Riding the Rails

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The railroad business is going strong, even after two centuries, as the efficiency of national rail networks has led to an increasing share of the nation’s freight traffic.  In an era of rising energy prices, an 18-wheel semi can’t hope to compete with the fuel efficiency of a locomotive.  The American Association of Railroads estimates that the industry’s volume of carloadings has risen 2-3% in 2012, after increases in 2011 and 2010.  Indeed, the industry’s long term investment prospects were validated by Berkshire Hathaway’s November 2009 purchase of railroad giant Burlington Northern for $44 billion in cash and stock.

Rail: A Growth Industry

Railroads have been a prime beneficiary of rising economic activity, as well as sharing in the growth of intermodal traffic.  Intermodal is defined as the movement of truck trailers or containers by rail and at least one other mode of transportation.  The intermodal segment transports a wide variety of goods and showcases railroads’ position as the preferred method of transportation over long distances.  The industry’s financial results provide evidence of their strong value to the country’s shippers.  Over the past four years, the nation’s largest railroad, Union Pacific (NYSE: UNP), grew its revenues and operating income by 20.1% and 70.1%, respectively.  Meanwhile, its smaller competitor Norfolk Southern (NYSE: NSC) grew revenues and operating income by 18.4% and 24.3%, respectively, over the same time period.  Both companies were able to grow their operating margins by upgrading their facilities and equipment, as well as implementing cost savings programs.  Despite flat volume growth in 2012 due to declines in coal shipments, both companies have maintained operating expense ratios at high levels by diversifying their customer base beyond the traditional sectors.  Investors have taken notice as railroad companies’ stock prices have outperformed the market averages over the past five years.

Finding a Derivative

Instead of looking at the railroads themselves, investors should be searching for the quality suppliers to the industry, given the railroads’ continuous needs to replace their fleets and upgrade their networks.  In addition, the Rail Safety Improvement Act passed by Congress in 2008 mandated changes to the railroad industry, including adding Positive Train Control (PTC) systems on all Class I railroads.  While subsequent Congressional legislation has delayed the implementation of the 2008 law until December 31, 2020, eventually the industry will need to adopt newer safety technology across their lines.  The leading global provider of these systems is Westinghouse Air Brake Technologies (NYSE: WAB).

Wabtec, as the company is known, is one of the largest global suppliers to the rail industry, and was formed in 1999 after merging with MotivePower Industries.  However, the company’s roots date back to 1869 when its namesake, George Westinghouse, invented the air brake system.  The company has grown through innovation, continuous improvement, and acquisitions in select product areas.  In 2011, Wabtec generated record levels of sales and net income of $2.0 billion and $170.1 million, increases of 30.6% and 38.2%, respectively.  Gross and operating margins remained near the highest levels of the last five years as the company’s Japanese-style performance measurement system continued to deliver gains.  Wabtec is truly global, with 47% of 2011 total sales derived from international markets, and the company is focusing on countries that are building out their transportation infrastructure, including Australia, Brazil, China, and India.  More recent results show the success of their operating strategy.  During the third quarter of 2012, Wabtec reported sales and net income of $587.6 million and $63.0 million, increases of 17.8% and 35.2%, respectively.  While gross margins contracted slightly, operating and net margins continued to expand as the company continued to derive operating efficiencies from its recent acquisitions.  More importantly, the company increased their net income forecasts for the remainder of 2012 and management is optimistic about the industry’s future growth.

Looking to the Future

Freight and mass transit rail will play an increasingly important role in the transportation system of tomorrow.  Despite current funding pressures, proactive leaders in growing international economies are building up their transit infrastructure, and the U.S. is sure to follow their lead.  With leading products and a management team focused on shareholder value, Wabtec is one for the portfolio.

rghanley owns shares of Westinghouse Air Brake Technologies. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Wabtec . 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.If you have questions about this post or the Fool’s blog network, click here for information.

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