Railroad Stocks: Not as Safe as You Think
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When Warren Buffet and Berkshire Hathaway made a $34 billion investment to buy the remaining shares in Burlington Northern Santa Fe, railroad stocks were off to the races. Nearly all of them surged past their pre-recession highs. Berkshire’s purchase gave the impression that they are utility-like, recession-resistant and the source for steady returns year after year. It is easy to fall into the trap that these are buy and hold investments. To the contrary, this industry is facing major headwinds, yet the valuation on these stocks is priced for perfection. The prices have recently diverged from the broader market, a sign of weakness. When fundamentals are weakening and the valuation is rich -- run for the hills.
Globally Exposed
Weakness in China and Europe doesn’t necessarily have to cause a recession in the United States, but some industries will fell the tremors more than others. Railroads are particularly vulnerable to slowing global growth due to heavy dependence on commodity and commodity-like products that are bound for export. Nearly all public railroads have diversity across the various segments of freight, but some are more exposed than others. Generally, commodities make up the lion’s share of freight revenues. Does it matter if China grows 6% instead of 8%? Yes it does and U.S. railroad stocks will feel pressure on both revenues and earnings-per-share in such a scenario.
If this were priced into the stocks, it would be one thing, but the valuation on the industry is close to all-time highs. The price-to-earnings is rather reasonable at 14x for the S&P 500 Railroad Index; however, the preferred valuation tool for this industry is the price-to-book. Here the industry trades around 2.5x book value, which has historically marked the peak for this indicator. This occurred in the early 1990’s and again in 2007. Levels below 1.5x book value generally indicate potential for multiple expansion.
Genesee & Wyoming (NYSE: GWR) is at the top of the my list. This non-Index regional rail operator has annual revenues just north of $800 million. This is up significantly following recent investments in Australia. The company’s Australian lines now account for roughly one-third of total operating revenues. Much of this is commodity-like products. Weakness in China will surely hit the bottom line and leaves the stock very vulnerable given recent Chinese data.
The company is very acquisitive, which makes the growth numbers look good, but doesn’t bear out in the all-important return on invested capital. The company has failed to produce a 10% return on invested capital in any of the last five years. The recent sell-off has brought the price-to-earnings ratio down to 19x, which is still pretty elevated. The stock has significant “hidden” exposure to commodity demand and any prick in that bubble will have plenty of spillover effects into GWR stock.
Weak Coal Fundamentals
Coal and natural gas fundamentals remain weak for the next couple of years. Coal fundamentals are likely to deteriorate for many years to come. This is pretty well known by investors, but has largely been shrugged off because of high shipments for industrial products in recent quarters. Any slowdown here and attention will quickly return to the weak outlook for coal. In fact, coal makes up approximately 20% of all freight carloads for the Class I railroads. The steady decline in demand as utilities switch to natural gas will make earnings-per-share growth hurdles that much harder.
CSX Corporation (NYSE: CSX) generates more than $11 billion in annual revenues and has a significant presence in the eastern United States. The company generates more than 30% of revenues from coal, one of the highest ratios among peers. This will be a persistent headwind to earnings growth for years to come. The price-to-book is a lofty 2.6x and the free cash flow yield is sub-par 3.9%. Similar to GWR, the company has been unable to generate double-digit returns on invested capital. Stay clear.
The other big player on the East Coast is Norfolk Southern (NYSE: NSC). The company is very similar in size to CSX and has a big presence in coal at nearly 30% of revenues as well. The stock has some favorable attributes such as a growing dividend, but other indications of value are not present. Like many in the industry, generating returns of invested capital above the firm’s weighted average cost of capital has not transpired for many years. Yet the stock prices have surged. The free cash flow yield for Norfolk Southern is a muted 3.5% and the price-to-book ratio is near historical highs. This, against a colossal headwind in their largest revenue segment, doesn’t paint the picture of stock poised for continued appreciation.
Other railroads with less coal and commodity exposure should be “relative” winners, but investors shouldn’t anticipate significant divergences within the industry. Union Pacific (NYSE: UNP) is the largest North American railroad and has annual revenues above $18 billion. The company has a limited coal presence, but has a lofty price-to-book (2.7x) and a sub-5% free cash flow yield (4.6%). Kansas City Southern (NYSE: KSU) stock has exploded and resides at a lofty 23x price-to-earnings and 2.7x price-to-book. The company operates in the South and Mexico with revenues approximately half of Union Pacific. With those ratios and a 1.5% free cash flow, forget the coal issue, the stock is just expensive.
Bottom Line
I think the weakness in railroad stocks should not be viewed as a buy the dip opportunity. Valuations remain elevated and earnings expectations are likely to disappoint. These stocks are not as safe as general perception would have you believe. China is a potential headwind and coal is a clear-cut headwind. Adding the rich valuations to the story only raises the likelihood of a coming train wreck.
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