Are Railroad Stocks Overpriced?

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Some investors have plunged into railroad stocks, believing they will benefit from a stronger North American economy in 2013. But are they overly optimistic?

Transportation stocks, as measured by the Dow Jones Transportation Average, gained 13% in the first two months of 2013, double the gain made in all of 2012.

Railroads reflect the health of their economies. For 2012, the US economy grew 2.2%, up from the 1.8% growth of 2011. And the Canadian economy in 2012 expanded 1.8%, down from the 2.6% growth in 2011. Both economies had sluggish fourth quarters, but this has been a slow recovery with choppy ups and downs.

Stock in Canadian Pacific Railway (NYSE: CP) gained 24% year to date through March 5, and is now sporting a 20 forward price/earnings ratio.

Canadian National Railway (NYSE: CNI) gained 12% year to date through March 5, and Union Pacific (NYSE: UNP) gained 11% through March 5. I believe CN and UP offer investors immediate value opportunities. Both stocks are cheaper than CP based on as price/earnings ratio, and their prospects for growth are decent, especially in the energy sector.

The forward P/E on CN and UP are 16.65 and 14.71, respectively -- which is lower than the multiple that Warren Buffett paid for Burlington Northern Santa Fe in 2010.

Buffett paid $100 per share, or 18 times forward earnings, for BNSF for Berkshire Hathaway. He called his purchase an “all-in wager” on the U.S. economy.

BNSF’s revenues increased 7% in 2012 to $20.8 billion, according to Berkshire Hathaway's 2012 annual report. Shipment volume in 2012 saw consumer products up 4%, industrial products up 13%, partially offset by declines in coal, down -6%, and agricultural products down -3%. BNSF’s earnings in 2012 were up 13.4% to $3.3 billion.

Grain shipments by railroads were down in 2012 because of drought. Demand for coal fell because utilities switched to cheaper-priced natural gas to burn in their power plants.

Union Pacific lost some coal business, but had less exposure than CSX or Norfolk Southern. UP also lost some grain business.

While grain and coal shipments are down, crude shipments have seen explosive growth. 

UP, CN, CP and BNSF have invested billions of dollars in track and infrastructure in the Bakken Region in North Dakota, Montana and Saskatchewan. Railroads haul in carloads of fracking sand and drilling pipe used to build wells. They haul out crude oil to refineries and other end users thousands of miles away in the Gulf Coast. Railroads haul crude and freight substantially cheaper than trucks, especially over long distances.

US railroads will spend $24.5 billion on its rail network this year, including $13 billion to increase capacity, according to The Association of American Railroads. The freight railroads also estimate they will hire more than 11,000 employees this year, primarily in response to attrition and retirements from the industry’s aging workforce, AAR said.

UP, the largest railroad in the United States, increased its revenues 7% in 2012 over 2011. Its earnings per share rose 23% to $8.27 per share. Argus Research raised its target price for UP to $148, from $140 per share. UP will likely split its shares once it gets to $150 per share -- which was the stock price at which the last split occurred in May 2008.

Standard & Poor's on Feb. 16 raised its 12-month target price for CN to $107 per share, saying earnings will grow 12% in 2013, after rising 11.8% in 2012. S&P considers CN “to be the most efficiently run of the major North American railroads.”

I believe those efficiencies were created in part by its former CEO E. Hunter Harrison, who left CN in great shape when he retired three years ago. Harrison came out of retirement in 2012 to join competitor CP, where, as president and CEO, he is working on improving efficiencies and growing revenue.

Since CN is the largest railroad in Canada, and UP claims the top spot in the U.S., I expect CN’s and UP's volumes to increase based on improving economic conditions in Canada and the United States.

It’s hard to beat the largest railroads in North America. CN and UP have excellent operating efficiencies and strong growth opportunities in the energy sector, which might make them superior long-term investments.

ScoopHoop owns shares of Canadian National Railway, Canadian Pacific Railway Limited (USA), Berkshire Hathaway, and Union Pacific. 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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