All Aboard! Next Stop, Profits
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Three developments will significantly increase railroad profits across the United States over the next 3 - 5 years:
- By 2015 the mandatory (and costly) installation of positive train control systems (PTC) will finally be complete.
- Compared to trucking, shipment by rail is inexpensive and almost 4 times more fuel efficient.
- Railroads should continue to benefit from improving operating ratios.
On September 12, 2008, at 4:21 PM, train engineer Robert Sanchez picked up his phone to reply to a text message. Simultaneously, the train passed a red light signal and Sanchez failed to stop the train. Little did he know that his actions would lead to the Rail Safety Improvement Act of 2008 that would enforce mandatory installation of PTC systems on railways across the US by 2015, costing railroads a gut wrenching $13 billion.
5 years after the tragic rail accident of Metrolink, the end of a long and costly upgrade is much closer. Investors with a long-term time horizon can look forward to capital expenditures decreasing by about 10% when railroads complete their installation of PTC by 2015. Take CSX (NYSE: CSX) for example: During 2012, CSX has already spent $250 million on PTC related upgrades, representing over 11% of capital expenditures.
Knocking 10% off capital expenditures will have a significant impact on earnings. Due to the extensive need for reinvestment in the railroad business, capital expenditures represent a very large portion of revenue--22% to be exact (still using CSX as an example). When you add $250 million back into CSX TTM earnings, you will see that a 10% reduction in capital spending has the potential to increase earnings by up to 13%.
Shipment by Rail is Fuel-efficient
In an ad running on the Wall Street Journal's website, Union Pacific (NYSE: UNP) proudly claims: "On average, railroads are four times more fuel efficient than trucks." Not only is switching to rail the "green" thing to do, it will reduce highway traffic; turns out that railroads have quite the value proposition.
In consideration of a growing US population and in recognition of the need for fuel efficient solutions, the US Department of Transportation agrees that the US needs more rail: Recently they set a goal to develop strategies to attract 50% of all shipments over 500 miles to intermodal rail.
Fuel efficiency and increasing highway traffic will continue to steer new customers toward rails for decades.
Improving operating ratios
Due to such a large percentage of revenue needed to maintain operations in the railroad business, an important ratio to keep on eye on is the operating ratio. The operating ratio is simply defined as operating expenses divided by operating revenue.
Nearly every major railroad in the United States has seen drastic improvements in their operating ratios over the last decade. Below is a chart of the operating ratios of Union Pacific, Norfolk Southern (NYSE: NSC), CSX, and Kansas City Southern (NYSE: KSU), going back to 2006.
Despite already drastic improvements, railroads remain ambitious. CSX, for example, maintained its goal in its most recent earnings release on October 17, aiming for an operating ratio of 65% by 2015. 65% isn't impossible: Just one day after CSX reported an operating ratio of 70% for Q3, Union Pacific reported a record operating ratio of 66.6%.
Improving operating ratios leaves more cash for activities that add shareholder value: dividends, investment in growth opportunities, share repurchase programs, and repayment of long-term debt.
A Fundamental Comparison
In the chart below I highlight some key profitability, growth, and valuation ratios for the four largest publicly traded railroads in the US:
After examining the ratios in the chart above, it is clear that, for the most part, Union Pacific stands out as a leader in terms of performance (growth & profitability). But in relation to its peers, shares of Union Pacific do not come cheap. There is one railroad, however, that measures up well in performance and still trades at a very conservative valuation: CSX.
The Bottom Line
As a fuel efficient alternative, PTC upgrades nearing an end, and drastically improving operating ratios with potential for further gains, railroads offer the patient investor a compelling long-term investment. Investors looking for value can invest in rail by snatching up CSX at just 11.94 times earnings. Or, investors looking for proven, high performers can buy Union Pacific--still trading at just 16.21 times earnings.
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