3 Safe Railway Stocks To Consider Buying

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If you think investors have overly discounted equities from the fiscal cliff, you ought to be buying railway stocks now. These stocks follow macro trends, have stable economic moats, and are sustainable. The sustainability is a result of the high capital costs that bar many would-be entrants while the strong free cash flow trends have to do with rising business in intermodal. Below, I review 3 railway stocks that you should consider buying.

Why You Should Buy Union Pacific (NYSE: UNP)

Despite its bull run over the last year, Union Pacific is still tracking well from an investment perspective. As Morningstar correctly notes, the company is quite attractive as a defensive investment. While the Western focus and diversification in agriculture and Asian imports grant it both stability and growth, annual operating ratio improvement will improve the upside/downside ratio. Access to Los Angeles, Tacoma, and Oakland, for example, provide the company with a steady stream of Mexican intermodal volume.

The bears, however, have presented several headwinds, according to Morningstar. (1) Despite improving profitability and ROIC, Union Pacific still lags peers. (2) Reregulation, such as greater safety bills, cut into margins, and (3) coal volume will only be worsened by the possible entry of a third Powder River Basin competitor. Canadian Pacific purchased the Dakota, Minnesota, and Eastern line, so this third headwind is very real and not just speculative.

In my view, the bulls are more likely to win out. Although the company's debt load is high against peers, it is being put to good use. Expansion in core markets will help the company capitalize on rising industrial activity generally. I encourage investing in the business given that volumes have improved despite a challenging market. Particular strength should be expected in automotive, metals, intermodal, minerals, and petroleum.

Lastly, the company is also led by top management. James Young has led the company for six years as CEO and delivered terrific results that will limit downside. The operating ratio, for example, has grown by 1,000 basis points during his leadership. A majority of the board is independent, although the roles of Chairman & CEO have not yet been separated.

CSX (NYSE: CSX) Vs. Norfolk Southern (NYSE: NSC)

In order to diversify, you should also consider backing CSX and Norfolk Southern. CSX is a relatively safe investment compared to its rail peers, because it has found ways to hedge against commodity volatility. "Take-or-pay" contracts in steam export provide the company a stable growth trajectory. Deutsche Bank argues that margins are also poised to expand from easy service business, improved productivity, improved velocity, and greater train lengths.

My main concern with CSX from a value perspective is that it doesn't seem to generate enough free cash flow. Over the last four years, free cash flow has hovered from as low as $612 million to as high as $1.4 billion. Put differently, the yield doesn't get much higher than 6%. ROE, on the other hand, has steadily and consistently improved from 13.6% in 2009 and is forecasted by Deutsche Bank to hit 25.4% by 2013. This improvement will drive the upside as the EBITDA margin concurrently grows to 38.9%.

What I like about Norfolk is its exposure to Eastern markets, which I believe will experience a boon from more liberalized free trade agreements. The railroad has also improved its operating ratio while reducing costs through lower equipment use and greater velocity. Despite lowering wage costs, the company has still maintained excellent services. Media promotion has also helped the company improve its corporate appeal. With a multiple of around 11.1x and forecasts for 13.5% annual EPS growth over the next half decade, the upside story looks bright.


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