Editor's Choice

The Cheapest Stock In This Industry

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

Many times investing is easy, I don't mean that stocks always move in the direction or at the pace you want, I mean selecting which stocks to buy. I have a simple rule of thumb, look for an industry where multiple companies are expected to do well, then buy the cheapest stock of the bunch relative to intrinsic value. In theory, if the industry performs well, and each company offers similar capabilities, then buying the cheapest stock should result in better returns. I believe this is exactly what investors should be considering in the railroad industry, and the stock that looks the cheapest to me is Norfolk Southern (NYSE: NSC).

I've made the argument in the past that owning a railroad stock is like an investment and an economic cheat sheet all in one. Each of these companies has their finger on the pulse of the economy because their business helps transport goods for multiple industries. If you are looking for proof that the economy is expected to recover over the next several years, look no further than analysts projections for earnings growth in the railroads. Norfolk Southern is expected to post the slowest growth of the bunch at just under 13%, with CSX (NYSE: CSX) and Union Pacific (NYSE: UNP) expected to post 13.8% and 14.4% growth in earnings respectively. If analysts are right, each of these stocks could be an attractive option for investors, but Norfolk Southern isn't being given its due at the current time.

Admittedly, looking at Norfolk Southern's last earnings report, investors see weaker results than their competition. The company saw railway operating revenue drop by 6.78% compared to a revenue decline of 2% at CSX and an increase of 5% at Union Pacific. In addition, Norfolk makes it a little harder for investors to compare results because the company doesn't break down its carloads into as many groups as its competition. Where both CSX and Union Pacific break down shipments of goods like automotive, agricultural, and industrial products, Norfolk Southern lumps these together under “General Merchandise.” Since this segment of the company's business is more than 50% of revenues, it's unfortunate that Norfolk doesn't give investors a little more information about where the strength and weaknesses lie. In addition, the major negative for all the railroads has been coal shipments, and Norfolk wasn't immune to this with a 22% drop in coal revenues. However, even with these challenges, Norfolk is doing everything it can to maximize shareholder value.

In the last year, Norfolk has retired nearly 8% of its diluted share count. In addition, even in one of the slower quarters of the year, the company still generated over $2 billion in operating cash flow. One worry that investors might have is about the company's margins relative to their competition. However, where some see a problem, I see opportunity. It's true that Norfolk's operating margin is lower than their competition. In fact, Norfolk's recent operating margin of 27.14% is more than 2% below CSX at 29.51%, and more than 6% below Union Pacific at 33.43%. While in the short-term this puts Norfolk at a disadvantage, this also gives the company a way to improve profits over the long-term. If CSX and Union Pacific can generate margins of 29.5% or better, than Norfolk should have room to cut expenses to improve their margins as well. It's hard to ask Union Pacific to improve on their class leading operating margin, but not as big of a challenge for Norfolk to improve. When it comes to the company's balance sheet, Norfolk ranks in the middle of the pack.

Since railroads require a lot of capital to run, it's expected that each company will carry some debt. Union Pacific is the leader among the three big railroads with a debt-to-equity ratio of 0.45. Norfolk Southern comes in at 0.86, and CSX has the weakest relative balance sheet with a debt-to-equity ratio of 0.92. While Norfolk doesn't have the strongest balance sheet, I don't see a great reason for the relative discount the shares currently sell for.

Maybe the most compelling reason to consider Norfolk today is the price of the shares relative to the opportunity the company provides. Anyone who knows me, knows that I'm a big fan of Peter Lynch. I regularly quote his Peter Principals and Lynch Laws and try to go back and read his two books “Beating the Street” and “One Up On Wall Street” on a regular basis. Lynch's status as one of the greatest investors of all time is unquestioned, so when he explains how to use a formula to value stocks, I believe intelligent investors should listen.

One of my favorite formulas Lynch used to compare companies, is something he called the PEG+Y. He explained it as somewhat of an inverse PEG ratio. In the traditional PEG ratio, you compare the company's growth rate to their P/E ratio and the lower the number the better. However, with the PEG+Y, you add the expected growth rate and yield and then divide by the P/E ratio. In this case, the higher the number the better. Take a look at how the three companies compare using this measure:

<table> <tbody> <tr> <td> <p>Name</p> </td> <td> <p>P/E on '13 EPS</p> </td> <td> <p>Yield</p> </td> <td> <p>Growth Rate</p> </td> <td> <p>PEG+Y</p> </td> </tr> <tr> <td> <p>Norfolk Southern</p> </td> <td> <p>10.73</p> </td> <td> <p>3.26%</p> </td> <td> <p>12.94%</p> </td> <td> <p>1.51</p> </td> </tr> <tr> <td> <p>CSX</p> </td> <td> <p>11.94</p> </td> <td> <p>2.65%</p> </td> <td> <p>13.83%</p> </td> <td> <p>1.38</p> </td> </tr> <tr> <td> <p>Union Pacific</p> </td> <td> <p>15.02</p> </td> <td> <p>1.93%</p> </td> <td> <p>14.40%</p> </td> <td> <p>1.09 </p> </td> </tr> </tbody> </table>

As you can see, though Norfolk has the lowest expected growth rate, their higher yield and lower P/E ratio tilts the scale in the company's favor. In plain English, investors are getting the best yield of the three, for the cheapest P/E ratio, and only giving up a little bit of growth to get there. According to this PEG+Y ratio, Norfolk is the cheapest stock in the industry using the three big railroads. This ratio is good enough for Lynch, and is good enough for me. Use this information as a starting point for your own research and consider adding NSC to your personalized Watchlist to keep up with results.

MHenage has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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