3 Companies That Should Keep on Rolling

By Chad Henage - September 24, 2012 | Tickers: CSX, NSC, UNP | 0 Comments

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I know that analysts get made fun of on a regular basis. I remember Peter Lynch saying that one of the things he heard the most when connected to analyst estimates was the word “surprise.” That being said, if analysts in the railroad industry are even close to correct, there are multiple good values. I've written before about these companies and when I compared the big three railroads, Union Pacific (NYSE: UNP) came out on top. The other great thing about the railroad industry is these companies serve multiple industries and can serve as sort of a roadmap to what is going on in the economy at large. Let me walk you through why Union Pacific is still a good buy today.

The three main competitors in the railroad industry that trade publicly are Union Pacific, CSX (NYSE: CSX), and Norfolk Southern (NYSE: NSC). Where CSX and Norfolk Southern generally compete on the eastern seaboard, Union Pacific and the Berkshire Hathaway owned Burlington Northern compete on the west coast. Speaking of Berkshire Hathaway, the fact that arguably the world's greatest investor saw enough value to buy one of the major railroads should tell us this sector is worth keeping up with. In this industry the main ways to measure efficiency are gross margin, train speed, safety, and time at station. After all, the less time the companies have their trains in the station and the faster they can safely travel, the higher the company's gross margin should be. What is somewhat uncontrollable is the economy that drives higher or lower deliveries. This is why many investors watch railroads to look for a turn in the economy. In theory, if railroads are seeing an increase in demand, the economy should pick up. In addition, railroad earnings reports can give investors hints about the health in specific industries as well. So what can investors learn from Union Pacific?

Union Pacific is growing by an impressive amount, and according to analysts the company should see impressive growth going forward. In their last quarter, the company reported revenue up 7%, but through operating efficiency and share repurchases, EPS increased 32%. The company's quarterly train speed was up 2% and time in station basically stayed flat. If you want tips on what industries are doing well, and which ones are struggling, you can't ask for a better cheat sheet than this:

(*NSC only reports in 3 segments, their numbers can be found here, CSX info found here, UNP from current earnings referenced above) 

As you can see, the automotive industry is turning in some very impressive numbers across the board. Industrial and chemicals are showing respectable gains as well. The main segment that jumps off the page as having problems is the coal industry. This should be no surprise as it has been well reported that as natural gas prices have fallen, coal demand has been down. That being said, investors interested in coal stocks should watch for improvement from the railroad reports to figure out when coal demand begins to firm up.

While all of this information is an excellent cheat sheet for multiple industries, the main thing I notice is Union Pacific shows the most gains across the board. In the categories that Union Pacific goes head-to-head, they usually win. In fact, across the board only CSX outperformed Union Pacific in the automotive category, everything else Union Pacific was the clear winner. What is also very good news for Union Pacific shareholders is the decline in coal has actually lead the intermodal and industrial divisions to surpass coal as the largest contributors to revenue. This means even as coal eventually recovers, the company stands to benefit more because of this increased growth from the other two divisions. As you can see, Union Pacific is doing amazingly well considering all that we hear about how the economy is slowly recovering. The company also leads the way in another category and that is their finances.

Using the last quarter as an example, Union Pacific repurchased shares again and on a year-over-year basis they have retired 3% of their diluted share count. Operating cash flow was up, and free cash flow was just under $1 billion. With $575 million in dividends paid, the company's free cash flow payout ratio was 59.90%. Most impressive was the company's gross margin of 72.73%. This was higher than either CSX's gross margin at 68.13% or Norfolk Southern at 65.66%. With all of these impressive numbers, the only question left to answer is should investors buy the shares?

There is a lot to like about Union Pacific, and the market is quite aware. Of the three major railroads, only Union Pacific sells for a forward P/E ratio above its expected growth rate. The company also sports the lowest yield. On a positive note, Union Pacific has consistently beaten earnings estimates by an average of almost 7% per quarter for the last four quarters. That being said, if analysts are right, I like Norfolk Southern slightly better. The company has the highest yield of the group, and the highest expected earnings growth. The stock is the second cheapest behind CSX and that changes day to day. In addition, only Norfolk Southern has outperformed analyst expectations by a wider margin than Union Pacific. In the last four quarters, Norfolk Southern has beaten estimates all four times by an average of 7.75%. Last but not least, their lowest gross margin of the three is actually a positive. The company can afford to run more efficiently, which means they can improve earnings even if their growth rate comes in slightly less than their competition. Asking Union Pacific to improve on a nearly 73% gross margin is a tough task, improving Norfolk Southern's gross margin from 65% should be possible.

No matter which you choose, if analysts are right, the economy is certain to improve. Investors would do well to have some exposure to the railroad industry in their portfolio. The companies give you a free economic report when they release earnings. With all three companies expected to show greater than 13% growth in earnings, their stocks should keep on rolling.

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