Railroad Stock Downgrades Unwarranted, Still Many "Buys"

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

The railroad industry has seen several downgrades of late. This stems for a bearish outlook on coal volumes--something that I believe has not been properly outweighed against penetration in intermodal. Investors should look at multiples and growth trajectories to gauge how undervalued producers are. But you should buy if, and only if, these producers are framed in a sound corporate strategy. The market is focused on the negatives right now in light of a stressed economy (rail is highly correlated to macro trends), so they need all the tailwinds they can get.

Why You Should Buy Dirt Cheap Norfolk Southern (NYSE: NSC)

This Class I railroad has a tight control over Eastern United States tracks, which I believe is relatively under-appreciated. This is reflected in the bargain valuation: Norfolk trades at only 10.8x past earnings and a PEG ratio of 0.85x, so future growth is not being fully factored into the stock price. In fact, analysts forecast 12.7% annual EPS growth over the next 5 years--more than enough to make the stock undervalued even if multiples hold steady.

There are several reasons to be optimistic that Norfolk will unlock that value, and this requires looking at why the market is so bullish right now. First, weak third quarter results--revenue was $40 million below consensus-- caused a downgrade by three analysts. Second, many are forecasting that the earnings headwinds from declining export coal shipments will carry into at least the first half of 2013. But the intermodal and merchandise segments are still performing terrifically and offsetting the weakness. Coupled with a recovery in coal prices, multiples should elevate to their historical levels. In its 5-member peer group, Norfolk and CSX are substantially cheaper than the other three, which average a PE multiple of 21.6x.

With a return on invested capital of 12.6%, Norfolk is also creating meaningful value. While the railroad gets plenty of media attention, it isn't incredibly expensive at $18.8 billion. I could see the company as a potential takeover target for a larger line seeking to connect more towards Eastern markets.

Avoid Canadian Pacific (NYSE: CP), Kansas City (NYSE: KSU)

In my view, Canadian Pacific and Kansas City are way too expensive and will see shareholders rushing towards Norfolk. Canadian Pacific recently was targeted by activist investor Bill Ackman in a successful proxy fight. The replacement of the CEO with an activist representative catalyzed substantial shareholder value. The stock is up 56.7% from its 52-week low and is now right around the 52-week high.

Furthermore, the company is looking bearish on growth opportunities. Just December 3rd, management announced that it would indefinitely move away from extending its network in the Powder River Basin. This coal producing region has been cited as a major catalyst for other railroads, and it seems to me that management is myopically focused on the short-term. Because of this decision, Canadian Pacific will incur a $180 million non-cash charge.

And Kansas City trades at unreasonable multiples, even for its growth prospects. At 22.1x past earnings and no better positioning against coal relative to competitors', the stock is not worth the price. Analysts forecast 17.6% annual EPS growth over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $6.65. At a multiple of 15x, this translates to a future stock value of nearly $100. Discounting backwards by 10% yields a present value of just over $62. This means the company is almost 20% overvalued.  At best, shareholders would be looking at a 7% average return with dividends reinvested.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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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