The Good and Bad About Transportion Stocks

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When industrial activity increases, railroads are an obvious beneficiary.  But so is the transportation sector in general. Mired by a history of bankruptcies and union strikes, airlines have fallen out of favor. I recommend looking at their ability to scale operations and hedge against fuel charges after screening for credit risk and multiples. Below, I present my case on Southwest and Union Pacific.

Southwest Airlines (NYSE: LUV): The Good & The Bad

As the only major airline that has not gone bankrupt and, in fact, still maintains an investment grade rating, Southwest has done well. This is certainly true year to date, as the stock has appreciated by 18.8% and outperformed the S&P 500 by around 620 bps. It is in the process of integrating AirTran, which I believe will generate meaningful revenue synergies by improving network connections. Southwest has recently reported that it will manage routes in four more cities for AirTran by next April as full integration continues. Moreover, management is looking to modernize its fleet, which internal reports guide for $700 million in savings starting 2015.

Several tailwinds look promising for carriers. The President recently signed a bill that shields US carriers from European carbon emission fees on travel over American soil. Moreover, several analysts are forecasting oil price declines from high production and domestic inventories. Outperformers in the industry include JetBlue (NASDAQ: JBLU), which grew passenger miles by 8.9% in the third quarter, and have hedged considerably against price increases. For the fourth quarter, more than a quarter of anticipated fuel use is hedged.

Southwest trades at a respective 14.8x and 10.4x past and forward earnings versus corresponding figures of 11.2x and 8.4x for JetBlue. The Street is generally reserved on both stocks, but even their growth forecasts have put the PEG ratio solidly below 1 in both instances. Perhaps the reason is because of weak value creation. JetBlue generates a ROIC of just 4%, which is around 300 bps lower than the industry average. Southwest is even worse with a ROIC of just 2.9%. The airline industry is expected to see 2% annual EPS declines over the next 3-5 years, but Southwest is forecasted for an 8.5% rate and Southwest for a 16% rate. 

If You Are Bullish on Transportation, Go with Union Pacific (NYSE: UNP)

If you don't like the idea of buying stock in companies that ship people, maybe companies that ship goods are more interesting. This railroad has a solid track record (in fact, it has by far the largest number of tracks in the United States!) and trades at a respective 15.3x and 13x past and forward earnings. Analysts forecast 13.9% annual EPS growth over the next five years. Assuming expectations are met, 2016 EPS will come out to $14.04. At a multiple of 15x, this translates to a future stock value of $210.60. Discounting backwards by 10% yields a present value of $130.80. Although this is not an incredible premium to the current prevailing price, it is enough given Union Pacific's steady earnings growth.

Union Pacific is also strengthening the market's confidence in its long-term trajectory. Management increased the dividend payout by 15%, which will be payable for shareholders of record Nov. 30. In addition to the tailwinds from built up demand due to Sandy, management is securing solid contracts in intermodal--the main catalyst. Specifically, in late October, Union Pacific reached an agreement with Pacer International to have the latter handle intermodal freight transportation between Canada, Mexico, and the United States. Though Norfolk Southern is forecasting a decline in coal far into 2013, Union Pacific's diversification in intermodal should buoy long-term confidence. The CEO of Union Pacific has also stated that he has not seen customers react negatively to the fiscal cliff in terms of scaling back production. Rather, he points to the auto market, which is more concerned with railroads decreasing capacity than with scaling back its own operations. With a 13.5% ROIC (100 bps greater than the industry average) and a $150 price target by FBR Capital, I strongly recommend buying shares.

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 JetBlue Airways and Southwest Airlines. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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