What’s Driving Heartland America? (Part 1)

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What’s Driving Heartland America? (Part 1)

As the U.S. economy shows signs of strengthening, the rail companies should manage to also strengthen. The OECD expects GDP growth to be up 2% in 2013 before rising to 2.8% in 2014. Rail companies are fundamental for moving a variety of products across America on a daily basis. The top rail companies moving products across the U.S. include: Norfolk Southern (NYSE: NSC)Genesse & Wyoming (NYSE: GWR)CSX Corp (NYSE: CSX)Kansas City Southern (NYSE: KSU) and Union Pacific (NYSE: UNP)

These various rail companies are also seeing a boost from rising demand in oil, where the rail companies are becoming a preference to pipelines. As far as the rail companies go, I'm putting my money on CSX. The stock pays investors a 2.7% dividend yield and is arguably the most undervalued company in the industry.  

In stacking up the other top rail companies, the industry is a solid provider of dividends: 

<table> <tbody> <tr> <td colspan="1" rowspan="1"><span> </span></td> <td colspan="1" rowspan="1"> <p><span><strong>Norfolk Southern</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>CSX Corp</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>Union Pacific</strong></span></p> </td> </tr> <tr> <td colspan="1" rowspan="1"> <p><span><em>Dividend Yield</em></span></p> </td> <td colspan="1" rowspan="1"> <p><span>2.90%</span></p> </td> <td colspan="1" rowspan="1"> <p><span>2.70%</span></p> </td> <td colspan="1" rowspan="1"> <p><span><br /></span></p> <p><span>2.0%</span></p> <div><span> </span></div> </td> </tr> </tbody> </table>
 
The Association of American Railroads showed full year 2011 numbers up nicely, with rail volumes up 15% in and traffic in ton miles up 3.2% for the U.S. There is much speculation about the decline in coal demand, which is a big product transported by the U.S. rail companies. The coal demand decline is due to power plants converting to natural gas and reduced steel production. Picking up the coal slack has been notable strength in the auto and oil products, not to mention lumber and wood products -- thanks to a rebound in the construction industry. 
 
Back to CSX, the valuation is quite impressive, trading below its peers on a forward price to earnings and price to cash flow basis:
  
<table> <tbody> <tr> <td colspan="1" rowspan="1"><span> </span></td> <td colspan="1" rowspan="1"> <p><span><strong>Norfolk Southern</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>CSX Corp</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>Kansas City Southern</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>Union Pacific</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>Genesee & Wyoming</strong></span></p> </td> </tr> <tr> <td colspan="1" rowspan="1"> <p><span><em>Price to Earnings (next year earnings)</em></span></p> </td> <td colspan="1" rowspan="1"> <p><span>12</span></p> </td> <td colspan="1" rowspan="1"> <p><span>11.3</span></p> </td> <td colspan="1" rowspan="1"> <p><span>22.6</span></p> </td> <td colspan="1" rowspan="1"> <p><span>14.1</span></p> </td> <td colspan="1" rowspan="1"> <p><span>19</span></p> </td> </tr> <tr> <td colspan="1" rowspan="1"> <p><span><em>Price to Operating Cash Flow</em></span></p> </td> <td colspan="1" rowspan="1"> <p><span>8</span></p> </td> <td colspan="1" rowspan="1"> <p><span>7.4</span></p> </td> <td colspan="1" rowspan="1"> <p><span>17.5</span></p> </td> <td colspan="1" rowspan="1"> <p><span>11.4</span></p> </td> <td colspan="1" rowspan="1"> <p><span>25.5</span></p> <div><span> </span></div> </td> </tr> </tbody> </table>

Over 50% of CSX revenues come by way of its merchandise business, which includes aggregates, fertilizer, food, paper and chemical products. CSX also delivers around 30% of North America's light vehicles. Norfolk Southern is CSX's top competitor, but recent earnings announcements shows CSX reporting fourth quarter 2012 earnings in line on a year over year basis; meanwhile, Norfolk posted a year over year decline in earnings. Union Pacific faces a bit more competition than say CSX. The rail operator has competition from not just its top rail competitor Burlington Northern, but also motor carriers running similar routes. The other key disadvantage to Union Pacific is that the motor carriers operate via public right of ways maintained by  government agencies (check out Union Pacific's hedge fund owners).
 
Kansas City is one of the smaller rail operators, but has a valuation that makes the company a rich-buy, meaning it is a bit expensive. Part of the overvaluing in Kansas City shares is due to the near-sourcing of manufacturing to Mexico, which is expected to help the company see above average growth. Genesee & Wyoming owns and operates short line and regional freight railroads, but is the smallest of the rail companies listed by market value (see how much Kansas Southern is worth).
 
Coupling the rail company's valuation with their growth takes us to the PEG ratio, were we still find that CSX is a great 'growth at a reasonable price' opportunity: 

<table> <tbody> <tr> <td colspan="1" rowspan="1"><span> </span></td> <td colspan="1" rowspan="1"> <p><span><strong>Norfolk Southern</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>CSX Corp</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>Kansas City Southern</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>Union Pacific</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>Genesee & Wyoming</strong></span></p> </td> </tr> <tr> <td colspan="1" rowspan="1"> <p><span><em>Price to Earnings to Growth</em></span></p> </td> <td colspan="1" rowspan="1"> <p><span>1.1</span></p> </td> <td colspan="1" rowspan="1"> <p><span>0.96</span></p> </td> <td colspan="1" rowspan="1"> <p><span>1.7</span></p> </td> <td colspan="1" rowspan="1"> <p><span>1.1</span></p> </td> <td colspan="1" rowspan="1"> <p><span>2.8</span></p> </td> </tr> </tbody> </table>

The PEG for CSX is at a 12.5% discount to other major rail companies Norfolk and Union. CSX is also a standout in relation to return on equity:

<table> <tbody> <tr> <td colspan="1" rowspan="1"><span> </span></td> <td colspan="1" rowspan="1"> <p><span><strong>Norfolk Southern</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>CSX Corp</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>Kansas City Southern</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>Union Pacific</strong></span></p> </td> <td colspan="1" rowspan="1"> <p><span><strong>Genesee & Wyoming</strong></span></p> </td> </tr> <tr> <td colspan="1" rowspan="1"> <p><span><em>Return on Equity</em></span></p> </td> <td colspan="1" rowspan="1"> <p><span>18%</span></p> </td> <td colspan="1" rowspan="1"> <p><span>21%</span></p> </td> <td colspan="1" rowspan="1"> <p><span>13%</span></p> </td> <td colspan="1" rowspan="1"> <p><span>20%</span></p> </td> <td colspan="1" rowspan="1"> <p><span>6.50%</span></p> </td> </tr> </tbody> </table>

Not only do the valuation and return on equity numbers shape up best for CSX, but so does its growth when compared to Norfolk. The estimated five-year earnings growth for Norfolk comes in at 7%, versus CSX's 12.8%. It appears that CSX may well be one of the best ways to play the rebounding U.S. economy, assuming you believe in an impending rebound. 

CSX will benefit from economic recovery in the U.S., given its role in transporting many of the basic materials required in manufacturing and construction. The rail company expects to see volume growth of 2% in 2013, thanks to boosts in intermodal container and auto shipments (check out the hedge funds that love CSX).

Part 2 to will be about the trucking companies.  


mhargra has no position in any stocks mentioned. The Motley Fool recommends Genesee & Wyoming. 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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