Invest in 3 'Quality' Transportation Companies

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

Investors seem to be increasingly asking the question: What is the fair price for a quality transportation company? With many traditional valuation methodologies reverting to mean historical multiples, investors could make the case that many transportation stocks are nearing ‘full’ valuation. However, with lower multiples relative to other large industrial companies and near top quartile return generation, certain ‘quality’ stocks within the group deserve a wider comparison universe apart from the usual suspects.

In this note, we take a fresh view on valuation for the largest and highest return companies. Slow growth and a rapidly appreciating market make stock picking a challenge for sell-side analysts and investors alike. It is surely acknowledged that upside from here in many stocks is challenging, at least through the cautious outlook. However, the chase for yield is powerful and has us revisiting what to pay for the high return generators in the transportation group. 

Screening the best transportation companies

We run a screening test on three filters:

1) Capital returns

2) Cash flow generation

3) Annual earnings growth

Results highlight that top performing transportation companies Canadian Railways (NYSE: CNI), Union Pacific (NYSE: UNP) and United Parcel Services (NYSE: UPS) screen favorably relative to both respective sub-sector and industrial peers, making a strong case for the ‘top-quality transport companies.’ These three companies ranked in the top two quartiles in terms of capital returns and potential earnings growth, while also screening favorably in terms of cash flow generation:

*Qtl denotes Quartile.

Union Pacific remains a top holding

Admittedly, Union Pacific's share performance this year (+9% vs. S&P) has captured a majority of the expected upside. But with an improving return and cash generation profile as well as higher near-term growth expectations, the shares are expected to benefit from an improved relative multiple, similar to other large industrial companies.

The railroad has been one of the most popular transportation companies at the Street for its potential growth. Its western network has helped it to benefit from the rising demand for crude oil in domestic energy markets. Not only this, the network has also helped the company to transport automotives and hence benefit from the rapidly surging US auto SAAR (seasonally adjusted auto rate). 

However, this should not mean the peak for Union Pacific. The company is still expected to make a business of $850 million by transporting crude oil by 2014. This would equal almost 4% of the overall revenue for the company. Also, the carrier is expected to benefit from pricing gains in its southern network where it is operating on near capacity conditions.

In the long run, the company is expected to achieve an operating ratio of 65% by focusing on price gains and cost efficiency. This could help the company to make an incremental EPS of $12, 45% more than current levels.

United Parcel’s cash generation makes solid case for higher multiple

United Parcel’s integrated business model is the global standard for package operators. The company generates some of the highest financial returns within the industrial universe and arguably has a lower beta (+3% vs. S&P). United Parcel’s cash flow profile suggests the shares are relatively attractive within a broader industrial universe.

UPS and other integrators face challenges in a slow growth global economy as supply chains focus on cost containment and shipment urgency decreases. However, unlike others, UPS has nonetheless been able to drive slight earnings expansion in this period. UPS’s conservative capital management and higher network profitability are likely to aid the company’s shares over the near-term. Moreover, given that UPS is trading at a discount to the industry, 8-11% capital appreciation is possible in the case of multiple expansion.

Canadian National: consistent results should alleviate near-term pressure

Canadian National’s market valuation suffered from recent operational challenges, but with industry-leading returns, investors are expected to come back to the story as the year progresses. Historically, returns generated at Canadian National were a bit more cyclical, but through the last cycle the company has benefited from cost improvements, favorable end markets and pricing gains that lead us to believe that higher returns may be here to stay.

Moreover, cash flow levels have risen and seem to be steady at these higher levels reflecting Canadian National’s dominant position within respective markets. Managements’ capital spending has also translated to higher profitability and shareholders are being rewarded with high cash distributions.

Lastly, the company is expected to demonstrate a meaningful shift in the return profile. Lower equity risk profiles should translate to a richer valuation over the passage of time.

Final word

On the basis of capital returns, cash flows generation and annual earnings growth, Union Pacific, Canadian National Railways and United Parcel Service seem to be the best companies in the transportation space.

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Zain Abbas has no position in any stocks mentioned. The Motley Fool recommends Canadian National Railway and United Parcel Service. 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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