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Railroads and the Unavoidable Coal Fiasco

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

The process of hydraulic fracturing, or "fracking," has led to a natural gas boom, resulting in a severe decline in demand for coal. In fact, for the first time in history, electricity generated by natural gas has surpassed electricity generated by coal. This poses a problem for railroads, who generate high-margin business from coal shipments. A closer look will help us see how the coal decline will affect railroads and how individual railroad companies are positioned to face these challenges.

The Trade-off

To put it bluntly: "fracking" has resulted in cheap natural gas that is negatively affecting demand for coal. Gas, in fact, is now half the price of Appalachian coal, which serves the majority of coal-dependent utility companies. But there is much more to the value proposition for natural gas than price.

According to a recent report from the National Oceanic and Atmospheric Administration, carbon emissions are down nearly 8% since 2006. Much of this decrease, the report claims, is due to the decline of coal as utility companies opt for cleaner-burning natural gas. Even more telling, in a recent study conducted by Lawrence Cathles, a professor at Cornell University, it was found that replacing coal with natural gas would reduce about 40% of carbon emissions linked to global warming. And to top it off, not only is it cleaner to burn fuel, it generates electricity with twice the efficiency.

Factors like these, of course, mean that coal demand is declining fast. To put it in perspective: Just four years ago coal generated 50% of electrical power in the U.S. Today, coal generates just 34% of our electricity.

Railroads are definitely compelling long-term investments. But some railroads are more susceptible to coal declines than others. Therefore, it's important to understand how each of the railroads are positioned to handle this decline.

Kansas City Southern (NYSE: KSU)

Kansas City Southern's revenue is less exposed to coal than any of the other four largest publicly traded railroads in the U.S. Only 13% of its revenue is derived from coal.

At 23 times earnings, however, Kansas City Southern trades at a premium relative to its peers. In addition, its dividend yield of 1.8% is the lowest of its peers. The premium is mainly due to its lack of exposure to coal and its potential to get acquired by one of the larger railroads at some point.


CSX is highly exposed to coal, deriving 30% of its revenue from Appalachian coal. This exposure, of course, is reflected in the stock price; CSX trades at just 11.5 times earnings with an attractive dividend yield of 2.72%. CSX' exposure to coal is the primary reason why it trades at such a conservative valuation.

Norfolk Southern (NYSE: NSC)

At Norfolk Southern, coal sales make up 30% of revenue, like CSX. But Norfolk's dependency on coal is even greater than it appears. A railroad's competitive advantage is tied directly to the location of its track. It turns out that some of Norfolk's very important and lucrative routes are highly dependent on coal sales.

Its most important and lucrative routes allow its trains to travel uphill with empty cars to load coal and return downhill with loaded cars to its East Coast coal-loading facilities. This, of course, leads to greater fuel efficiency and high-margin routes, significantly boosting the bottom line.

Efficiency like this has enabled Norfolk to average about $1 billiion in free cash flow (FCF) over the last 7 years. In fact, Norfolk has the highest FCF-sales ratio among its peers: 8.4%. In other words, $0.08 of every dollar of revenue is converted into FCF. Who said railroads are not profitable?

Despite Norfolk's ability to generate FCF, this high dependency on coal weighs heavily on the stock. Norfolk trades at just 11.38 times earnings with a 3.2% and 4.8% dividend and FCF yield, respectively.

Union Pacific (NYSE: UNP)

Union Pacific's situation is very unique. First of all, only about 20% of its business is exposed to coal--much less than CSX and Norfolk. Second, 75% of this exposure comes from PRB coal, which is far less expensive than Appalachian coal.

PRB coal, or coal mined in the Powder River Basin region, is actually witnessing increasing demand and rising prices. Measured by BTU per ton, PRB coal is much less expensive than Appalachian coal. Furthermore, PRB coal is low on sulfur and fly ash content, making it even more compelling.

Many utility companies in the east are tied up in contracts with Appalachian coal providers. Well aware of the cheaper PRB coal, many of these utility companies will likely make the switch to PRB coal when their contracts expire. Making PRB even more compelling to utility companies, retrofitting Appalachian coal plants for cheaper PRB coal is not very costly. Plus, any cost can be recouped promptly from the incremental profits realized using the cheaper coal.

Union Pacific, therefore, is well positioned to manage the decline in Appalachian coal since most of its exposure to coal is to PRB coal. But natural gas is still a threat. Investors shouldn't look to PRB as a savior to coal problems but instead as a short-term buffer to help Union Pacific manage an inevitable decline in coal sales over the long haul.

Union Pacific's relatively small reliance on Appalachian coal explains its stock price premium over CSX and Norfolk. It trades at trades at 15 times earnings, with a 1.97% and 3.2% dividend and FCF yield, respectively.

The Bottom Line

The trade-off between natural gas and coal is a no-brainer. Natural gas is cheaper and less environmentally damaging. As a result, railroads are facing challenges as they continue to endure declines in coal sales. While CSX and Norfolk trade at conservative valuations, their heavy exposure to coal may not be worth the risk. Investors with little tolerance for gambling should stick with Union Pacific or Kansas City Southern, both well positioned to handle the coal challenges.

DanielSparks has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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