Riding the Rails to Coal Profits

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

One of the most significant pressures being faced by the major rail companies – Union Pacific (NYSE: UNP), CSX Corp. (NYSE: CSX) and Norfolk Southern (NYSE: NSC) – is lost revenues due to declining coal shipments. While hope remained high under a potential election win by Mitt Romney, who was on record as “liking coal,” the Obama administration’s tough stance on the industry will likely keep pressure on major coal producers. Particularly in the U.S., the abundance of natural gas from fracking operations has kept coal prices low. Despite this drag, however, the railroads offer both upside exposure to a recovery in coal and an intrinsically attractive investment profile.

Recent Earnings

Within the last few weeks, each of the major rail companies announced earnings results for the most recent quarter. CSX saw earnings fall by 2% to $455 million, but beat consensus estimates. Earnings represented a rise on a per share basis due to recent share repurchases; revenues numbers were below expectations. During the quarter, U.S. coal volume fell by 26%, being negatively impacted by low natural gas prices and low electricity demand. When natural gas prices are low, thermal coal prices come under pressure as electricity production facilities are able to use natural gas as an alternative energy source.

On the more favorable end of the spectrum, Union Pacific saw an increase of 15% in net income over the course of the quarter. Earnings beat consensus analyst expectations of $2.18, coming in at $2.19; the number is a nice increase on a year-over-year basis, rising from $1.85. Union Pacific only saw a 12% drop in volume from coal shipments, which resulted in a 5% revenue decline. The figures help to demonstrate that the company was able to increase rates to offset some of the lower volume. Also helping the bottom line was an uptick in shipments of shale-oil. Norfolk Southern is in line with these competitors and faces the same pressures.

Global Trends

Despite the relative abundance of cheap natural gas, prices of the commodity have firmed considerably since they hit historical lows earlier in the year. Rising gas prices are expected to continue, which should give some breathing room to coal prices that have struggled for some time. Against the global backdrop, however, is the fact that standards put in place by the Obama administration have made the construction of new coal-based plants untenable. Upgrading existing facilities, in many cases, has also become cost prohibitive. Domestic policies, therefore, seem to favor natural gas.

Increased growth in China, particularly on government-sponsored infrastructure projects may also help demand, particularly for metallurgic coal, to recover. This, then, drives the question of whether the export of coal may grow sufficiently to aid the industry. Strict limitations on the export of natural gas are beneficial to coal export, but even these standards have begun to loosen in the face of the increasing natural gas surplus in the U.S. relative to the rest of the world; liquefied natural gas (LNG) is as much as five times cheaper domestically than abroad.

The Trade

In spite of some significant headwinds, the prospects for rising coal prices seem strong heading into the rest of this year and into the next. This should prove favorable for the rails as shipments would be expected to uptick with prices. Union Pacific, in particular, has been able to defray some of its lost revenue, finding alternative sources of cash flow and positioning itself to compete independent of coal. This positioning works as a positive hedge against coal prices, should a recovery not materialize.

Given the strength of Union Pacific overall, the stock appears to be a buy at current levels. Its exposure to coal prices should be favorable to shareholders, while carrying limited downside risk from here. As such, the stock should be added to your core portfolio.

Mr. Ehrman 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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