2 Reasons Why Railroads Still Look Attractive

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On Tuesday, railroad company Norfolk Southern (NYSE: NSC) posted weaker-than-expected second-quarter earnings, as weak demand for coal hurt its top line. Indeed, that sharp decline in demand has also been a concern for other railroad companies such as CSX (NYSE: CSX) and Union Pacific (NYSE: UNP), which reported quarterly results last week. However, railroad stocks still look attractive for two major reasons; improving auto sales and production, and rising crude oil production.

Reduced coal demand negatively impacts railroad companies’ results

Norfolk Southern’s second-quarter total operating revenue slipped 2.5% to $2.8 billion as a 17% drop in coal revenue offset increases in general merchandise and intermodal revenue. As a result, the company also registered a downward movement in its second-quarter profit.

CSX and Union Pacific’s second-quarter results were also negatively impacted by this trend in coal demand. CSX’s coal revenue for the quarter dropped 6%. Although Union Pacific’s revenue from coal rose 12%, this was mainly due to core pricing gains, which led to a 12% increase in average revenue per car. Coal volumes during the quarter showed only a marginal increase when compared to last year.

Why railroads still look attractive

Two significant factors still make railroads attractive.

The first is improving auto sales and production in the U.S. Auto sales have continued to recover this year, driven by cheap financing and pent-up demand. Improving sales have led to an increase in auto production, benefiting railroad companies. In the second quarter of 2013, Norfolk Southern registered an 8% increase in automotive volumes, while Union Pacific saw a 4% increase in volume.

Auto sales are expected to remain strong going forward as interest rates remain at record low levels. Also, an improvement in labor market should boost demand for vehicles. Speaking at a conference call last week, Clarence W. Gooden, Executive Vice President, Sales and Marketing and CCO at CSX, said annual production estimates for automobile or light truck production now exceed 16 million vehicles.

The second major factor that is helping railroad companies is rising crude oil production in the U.S., thanks to the shale boom. This has actually helped railroads get more orders for delivering crude oil to refineries, since pipelines that supply oil to refineries have not been able to keep up pace.

Although railroads account for only a small percentage of the total crude oil received by refineries, there has been a sharp increase in this mode of oil transportation. According to data released by U.S. EIA last week, refineries across the U.S. received over 1 million barrels per day (bbl/d) of crude oil by rail, truck and barge in 2012. This represents a 57% increase from the previous year. More importantly, there is likely to be further increase in 2013 as the shale boom continues.

Eric L. Butler, Executive Vice President, Marketing and Sales of the Railroad at Union Pacific, said that the company’s crude oil volume in the second quarter was up 3% on a quarter-over-quarter basis and 40% on a year-over-year basis. Norfolk’s chemicals volume registered a 16% increase in the second quarter, driven mainly by growth in the crude by rail business. CSX’s Gooden noted last week that the company’s chemical segment is expected to benefit from the expanding domestic oil and gas industry.

Pullback in railroad stocks a buying opportunity

Railroad companies’ second-quarter results highlighted some of the challenges that lie ahead especially with respect to poor coal demand. However, that demand is stabilizing due to higher natural gas prices. The EIA in its short-term energy outlook released earlier this month noted the share of electricity generation fueled by natural gas averaged 39.50% during the first four months of 2013, and is expected to improve going forward. This should further boost coal demand.

Railroad stocks have seen a sharp pullback on Wednesday, July 24, with Norfolk Southern leading the losses. However, the pullback should be seen as a buying opportunity. Railroad stocks are also attractively valued at the moment. Union Pacific currently trades on a P/E ratio of 18.21, CSX trades on a P/E ratio of 13.50 and Norfolk Southern trades on a P/E ratio of 13.65. Given the attractive valuation, increasing crude oil production, and the outlook for auto production, I believe that railroad stocks have upside potential.

Chandan Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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