Please ensure Javascript is enabled for purposes of website accessibility

Here's What to Expect From Railroad Stocks in 2020

By Lee Samaha - Apr 25, 2020 at 8:07AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

The sector remains a good way to play a recovery in economic growth.

The investment thesis behind buying railroad stocks got a boost recently with the earnings report from the smallest Class 1 railroad, Kansas City Southern (KSU). Let's take a look at what happened, and why investors should be feeling a bit more positive after management's commentary.

The case for buying railroad stocks

There are three main parts to the argument for buying the U.S. listed class 1 railroads, CSX (CSX 0.56%), Union Pacific (UNP 0.29%), Kansas City Southern, and Norfolk Southern (NSC 0.63%). As follows:

  • Railroad carloads and revenue are correlated to the industrial economy, so when economic growth returns you can safely assume the railroads will grow revenue, too.
  • The major railroads are highly likely to retain their competitive positioning through the COVID-19 pandemic, so you can feel confident that investing in any one railroad will be rewarded by an eventual recovery.
  • The U.S. Class 1 listed railroads continue to generate operational improvements through the adoption of precision scheduled railroading, or PSR, management techniques -- something set to generate improvements in profitability over the long term.
A freight train moving through a wooded area

Increasing train length is a key aim of precision scheduled railroading management techniques. Image source: Getty Images.

The first two points are reinforced when looking at Kansas City Southern's revenue by end markets in the first quarter. As you can see below, they pretty much correlate with what was happening in the economy in the first quarter. As an aside, note that the major impact from the measures taken to contain the COVID-19 pandemic started to hit the railroads after the end of the first quarter.

The weakness in automotive production (something subsequently increased by production shutdowns due to the pandemic) was borne out in Kansas City Southern's results. Similarly, the turmoil in energy markets (the slump in the price of oil has led to reductions in carloads for crude and sand for fracking in the U.S.) can also be seen in the results. Nevertheless, the 4% increase in carloads and 8% increase in year-over-year revenue suggests railroads were on a good growth track in the first quarter.

Kansas City Southern first quarter revenue growth by end market.

Data source: Kansas City Southern presentations. YOY=year over year. Chart by author.

Clearly, the railroads remain a key bellwether of the economy, and when growth bounces back from the COVID-19 slump they will surely be beneficiaries.

Notwithstanding a long-term decline in coal rail traffic -- traditionally a key revenue generator for railroads  -- the sector's revenues have tended to follow the direction of U.S industrial production. 

UNP Revenue (Quarterly) Chart

UNP Revenue (Quarterly) data by YCharts

Operational improvements

The third point is what differentiates the railroads from many other stocks to play a recovery. In a nutshell, they are a play on a recovery and an ongoing improvement in underlying profitability from PSR.

PSR is a set of management techniques that emphasizes running trains between two points on a network on a fixed schedule, as opposed to the traditional hub-and-spoke approach. PSR practitioners tend to follow metrics like train velocity, the amount of time a carload spends idle at a terminal location, and train length.

Improving all of these metrics should allow railroads to generate the same amount of revenue by using fewer assets. In addition, railroad operating ratio, or OR, should improve. For reference, the OR is simply operating expenses divided by revenue, so a lower number is better.

After their fourth-quarter earnings reports, CSX, Union Pacific, Norfolk Southern, and Kansas City Southern all predicted OR improvement in 2020. The good news from Kansas City Southern's first quarter is that it reported improvements in all of its key PSR metrics.

The table below outlines the improvements across the board. Furthermore, Kansas City Southern's VP of PSR Sameh Fahmy outlined how the operational improvements were allowing the railroad to reduce the number of locomotives and cars in its fleet. Quoting Fahmy from the earnings call, "We have taken out about 20% of all locomotives. We have taken out about 10% of the cars" (as of the end of February) since the adoption of PSR.

Kansas City Southern PSR Metric

First Quarter 2020

First Quarter 2019

Direction

Full-Year 2020 Target

Adjusted operating ratio

59.7%

66.20%

Better

60%-61%

Velocity 

15.9 mph

12.6 mph

Better

17 mph

Terminal dwell 

19.8 hours

21.8 hours

Better

18 hours

Train length 

5,973 feet

5,760 feet

Better

6,350 feet

Car miles per day

120.7 miles

101 miles

Better

135 miles

Data source: Kansas City Southern presentations.

Railroad stocks are a good way to play a recovery

To be clear, the railroad's first-quarter numbers are somewhat flattering and not reflective of the carnage that's going to come in the second quarter when the COVID-19 impact will hit the figures. It's definitely going to get worse before it gets better for the railroads. 

Nevertheless, the improvements in PSR metrics are a real and tangible catalyst of the underlying improvements the railroads continue to make in profitability. It suggests they can emerge from the COVID-19 pandemic in stronger shape than when they entered it. That's an added plus for anyone looking to invest in a recovery play, and a sector set to benefit from economic growth over the long term.

Lee Samaha has no position in any of the stocks mentioned. The Motley Fool recommends Union Pacific. The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

CSX Corporation Stock Quote
CSX Corporation
CSX
$34.35 (0.56%) $0.19
Norfolk Southern Corporation Stock Quote
Norfolk Southern Corporation
NSC
$261.84 (0.63%) $1.63
Union Pacific Corporation Stock Quote
Union Pacific Corporation
UNP
$239.95 (0.29%) $0.70
Kansas City Southern Stock Quote
Kansas City Southern
KSU

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
389%
 
S&P 500 Returns
125%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 08/12/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.