Despite tough end market conditions in 2016, it's been a pretty good year so far the railroad stocks. Union Pacific Corporation (NYSE:UNP) and CSX Corp (NASDAQ:CSX) are both up on the year, and with the recent uptick in manufacturing indicators and the price of oil, there's reason to believe better days are coming for the railroads. That said, is now the time to buy Union Pacific?

UNP Chart

UNP data by YCharts

4 reasons to buy Union Pacific Corporation stock

Listening in on Union Pacific CFO Rob Knight's presentation at a recent Wolfe Research Transportation conference, there appears to be four key reasons to buy the stock:

  • While it was a tough quarter for coal (carloads down 34%) and intermodal (down 3%), other parts of the business are starting to look better.
  • While end markets are weak and revenue falling, Union Pacific continues to generate productivity improvements -- CSX is also focusing on efficiency gains.
  • Knight reiterated expectations for margin improvement for the full-year despite falling revenue.
  • The biggest negative change to expectations is in intermodal, a segment usually correlated with industrial and economic growth -- it could turnaround, however, with better economic growth.

Let's look closer at these points.

Coal's structural problems are hurting railroad companies. Image source: Getty Images.

Coal, always coal

Two facts. First, there's no denying that coal is facing a structural decline; and second, it remains a key revenue generator for railroads. However, its importance is diminishing as coal carloads decline, and strength in other areas could offset coal declines in future years.

For example, CSX generated just 15% of first quarter revenue from coal, down from 21% in the same period last year. For Union Pacific, the respective figures are 11.5% and 17.4%. Whichever way you look at it, coal is less important to railroad earnings now.

While Knight didn't have many positive things to say about coal, he did outline positive signs for chemicals (carload growth was flat in the quarter) and grains (high global grain inventories are expected to lead to better conditions in the second half), while automotive remains strong (carloads up 7% in the first quarter). Adding the first quarter revenues of these three elements produces a figure equivalent to around 46% of total first quarter revenue -- much more important than coal's contribution of 11.5%.

Productivity and margin improvements

Union Pacific highlights its operating ratio as a key marker of productivity. It's just a simple way of defining operating expenses divided by revenue -- a useful measure for cost intensive industries like railroads. Knight reiterated expectations to reach around 60% by 2019, and a longer term hope to hit 55%. As you can see below, it's an area where Union Pacific has performed well in the last decade.

Data source: Union Pacific Corporation

In a similar vein, CSX Corp management recently outlined expectations for "efficiency savings for the full year to exceed $250 million, approaching a company record." That's not enough to offset the negative impact of market forces for CSX, but it does indicate both companies could generate an increased level of profitability if the economy improves in the future. Moreover, both companies are still generating price increases even with falling revenues -- a sign of well run companies.

Economy improving for intermodal?

Intermodal is a key revenue generator for Union Pacific, contributing 19.5% of first quarter revenue, and it's almost as important for CSX Corp (15.5%). However, both companies saw declines in intermodal revenue in the first quarter, with Union Pacific's intermodal revenue down 9% and CSX's down 2%.

It's partly a consequence of a weak industrial economy, but if the latest data from the Institute for Supply Management Purchasing Managers Index is anything to go by, conditions are likely to improve going forward. Moreover, energy prices may have bottomed. All told, industrial conditions appear to be getting a bit better.

ISM Purchasing Managers Index Chart

ISM Purchasing Managers Index data by YCharts

One reason to avoid

Putting all of this together, there is a case for buying railroad stocks -- but unfortunately, it's not strongly supported by valuations. As always with railroads, you have to look out for free cash flow; they are businesses that require a substantial amount of ongoing capital spending, not to mention high operating expenses, as discussed above.

A quick look at enterprise value (market cap plus net debt) to free cash flow suggests neither company is cheap (a figure of around 20 times is attractive).

UNP EV to Free Cash Flow (TTM) Chart

UNP EV to Free Cash Flow (TTM) data by YCharts

In short, conditions are starting to look better for the railroads, but they look fully priced, and it's hard to argue they are a good value on a risk/reward basis. There are ways to play a potential pickup in industrial conditions, but the railroads are not necessarily the best way to play it.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.