Thursday, August 20, 2009

Analysts: Railroads “still our favorite”

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Class I railroad stocks have been rising steadily since bottoming out in late March, strongly supporting the belief of many Wall Street analysts that an economic recovery is under way.

“Inventory and trade data are supportive of our attractive view on freight,” say Morgan Stanley transportation analysts William Greene and Adam Longson in a research report released today. “We’ve argued for some time that as destocking slows and the stimulus takes hold, the resulting improvement in volume trends should drive earnings revisions and improved sentiment across the group. We’ve already seen early signs of these trends playing out in rail traffic, but recent inventory and sales trends give us greater conviction that traffic is on the mend. June data shows inventories continue to fall across all industries, and sales figures have stabilized or improved. Given transports’ early cycle characteristics, and our view that growth could surprise to the upside, we continue to recommend owning transports here, especially for investors with a 6-18 month time horizon.”

Greene and Longson say that manufacturing is poised for a recovery: “June inventory and sales data suggests retail destocking has likely finished. While this would seem to favor more consumer-oriented carriers like truckload and parcel, we believe looking purely at inventory-to-sales ratios may be too simple here. When we analyze the data in more detail, we see more opportunity for incremental improvement and positive surprises on the wholesale and manufacturing side, which should cater to railroads. Census trade data tends to lag by 1-2 months, which suggests retail bottomed months ago. Wholesale sales started to see a pickup in June, which means we could see a recovery in manufacturing in August/September—also supported by improving rail traffic trends. Moreover, most of the discrepancy in inventory-to-sales ratios between industries is the result of sales differentials rather than inventories. Therefore, if retailers start to increase orders, we could see a rapid improvement in inventory/sales ratios for manufacturers and wholesalers. Given that we see more incremental improvement at the wholesale and industrial level (and demand recovery at the consumer and retail side seems slow to come), we believe the current inventory trends will be more supportive of rail stocks than trucks or parcel.”

“Railroads are still our favorite way to play the recovery,” say Greene and Longson. “Our bias is that the risks are likely to the upside on the trajectory of the industrial recovery— at least for freight shipments. The reason is that the destocking of industrial inventories was aggressive and severe in the first half of 2009. As destocking simply ends, we believe that freight shipments will rise quickly to match current selling rates. Moreover, we can’t ignore the magnitude of unprecedented global stimulus that is just beginning to gain traction. If correct, we think railroads are among the best ways to play an industrial rebound in freight transports. This is because: 1) Railroads have held firm on pricing despite volumes collapsing by  about 20% this year; 2) Railroads are the most levered to an industrial rebound; and 3) Railroads have demonstrated a far better ability to adjust costs lower to match volumes than analysts anticipated. Should productivity gains hold in the upturn, the leverage to a rebound is likely to be more significant than at other freight verticals.”