Wednesday, July 28, 2010

2010 Midyear Report: Why investors are switching to rail

Written by  William C. Vantuono, Editor-in-Chief
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Solid earnings in a shaky economy is one reason. The emerging picture of a growth industry is another.

In a shaky economy, the railroads have been able to produce solid earnings, consistently outperforming financial barometers like the Dow Jones Industrial Average and the S&P 500. During the past six months, as the U.S. economy has gradually and painfully emerged from the Great Recession, the price of railroad stocks has grown up to twice as fast as the Dow.

Take a look at one of the most recent Wall Street analyst recommendations. This one, released June 28, comes from Dahlman Rose & Company Director-Equity Research and Railway Age Contributing Editor Jason Siedl. The stock prices reflect current value (as of 6/28) and their long-term target, if applicable:

CN: Buy, $60.47/$70.00; Canadian Pacific (CP): Hold, $56.47; CSX: Buy, $52.25/$69.00; Kansas City Southern (KSU): Hold, $39.29; Norfolk Southern (NSC): Buy, $56.68/$67.00; Union Pacific (UNP): Buy, $72.72/$88.00.

There isn’t a “Sell” recommendation to be seen.

Not surprisingly, Dalman Rose has raised its second-quarter 2010 and full-year EPS (earnings per share) estimates for all Class I’s because “significantly better-than-expected volume growth should translate into strong incremental margins,” according to Seidl. “It is our belief that the railroads will utilize strong free cash flows to support higher dividends and share repurchases.”

Here’s another benchmark: Union Pacific made Bloomberg BusinessWeek’s 2010 list of the 50 top-performing stocks, with a five-year return of 127.9%. UP is ranked No. 44. During the same period—March 31, 2005 to March 31, 2010—the S&P 500 Index returned 10%. “While we are proud of our performance over the past five years, which includes one of the biggest downturns the U.S. economy has ever seen, we know the importance of remaining focused on safety, service, and efficiency,” said UP Chairman and CEO Jim Young. “We continue to introduce valuable products and services for our customers. These and other long-term capital investments support our growth strategy and help Union Pacific reward shareholders.”

What’s behind all the optimism? It perhaps can be summed up in one word: productivity. For example, at last month’s 2010 Bank of America-Merrill Lynch Global Transportation Conference, Norfolk Southern Executive Vice President Finance and CFO James A. Squires illustrated how NS took advantage of the economic lull to boost the railroad’s productivity by several measures. NS’s Productivity Scorecard (see chart, opposite) comparing the first two months (April and May) of this year’s second quarter with the same period last year showed some impressive gains. As the economy began to recover, carload volume grew by 25%, but crew starts grew by only 10% while the number of railroad employees fell slightly, by 1%. Gross ton-miles per employee, per gallon of fuel, and per train-hour improved 29%, 8%, and 5%, respectively.

Such productivity gains, along with improvements in other performance and efficiency measures, are driving investors to the railroads. Growing volume, continued pricing strength, and lower costs are expected to produce higher-than-expected second-quarter profits, according to some Wall Street analysts.

Morgan Stanley Research analysts William Greene, John Godyn, and Adam Longson last month issued an upbeat report adjusting estimates upwards for freight railroad earnings, based on predictions of better-than-expected volume for the second quarter of the year, full-year 2010, and full-year 2011. “Despite consensus revisions throughout the quarter, we believe railroads remain positioned to beat consensus 2Q10 estimates,” the Morgan Stanley Research trio said. Because of this, “we are revising estimates across our rail coverage to account for recent traffic trends, management commentary, and updated guidance. Class I’s are likely to see upside revisions driven by the following trends: (1) volumes tracking better than expectations, (2) operating leverage to recovering volumes, and (3) sustained momentum on core price.”

“Traffic growth is still in high gear,” says Jason Seidl. “North American Class I traffic has exceeded most investors’ expectations.”

As for pricing, “We continue to believe that first-quarter 2010 has marked a bottom,” says Seidl. “The rate environment will likely continue to be favorably impacted by improving volume levels, strong intermodal traffic, tightness in the truckload industry, robust growth in Asian markets, and the railroads’ focus on improving service. Truck-competitive traffic is also receiving a boost from rapidly rising truckload rates, which enable railroads to garner more for their services in competing lanes. This trend of positive truck pricing should continue throughout 2011, based on supply and demand factors in the truckload sector. We believe the railroads will continue to post strong incremental margins in 2010. While this operating leverage should eventually begin to diminish, we believe that one of the recent recession’s silver linings is that it taught the railroads what costs they can live without, ultimately forcing them to run much leaner networks. We continue to be favorably disposed to investing in the rail sector.”

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