3 Rail Stocks to Consider Buying
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you are optimistic on the domestic economy, railroads are the way to go. They directly benefit from increased trade and commercial activity. While some have elevated multiples, positive macro trends will likely prevent multiples from meaningfully compressing. At the same time, stocks that are currently cheap from a multiples perspective have plenty of room to appreciate off of further expansion and a greater market acceptance of risk.
Kansas City trades at a respective 21.2x and 18.3x past and forward earnings; Canadian Pacific trades at a respective 22.8x and 16.1x past and forward earnings. All of these multiples are at a premium to not only peer levels but to the S&P 500 at large. However, high multiples do not necessarily imply that shareholders will be left holding the back. For Kansas City shareholders at least, analysts are forecasting 17.9% annual EPS growth over the next five years.
Assuming Kansas City meets expectations (and it has realized 22.7% annual EPS growth over the past five years), 2016 EPS will come out to $6.71. At a multiple of 16x, this translates to a future stock value of $107.36. Discounting backwards by 10% yields a present value of $66.66. Put differently, Kansas City's growth will offset any overvaluation. Moreover, the company has beaten expectations in all of the last five quarters by an average of 4.2%.
With as much as 2% of the intermodal market that is expected to cross 2.6 million truckloads per year, Kansas City also has strong room for penetration. But having strong room for penetration is a lot different that actually yielding results. And, in Kansas City's case, momentum has been working in the ideal direction.
By contrast, Canadian Pacific has failed to keep up with the competition. This underperformance resulted in activist investor Bill Ackman contesting the current board. He was victorious in the proxy fight and ended up having Hunter Harrison elected as CEO. Harrison has been quick to make changes.
Of the many decisions he has made since taking the helm, the one that I am most optimistic about was launching a long-haul service. This will cut freight shipment travel times by as much as 33%. For some time now, Canadian has had weaker train velocity than domestic peers, so it also has room for improvement. The emphasis on more rigid time schedules will also help strengthen connections with consumers. Even still, Canadian Pacific is forecasted for just 10.6% annual EPS growth over the next five years. This makes it hard for the firm to justify the current multiples.
Union Pacific (NYSE: UNP) Keeps Chugging Along
Over the last twelve months, Union Pacific has chugged along with a return of 32%, approximately double what was realized by the S&P 500 during the same time period. In my view, the world's largest railroad continues to be undervalued. When you consider that it trades at only 15.7x past earnings with forecasts for 13.9% annual 5-year EPS growth, it is cheap relative to Canadian Pacific and Kansas City.
Operating with a control on west rail and in an industry where brand names are important, Union Pacific also commands a degree of safety that its peers do not. On top of this, it offers a 2% (and growing) dividend yield, along with double-digit ROE. In addition, according to Citi, the worst from negative bottom-line pre-announcements have been priced in. Finally, given my bullish outlook on the domestic economy, Union Pacific, which positively correlates with macro trends, looks attractive. At the same time, a movement towards more liberalized free trade agreements will secure increased truckloads.
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