3 Undervalued Rail Stocks To Buy
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Railroads represent much of what I love about stock markets: the ability to find an asset that contributes a lot to the economy but often goes unrecognized. The sector is nothing in terms of visibility like it was during the Gilded Age, but it still provides a critical link in the economy. Rail transport is by far the cheapest way to deliver goods, and it is thus a good indicator on the overall health of the market. Given that I am bullish on the economy (rejecting arguments that suggest a double dip), I recommend diversifying across the major leaders, which include CSX (NYSE: CSX), Union Pacific (NYSE: UNP), and Norfolk Southern (NYSE: NSC). The first two, I find to be particularly undervalued.
CSX & Union Pacific
Union Pacific owns more track than any other domestic railroad company and, as such, has the largest economic moat. Its tracks run from the West to the middle part of the US. CSX has tracks that pretty much lie everywhere to the East of Union Pacific's. Generally every year, Union Pacific gets larger and more leverage in terms of bargaining power over customers.
Although many are concerned with its leverage towards coal, the fact of the matter is that Union Pacific can easily diversify into a variety of segments, which include intermodal and agriculture. Management has done a stellar job in slashing costs, and I anticipate margins to reach record margin in the year ahead given the increasingly shareholder-friendly capital allocation policy. Particularly strong execution in trimming unnecessary costs was seen in 2009 when volumes fell 2009, and the bottom line badly needed a boost. Free cash flow has hit the pace of Class I peers - a trend that the market has yet to fully appreciate. Union Pacific has attractive routes in intermodal and agriculture than can help sustain business as demand starts to rise in coal. As the company continues to denominate in operating ratios through cheap labor, I see it being able to maximize the returns from these segments.
CSX is nowhere near as reputable as Union Pacific, but that doesn't mean it doesn't deserve to be and won't be. The firm is trading at a discount to its historical PE multiple despite performing well through challenging macro periods. Unlike Union Pacific, cost overruns have been a problem. "Take-or-pay" contracts in coal have been underappreciated by the market and margins are positioned for an upswing as service becomes easier. According to Deutsche Bank, it would take a 20-40% y-o-y decline in met coal volumes for export coal tonnage to hit 30-35 million tons again under the case that CSX moves export steam coal that is contracted. Net debt is expected to rise slightly from $8.5 billion in 2011 to more than $8.7 billion next year, but I believe this won't be commensurate with the rise in shareholder value and, hence, a non-issue for emerging investors.
Norfolk is also a worthwhile investment, although I recommend accumulating fewer shares relative to Union Pacific & CSX. Like CSX, Norfolk also operates largely in the Eastern part of the United States, although it extends somewhat nearer to Union Pacific's tracks. It is a less popular stock than the two larger railroads, but still has a PEG ratio below 1, which indicates that future growth has not been fully factored into the stock price.
Over the past 5 years, EPS grew annually by 8.8%. Analysts now expect 14.1% over the next 5. In my view, this is too aggressive and misses will keep the company from generating the returns it otherwise would. On a positive note, the company is not nearly as tied up in inventories as its peers are, as evidenced by the 1.1x quick ratio.
If you assume that the company grows by 15.5% annually in the top-line over the next 6 years and 2.5% into perpetuity while having consistent operating metrics and an 8.5% discount rate, the present value of the stock is roughly in-line with the $82.87 consensus price target. That's a significant premium to the current market value and a huge reason to buy shares.
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