Why CSX, Union Pacific Are Both "Buys"
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There is something about railroads that has always attracted me. From their unsuspecting nurturing of the industrial economy to their business-to-multiple-business earnings model, they do a lot but do not receive the attention they deserve. Maybe it has to do with the lack of passenger rail travel or that they are tucked behind the landscape, but rail is actually the cheapest form of goods transportation by far. Below, I recommend buying two stocks to diversify in the industry: Union Pacific (NYSE: UNP) and CSX (NYSE: CSX). Both are meaningfully undervalued and well positioned to outperform broader indices, as they have done recently.
Union Pacific is the largest railroad and concentrates its tracks from the West to a little right of the middle-part of the continental United States. Northeast transportation is missing from the transportation, which CSX has… and a dense network at that. In my view, this represents one of Union Pacific's greatest catalysts going forward: buying northeast connections. Union Pacific may have the most tracks in the business, but it could improve its network.
In terms of valuation, Union Pacific seems neither cheap nor expensive at a respective 15.7x and 12.7x past and forward earnings. However, when you consider the low growth prospects that are being factored to produce those multiples, it becomes clear why analysts are bullishly rating the stock a "buy." Over the past five years, EPS has grown by 16.2% annually. Yet over the next five years, only 13.9% is expected. How could a company that depends on the activity of the global economy grow more during one of the worst recessions in US history than during its recovery?
Union Pacific is also surprisingly defensive. It not only has an oligopoly position in the market, the growth of cities is pushing an increasing dependency away from trucks and towards rail. Fuel efficiency is also much better for rail, so it is a cheaper investment for businesses to make in the long run.
As appealing as Union Pacific is, I always encourage diversification. CSX is an attractive way to do this, because of its concentration in the active northeast. In my view, the firm will be aggressive in takeovers to expand closer to the middle part of the United States. If goods could be shipped between those two regions that would greatly benefit consumers and ultimately shareholders.
Currently, the stock is even cheaper than larger competitor Union Pacific in terms of multiples. It trades at a respective 12.4x and 10.7x past and forward earnings with a dividend yield of 2.5%. Consensus estimates forecast 9.1% annual EPS growth over the next five years, which implies that the stock will be worth $40.26 at a 15x multiple. Discounting backwards by 10% yields a present value of $25. This is less than a comfortable margin of safety but is nevertheless worth dealing with given the strong growth prospects. Like Union Pacific, the bar has also been set low in this regard.
Part of the reason why CSX is trading below its historical PE multiple is the lingering fears of the US economy. Some time back, there was a lot of talk about a "double dip." While those bearish sentiments are still there, they are much less mainstream than they once were. The Fed has come out numerous times and said that they do not see a double dip, and improving job numbers indicate that the economy is heading, albeit very slowly, in the right direction. In any event, CSX has done well through good times and bad. It generated $1.3 billion in FCF from the TTM ending 1Q12 - more or less even with 1Q11. It's ability to hold up despite operational challenges also make it surprisingly more defensive than what investors give it credit for.
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