North American rail companies have been on a steep upward climb for a decade, but there's still a strong case for hopping aboard their shares.
Each of the six major Canadian and U.S. companies look like compelling buys – although some of these stocks promise more profit than others.
The reason for the sector's rosy outlook? First off, rail remains cheaper than truck transport, and while it's slower, the difference isn't big enough to deter many shippers.
Meanwhile, the U.S. economy is growing, many sectors that rely on rail transport are on the upswing, and energy companies are warming to the idea of transporting crude oil by rail, giving the railways their first emerging cargo category in some time.
The positive factors outweigh concerns about the declining volume of coal shipments. The cloud over coal, which faces environmental issues and competition from bargain-priced natural gas, has cast a shadow on U.S. rail stocks, particularly the two eastern railroads, CSX Corp. and Norfolk Southern Corp., which are major haulers of the black fuel.
U.S. railroads depend on coal roughly twice as much as their Canadian counterparts. The good news, though, is they are kicking the habit. Morgan Stanley analyst William Greene estimates domestic coal will contribute 15 per cent of CSX's earnings and 21 per cent of Norfolk Southern's this year, down from 58 per cent and 40 per cent, respectively, in 2006.
For investors, the declining fortunes of coal may mean an opportunity. As a result of the pessimism over coal, U.S. rail stocks are trading well below the valuation levels of their Canadian counterparts. CSX and Norfolk Southern are the two cheapest stocks in the sector, suggesting investors are penalizing them for coal's issues while not giving them enough credit for the broader industrial rebound.
"Coal's not going to snap back this quarter," said Keith Schoonmaker, the director of industrial securities research at Morningstar Inc. "But if we're looking at three years from now, there's no question [railroads] will still exist, they'll still gush cash and they'll still have extremely powerful competitive advantages, even if coal goes to zero, which we're not projecting. We're already baking in considerable coal malaise into our models and still coming up with undervalued stocks."
Mr. Schoonmaker said rail-based intermodal containers are four times more fuel efficient per "ton mile" than trucking. "It's only a day slower to get to L.A. from Chicago by train than by truck, and it's 30 per cent less expensive."
Fadi Chamoun, the managing director of transportation and aerospace equity research for BMO Nesbitt Burns, said that if you set coal aside, U.S. railroads' volumes grew 4 per cent last year in an economy that grew 2 per cent – one of the best ratios of rail volume to GDP in some years.
"We're seeing the industrial economy doing well, from automotive production to housing, to the chemical industry and the steel industry," he said. Another factor: Crude by rail, which accounts for a small proportion of cargo but a large amount of rail companies' future growth.
BMO likes the U.S. railroads better than the Canadian ones, because they are generally cheaper, despite similar cash-flow profiles and better prospects for volume growth. The firm's top picks are CSX and Union Pacific Corp.
Mr. Chamoun said Union Pacific "has the best infrastructure in North America," gets 10 per cent of revenue from U.S.-Mexico trade and has the most diversified cargo mix. Its operating margins are second-best on the continent, behind only Canadian National Railway Co.
While Union Pacific gets about 20 per cent of its revenue from coal transportation, it hauls product from the Powder River Basin of Wyoming that's cheaper than the Appalachian coal of CSX and Norfolk Southern. As a result, Union Pacific's coal business can withstand natural gas prices around $3.50 per McF, a level that still causes problems for Appalachian coal.
Least-known, but most expensive, among all the North American rail stocks is Kansas City Southern. Mr. Greene of Morgan Stanley said the company gained full ownership of its current subsidiary Kansas City Southern de Mexico in 2005, then spent a couple of years upgrading it. The company now has a modern, efficient line that can take goods from much of Mexico well into the U.S.
"They believed, and it turns out they were correct, that Mexico was the next big industrializing market, and the bet has worked out very well."
Kansas City Southern targets sales volume growth that is double that of its U.S. peers, and lower labour costs in Mexico have helped lead to superior margins on that property, as well. The result is annual earnings growth of 20 per cent or more. "That's why it's a unique play that trades at a very high valuation – it's about Mexico's industrialization, and a U.S. way to play it."
What of Canada's two railways, whose multiples are well above the three largest U.S. railroads? Each are trading above analysts' 12-month target prices, according to Bloomberg, suggesting their potential gains may be more limited than with the U.S. names.
However, the downside doesn't seem terribly large, particularly at Canadian National Railway Co. It is universally regarded as the continent's top performer, with kudos for its management team and its lush profit margins, which are the best in the industry.
Canadian Pacific Railway Ltd. has long lagged behind CN, but is now enjoying its own remarkable run – the shares have nearly doubled since the beginning of 2012, largely on the basis of optimism about its new chief executive officer, Hunter Harrison, the former head of CN and a renowned cost cutter. While the stock's big gains may indicate that enthusiasm about Mr. Hunter has been fully priced in, bulls suggest there are more gains to come.
Mr. Greene of Morgan Stanley notes CP and Burlington Northern and Santa Fe Railway Co.– now part of the Berkshire Hathaway conglomerate – are the only two companies that own lines running through the Bakken oil fields, and CP can carry the crude all the way to refineries in the northeastern United States.
Mr. Greene is modeling 7-per-cent revenue growth, but depending on growth in crude by rail, thinks it could exceed that target. That, combined with operating margins expanding to 37 per cent – a level Mr. Harrison has achieved in past turnarounds – suggests annual earnings growth could end up "well north" of 30 per cent.
"I look at this and say, 'It's not over,' " Mr. Greene said, noting Mr. Harrison has produced returns of 200 per cent to 400 per cent in the shares of his previous employers (before dividends). "I believe in Hunter. I'm going to stick around and see what happens."