Why This Railroad Is a Compelling Buy

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Railroads are often seen as a bellwether for the broader economy because of the amount of retail and manufactured goods they transport across the nation. Norfolk Southern (NYSE: NSC) is one of the biggest railroads in the United States, with a $23 billion market capitalization. In addition, Norfolk Southern operates approximately 20,000 route miles in 22 states and serves every major container port in the eastern US.

The railroad industry counts Warren Buffett, one of the world’s most famous investors of all time, as a fan. Buffett is a well-known railroad enthusiast and proved it when his Berkshire Hathaway bought Burlington Northern Santa Fe, then the nation’s second-largest railroad, for $34 billion in 2009.

Should you follow the philosophy of the world’s most famous investor and add Norfolk Southern to your portfolio?

Railroad profits keep chugging along

Of course, Norfolk Southern isn’t the only railway operator in the United States. Major competitor Union Pacific (NYSE: UNP) operates a rail network including 31,000 route miles.

Union Pacific managed to impressively reverse the pattern of railroads reporting disappointing 2012 results, with last year being the most profitable year in the company’s 150-year history. Union Pacific reported full-year diluted earnings per share of $8.27, an increase of 23% year over year.

Furthermore, Union Pacific’s record results extended into the first quarter of 2013. The company’s diluted earnings per share represented another record, growing 13% year over year. Operating revenue grew 3%, also a new record.

In addition, Canada is home to some excellent railroads, including Canadian National Railway (NYSE: CNI), which carries a $40 billion market value.

Unfortunately, CNI’s first quarter report was less than impressive. The company’s net income per share declined 25% during the first three months, year over year. Moreover, CNI’s operating ratio, which compares expenses to sales, deteriorated by more than two percentage points. This was due largely to a 7.7% increase in fuel costs.

That being said, analysts were quick to point to the extremely tough weather conditions seen in the first quarter and are more optimistic about the company’s future.

Meanwhile, Norfolk Southern recently issued a very solid first-quarter earnings report. The railroad reported 15% growth in diluted earnings per share on $2.7 billion in railway operating revenues through the first three months of the year.

Shipment volumes increased 3% year over year, and particular strength was seen in the company’s general merchandise revenues (up 2%) and in its intermodal revenues (up 9%) versus the prior year’s first quarter.

Once again, coal revenues were an area of weakness, dropping 17% year over year. Coal has served as a drag on the nation’s railroads due to a number of industry headwinds in recent quarters. In particular, mild winter weather and low natural gas prices have depressed both coal volumes and average revenue per unit.

However, it’s worth noting that coal revenues made up just 23% of Norfolk Southern’s revenues in the first quarter, with its general merchandise business making up more than half of its sales.

Going forward, it’s reasonable to assume natural gas prices won’t stay at depressed levels forever. This should bring utility customers back to coal, and it’s fair to think that coal prices and volumes should recover at least moderately in the future.

NSC: Compelling value and income

Norfolk Southern is firmly committed to returning cash to shareholders. The company raised its dividend last year by 6% and will likely increase its shareholder payout in time for its next quarterly distribution.

At recent prices, Norfolk Southern’s $2 per share annualized distribution yields 2.8%, which exceeds both the yield on the broader market as well as the 2.6% yield on the 10-Year Treasury.

Moreover, Norfolk Southern is attractively valued when compared to both its industry and the broader market. Whereas both the S&P 500 Index and the railroad industry hold price-to-earnings ratios in the high teens, Norfolk Southern changes hands for just 12 times its trailing earnings per share.

Union Pacific and CNI are profitable railroads, but they both trade for 17 times trailing earnings and offer dividend yields less than 2%.

As a result, while each of these three is investment worthy, Norfolk Southern offers the best value and income for new investors. I consider Norfolk Southern to be the industry leader and an attractive buy. 

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Robert Ciura has no position in any stocks mentioned. The Motley Fool recommends Canadian National Railway. 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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