posting record net income of $513 million, or $1.64 per share. This was up 24% on a year-over-year basis. Like Union Pacific, Norfolk Southern also saw an increase in its overall volume even as coal volumes declined. Norfolk Southern's overall volume rose 4%, driven by growth in merchandise and intermodal traffic.

CSX also registered a drop in coal volumes but managed to post a 6% increase in total volume, helped by growth in the merchandise and intermodal markets. Unlike Union Pacific and Norfolk Southern, however, CSX shares tumbled as the company's profit missed estimates and the company's operating ratio rose 140 basis points to 73.2%. This compares to Union Pacific's operating ratio of 65% and Norfolk's operating ratio of 69.4%. For 2013, CSX had operating ratio of 71.1%, compared to 70.6% reported in 2012. Union Pacific's operating ratio for 2013 improved 1.7 percentage points to 66.7%, while Norfolk Southern's operating ratio for 2013 improved one percentage point to 71%.

Operating Ratios
Company 2012 2013 Increase/Decrease 
CSX  70.6%  71.1%  50 basis points
Union Pacific  68.4%  66.7%  170 basis points
Norfolk Southern  72%  71%  100 basis points

Railroads attractive despite declining coal volume
Declining coal volume is a major concern for railroad companies since coal revenues still account for a significant portion of their total revenue. For example at Norfolk Southern, coal revenue accounted for around 22% of the total revenue in the fourth quarter of 2013. However, the weakness in coal is being more than offset by growth in other areas such as automotive and intermodal as highlighted by the fourth-quarter results. Railroad companies are directly benefiting from an improved economic environment and therefore the continuing weakness in coal will be offset by strength in automotive, chemical, and intermodal shipments.

Are the valuations justified?
Union Pacific gained nearly 36% last year, while Norfolk Sothern rose 52%. CSX , which has struggled over the past week, rose more than 48% in 2013. The strong performance over the past year has meant that railroad stocks are now trading a relatively high multiple. Union Pacific currently trades at a P/E multiple of over 19, while Norfolk Southern trades at a multiple of over 16. CSX is the cheapest of the three major railroad companies, trading at a multiple of nearly 15. However, this is still higher than the 10-year average of around 14.50 for railroad companies.

However, I think the premium commanded by railroad stocks currently are justified as an ongoing improvement in the economy will continue to drive growth. The U.S. economy grew 4.1% in the third quarter of 2013, driven by consumer spending. The International Monetary Fund recently raised its outlook for the U.S. economy for 2014. Recently, the International Energy Agency said in a report that U.S. demand for oil grew by more than China's in 2013 for the first time since 1999. Oil demand in the U.S. rose 2% to 390,000 barrels a day in 2013. A pickup in oil demand is a strong sign that industrial activity in the U.S. is picking up pace. This is a positive for railroad companies. Also, the outlook for automotive, which was one of the key growth drivers for railroads in 2013, remains strong.

Among the three major railroad companies, Union Pacific commands the highest premium, which again is justified as the company has managed to bring down its operating ratio to mid-60s already. However, my pick among the three companies would be Norfolk Southern. The company improved its operating ratio in the fourth quarter and 2013, and if the trend continues, I would expect Norfolk Southern to trade at a similar multiple to Union Pacific. That would mean a significant upside for the stock from the current level. 

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Varun Chandan Arora has no position in any stocks mentioned. The Motley Fool owns shares of CSX. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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