Have We Seen the Bottom in the Railroad Industry?

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The shale gas boom has severely hit the railroad sector. The declining natural gas prices have led to a sharp decline in the demand for coal, especially for the purposes of power generation. Given that coal forms the highest percentage of carloads of most of the railroads, the railroads have suffered a lot as a result.

However, there are some factors that are suggesting that the worst times might be over for the railroad investors:

1)      Sharp rebound in natural gas prices

2)      Growth in ex-coal carloads

3)      Compelling valuations for some of the stocks

4)      Low coal carloads have already been priced into the railroad stocks

I have picked up my most preferred three railroad stocks on the following basis:

Union Pacific (NYSE: UNP)

Legacy re-pricing is expected to generate superior incremental margins in 2013 and beyond. Following renewals on ~$750 million of its book in 2012, Union Pacific still has close to $1 billion in re-pricing opportunities in 2013-15+. Growth in relatively high-yielding and profitable drilling and shale-related activities is helping offset weak utility coal volumes.

Union Pacific is better positioned than most other rails from a commodity exposure perspective. Most of the coal transported by the railroad company comes from Power River Basin (PRB). In 2011, 75% of the company's total coal carloads came from this region. The PRB coal is competitive versus the natural gas price at around $3/btu. By this I mean that natural gas will not be a cheaper substitute for the PRB coal if its price crosses the $3/btu mark. The PRB coal is of low quality as compared to coal obtained from Illinois Basin or Appalachian coal. The coal of Illinois Basin becomes competitive versus the natural gas price in the range of $3.5-$4. Similarly, the Appalachian coal becomes competitive versus the natural gas price at $5. At the current natural gas spot price of $3.35, Union Pacific will definitely recover some of its car loads that were lost after the shale gas boom.

The company is also witnessing a sharp rise in the crude oil shipments as it transports crude from Bakken to Saint James Louisiana.

Kansas City Southern (NYSE: KSU)

The stock seems attractive given its compelling structural, secular and cyclical growth story, driven by cross-border U.S./Mexico business. Near-sourcing opportunities, truckload conversions at the border, and share gains in the finished vehicles market are expected to drive industry leading revenue and EBIT growth over the next 3-5 years.

KCS is expecting incremental sales from the automotive segment. There are a total of 10 automotive assembly plants in Mexico, and nine of them are controlled by KSU and Ferromex. New plants are also expected to open in the next 2-3 years, which will give additional carloads to the railroad company. In its conference call, the company claimed that $68 million worth of business is expected to come from the automotive segment through 2015.

CSX Corp. (NYSE: CSX)

There is no doubt that CSX is the cheapest large-cap railroad stock. The stock has been overly punished because of its largest exposure in coal carloads in the railroad industry. Not only this, the company also has a large exposure to met coal that is used in the production of steel. A weak outlook for met coal has also led to a decline in the stock price. However, growth in intermodal/merchandise businesses, pricing gains and productivity improvements are expected to drive significant margin improvement and double-digit EPS growth over the next few years. Most of the people believe that the worst of coal comps are probably behind us.

Foolish Bottom Line

Railroad stocks have been overly punished by the decline in coal carloads. However, given the stable natural gas prices and a long-term bullish stance on them, the railroad might be up for a rally due to revived coal carload volumes.  


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