At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Here, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.
Bullish on Buffett (and railroads)
Do great minds really think alike? Fans of Warren Buffett, new owner of the Burlington Northern railway (by virtue of his holdings in Berkshire Hathaway (NYSE: BRK-B)) famously made a bet on the future of rail two years ago. Today, the brilliance of that move is becoming apparent -- and according to the smart stockpickers at British investment bank Barclays, there's more good news to come.
Yesterday, Barclays upped its rating on the U.S. railroad operators in general (to "positive"), and on CSX (NYSE: CSX) in particular (to "overweight"). Spreading the joy, the analyst actually raised price targets on several other operators -- Canadian National (NYSE: CNI), Norfolk Southern (NYSE: NSC), and Union Pacific (NYSE: UNP) -- while downgrading only one stock in the industry.
That luckless company: Canadian Pacific (NYSE: CP), which Barclays now rates "underperform." Barclays doesn't hate the stock -- it merely considers Canadian Pacific less attractive than the alternatives. But why?
According to Barclays: "Significant capital investments made by the industry following the Great Recession have had a more profound impact on core productivity than we expected. Because we view these gains as core productivity rather than operating leverage, we believe they will be sustained, if not compounded, as volumes recover further..."
In other words, railroads won't simply spread out fixed costs among more goods being shipped in good times. Barclays expects "cost leverage to remain impressive" even after the economic cycle turns down and fewer goods get shipped. And you know what? Barclays may be right.
Let's go to the tape
Whatever the big trends affecting railroads in general, at first glance there seems little logic to Barclays's choosing CSX over Canadian Pacific in particular. Sure, Barclays is a great stockpicker; within days of becoming a rated analyst on CAPS, it had already established a name for itself, rocketing quickly to the top of our charts. Today, the English megabanker ranks among Wall Street's absolute best analysts, outperforming more than 97% of the investors we track.
But aside from the banker's reputation ... well, see for yourself. Scan the relevant statistics among major North American railroads:
|
Company |
Gross Margin |
P/E Ratio |
Five-Year Forward Annual Growth Rate |
|---|---|---|---|
| CSX | 37.8% | 19.3 | 17% |
| Canadian National | 50.9% | 15.9 | 14.6% |
| Union Pacific | 42.4% | 17.1 | 14.8% |
| Kansas City Southern (NYSE: KSU) | 37% | 31.3 | 34% |
| Norfolk Southern | 36.7% | 16.8 | 14.5% |
| Canadian Pacific | 32.2% | 16.2 | 18.1% |
*Gross margins provided by Capital IQ, a division of Standard & Poor's. P/E ratio and growth rates courtesy of Yahoo! Finance.
You'll find that while Canadian Pacific may not be a very efficient operator, CSX isn't the most profitable train set on the track, either. Moreover, Canadian Pacific's low P/E ratio and relatively high growth rate would seem to suggest that there are greater prospects for profits there than at CSX. In the entire rail industry, only tiny Kansas City Southern boasts a better PEG ratio.
Interestingly, CSX has another thing in common with Kansas City Southern -- together, they're the two publicly traded railroads generating free cash flow most closely aligned with their reported GAAP profits. (CSX's FCF backs up roughly 91% of reported profits, while KCS actually generates a bit more free cash flow than its income statement would suggest. The next closest contender is Norfolk Southern -- incidentally, another Barclays recommendation.)
Valuation matters
Dig into the cash flow statements at Union Pacific and Canadian National, and you'll find even larger disparities between reported profits and actual free cash flow. While I'm not entirely convinced that CSX is a bargain, Barclays's focus on railroads with a relatively higher quality of earnings does appeal to me. Furthermore, the banker's belief in Canadian Pacific's underperformance also rings true. Alone among the railroads mentioned, Canadian Pacific actually burned cash last year, even as it reported earning a GAAP "profit."
When you get right down to it, this is what finally sways me in Barclays's favor on this week's recommendations: A great analyst, making educated guesses on which companies offer the best bargains, based on the cash the businesses produce. I can't ask for much more than that.
