Three Stocks to Consider in the Railroad Business

Damian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With rumors of a possible Berkshire-owned BNSF Railway expansion, let's look at other major railroad companies with potential for future partnerships. BNSF operates in the western US. So, we'll look at one company in Canada, and two East Coast leaders. The rail companies are: Canadian National Railway (NYSE: CNI), CSX (NYSE: CSX), and Norfolk Southern (NYSE: NSC).

International market

Canadian National maintains a small economic moat because it's the largest railway company in Canada, owns a route down the Mississippi, and is present in most segments. The company is in the best position to benefit from growing potash demand and mining in the Yukon. The stock is also undervalued, offering long-term investors a good chance to make a buck.

With a focus on efficiency, speed improvement, and fuel efficiency, Canadian National continues to increase transported volumes. That's in part why the firm holds the highest operating margin in North America, and revenues have risen steadily with higher demands for the oil, car, and intermodal segments. Also, recent long-term contracts have secured the steady future demand for the fertilizer segment, while management keeps focusing on cost reduction. All that has resulted in stronger financial indicators over time and a stronger balance sheet.

Looking at financial indicators, Canadian National’s revenues, net income, and free cash have risen since 2009. Debt has has been reduced since 2008, and its operating margin is the highest in the industry at 37.10%. Management initiatives have taken return on equity to a historical high, while EBITDA has taken a small step backward.

Currently trading at 16.7 times its earnings, at a slight discount to the 17.5 times industry average, the stock is fairly valued. With rising dividends and yield – today at, $0.43 and 1.64% each – Canadian National is a recommended buy for the long-term investor.

Domestic market: Stock #1

Norfolk holds a potential partnership with BNSF Railroad due to geographic presence (East Coast). Additionally, the firm is benefiting from America's economic recovery, while reducing exposure to the coal segment. But, in comparison with CSX, the firm has not arrived to Florida yet.

In the second quarter, Norfolk reported a 2% increase year to year in volume. The rise was primarily driven by the chemicals (10%), intermodal (9%), and automotive (2%) segments. Besides the coal segment, agriculture (3%) and metals (6%) have also seen a slowdown. The moderate cuts on these segments represent a direct market-share increment for its main competitor.

Financially, Norfolk’s revenue and net income have seen a steady rise the last four years, providing the necessary free cash for infrastructure. Four corridors have seen improvements, while a new terminal has been inaugurated in Knoxville, and another is expected to open next year. Operating margin is nine points lower than Canadian National’s 37.10%, and the debt level has been on the rise.

Similar to CSX, Norfolk is trading at a 25% discount to the 17.5 times industry average, but triples its price tag. Yield is higher than CSX at 2.75%. I recommend to buy, because structural investments will give the company an important competitive edge.

Domestic market: Stock #2

Coal dependence has chipped away profits from CSX, and management is acting in order to reverse the trend. Aided by the reduction of market competitors, fuel-efficiency initiatives, and internal restructuring, management is returning the company to increasing profits.

CSX will benefit from partnerships with government regulators, and state initiatives in Massachusetts, New York, and Florida. Main competitor Norfolk lacks that last state. Additionally, increasing terminal capacity, demand for industrial and intermodal segments, upward operating margins and revenues, coupled on cost-reduction policies, will improve financial health. Results are already visible as other segments’ contributions to revenue rise, and exposure to coal’s cyclicality is reduced.

Financially, CSX is very solid. Revenue, net income, and cash flow have been on the rise, and the catalysts mentioned above should sustain the trend. The downside: Debt has been on the rise and is not expected to change since further investment is projected.

Currently trading at 13 times its earnings, a 25% discount to the 17.5 times industry average, and higher yield (2.43%) than Canadian National, CSX is a hold. The stock is relatively cheap, and the price has entered a downtrend, but the firm’s exposure to coal makes it not suitable for a long-term investment, and dividends are small (0.14%).

Bottom line

Railways require heavy investment on capital that cannot be moved easily. Once constructed, routes change very little. I prefer Canadian National because it complements all the other companies, holds a greater potential for a future merger, and is highly competitive.

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Damian Illia has no position in any stocks mentioned. The Motley Fool recommends Canadian National Railway. 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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