2 Transportation Stocks to Buy, 1 to Avoid

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

As economic activity heats up, transportation is likely to experience an overall boom. However, not all transportation industries will fare as well as others. In my view, rail is best positioned to gain the most from greater economic activity, since it remains by far the cheapest form of transportation. At the same time, this viewpoint is common in the market and is largely priced in. The result is that other transportation industries, like airlines, have become overly discounted and created an environment for consolidation.

Southwest Airlines (NYSE: LUV) Ought To Pursue Takeover Activity

For the year to date, Southwest has had quite a bit of turbulence that has amounted to a nearly 1,200 bps underperformance against the S&P 500. In my view, however, the stock is undervalued. It continues to trade at a PEG ratio below 1x, because the market remains myopically focused on the past. Unfortunately, even the interpretation over the past overly discounts corporate strengths. For example, while earnings fell 17.6% annually, Southwest is the only major airline that has not gone bankrupt. It is this kind of resiliency that will enable the company to reach the forecast for 22% 5-year annual EPS growth.

As fuel prices decline, Southwest is also positioned to post margin expansion, which it can then use to reinvest in the business. Equipped with a balance sheet, the company should also consider pursuing takeover activity to dilute fixed costs through increases in scale. AirTran should unlock meaningful synergies through improving passenger connections to key destinations. However, a full integration won't be completed until 2014, and investors are looking for a faster turnaround / corporate strategy.

To be clear, Southwest recently generated a staggering 42% rise in earnings for 2Q 2012. Given how clean the balance sheet is relative to competitors, the airline also has strong bargaining power to acquire bankrupt, but still valuable, assets. With a strong ability to keep margins high relative to competitors, there is little reason to doubt that it could create value in businesses that have failed to cut the fat.

Norfolk Southern (NYSE: NSC) A "Buy" Over UPS (NYSE: UPS)

While both of these companies will benefit from free trade agreements, only Norfolk Southern is meaningfully undervalued. It trades at a respective 11.6x and 11.1x past and forward earnings, versus corresponding figures of 18.1x and 14.1x for UPS. Norfolk is also forecast for higher 5-year annual EPS growth (14.5%, versus 10.9% at UPS).

Bernstein recently upgraded Norfolk Southern on news that rails will invest ~$23 billion in improving infrastructure in 2012. While the stock has fallen significantly since it announced earnings 25% below consensus, forecasts in the coal business have been overly negative. Coal has been weak largely due to poor Chinese demand; however, the secular trends are still strong in China and will provide a healthy stream of free cash flow in the longer-term. The Chinese government and Federal Reserve have all announced stimulus packages that will drive up interest in energy, and thus coal. Freight volumes will correspondingly pick up, and greater train velocity will expand margins.

UPS, on the other hand, has the best factored in. Assuming that it meets analyst expectations, 2016 EPS will come out to $7.09. At a 16x multiple, this translates to a future stock value of $113.50. Discounting backwards by 10% yields a present value of $70.48. That is worth less than the current market assessment, which indicates the stock is overvalued.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Southwest Airlines 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.If you have questions about this post or the Fool’s blog network, click here for information.

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