3 Rail Stocks to Buy Now

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

Rail has been one of my favorite industries for some time now. It is the backbone of our economy, but many fail to appreciate. Railroads deliver goods at by far the cheapest cost, and is not going away any time soon. With business historically tracking well over these next months, it is an opportune time to consider buying.

Union Pacific (NYSE: UNP) & CSX (NYSE: CSX): Still Undervalued

Union Pacific is one of the strongest, most under-recognized brands on the Street. It is by far the largest railroad in the world in terms of tracks and revenue, but still trades fairly cheaply at 12.9x forward earnings. Considering that analysts forecast 13.9% annual EPS growth over the next 5 years, while Union Pacific achieved 16.2% growth annually over the past 5 years, I also believe the Street is underestimating Union Pacific's potential.

That has been at least the case in all 5 of the last quarters. During that time period, Union Pacific was an average of 5.8% ahead of consensus. While it has been justly rewarded with a 37.2% stock return over the last 12 months, the secular trends point to even greater upside than what the market appreciates.

For one, Union Pacific optimally targets key export markets that are likely to take off in the presence of a full recovery and more liberalized free trade agreements. According to Citi, it is now an attractive time to jump on the railroad, since transports generally perform well between October and April.

CSX is similarly a compelling buy, and it looks even cheaper. The stock trades at a respective 12x and 10.7x past and forward earnings, with a dividend yield of 2.6%. While the company is much smaller than Union Pacific, it has the potential to penetrate even more markets. Analysts only forecast 8.8% annual EPS growth over the next 5 years, which is nearly 350 bps below what it achieved in the preceding 5.

Assuming CSX merely meets analyst expectations, it will generate 2016 EPS of $2.59. At a multiple of 17x, the future stock value of the firm will be $44.03. Discounting backwards by 10% yields a present value of $27.34, which is at around a 28% premium to the current market assessment.

Norfolk Southern (NYSE: NSC)

Unlike CSX, Norfolk is forecast to have double-digit annual EPS growth of 13.7% over the next 5 years. Moreover, it manages to trade at a lower PE multiple of 11.5x, in addition to having a higher dividend yield (3%). While the firm may have a worse track record than CSX (no pun intended), it's always the future that matters in determining intrinsic value. Accordingly, I believe the stock will actually outperform CSX as the market picks up on its higher growth trajectory.

Rail has seen a strong increase in demand, and during this time, Norfolk has opportunistically cut costs to maximize free cash flow yield. By replacing its locomotives and improving operational efficiency, Norfolk will also improve its bargaining power with labor through reduced fixed costs. Accordingly, I recommend buying the stock for its prospects of greater margins and faster-than-expected growth.

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