What Really Matters in the Railroad Industry

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

Investors have all sorts of options when it comes to measuring business performance. You can look at earnings per share, free cash flow, EBITDA, profit margins, and a host of other metrics. But usually there are just one or two metrics that really matter in the long run.

It is important to determine what the important metrics are so that you can focus all of your attention on evaluating the business with respect to those metrics and ultimately decide whether it indicates the stock is a good investment or not.

For instance, for a community bank investors are going to focus on the bank's deposit base and loan book. The important questions to ask are, "What kind of a return does the bank earn on deposits?" and "How much is the current loan book worth?" Investors could not care less what the price to earnings ratio is or how much free cash flow is produced each year. EPS and free cash flow are not important metrics for community banks -- they can't tell investors how well the bank has done in the past or how well it might do in the future. Return on deposits does.

In this article, we are going to take a look at the railroad industry. Railroads have inherent moats due to regulations governing where and under what conditions new track can be laid. In many cases, railroads operate without any significant competition in the regions in which they operate. Although it varies depending on a railroad's typical freight type, the government-created monopoly positions enable railroads to earn stable profits over time.

The Most Important Metric for Railroads

While community banks' business models are centered around maximizing return on deposits, railroads' models are geared toward maximizing return on tangible assets. Railroads want to earn as much as possible per dollar of track laid, train cars owned, and other equipment owned. Therefore, investors should focus on return on tangible assets in order to determine how well a railroad has performed in the past and what kind of return investors in the stock can expect going forward.

(Note: The operating ratio -- a railroad's expenses as a percentage of revenue -- is undoubtedly important, but only insofar as it increases a railroad's return on tangible assets.)

Over the last few years, Union Pacific (NYSE: UNP) has outperformed its rivals in a metric similar to return on tangible assets -- pre-tax return on tangible invested assets (pre-tax earnings as a percent of tangible assets minus cash).

<img alt="" src="http://g.fool.com/editorial/images/23010/railroad-ptronca_large.png" />

All railroads have improved over the last decade due to rising energy prices that have made rail more attractive than substitutes. But Union Pacific has managed to cut costs during the last few years, which has enabled it to earn higher returns on assets than its peers.Over the last ten years, Union Pacific has averaged an 8.46% pre-tax return on tangible invested assets. Railroad profitability does not get much higher than this across a full economic cycle due to the capital-intensive nature of the industry. But Union Pacific may be able to continue earning this high return because many of its long-term contracts coming up for renewal are likely to be renegotiated on more favorable terms to Union Pacific. As a result, investors may expect further upside from this best-in-class railroad.

While Union Pacific has out-earned other railroads, Kansas City Southern (NYSE: KSU) is bringing up the rear. The railroad earned less than 4% on tangible invested assets over the last ten years. In addition, sales growth has barely outpaced asset growth, which suggests the company can only grow by adding more assets. But at a 4% return on assets, investing in new assets is not a value-creating initiative.

KSU's low return can be explained in part by its operating model -- it derives a significant share of its revenue through concessions, not actually operating the railroads itself. The best thing that can be said about KSU is that it has plenty of room to improve its operating ratio, thus affording it lots of upside despite no/slow growth.

Norfolk Southern(NYSE: NSC) has not done quite as well as UNP -- it has averaged a 7.63% return on tangible invested assets since 2002 -- but its performance has been stellar relative to industry expectations. The railroad's intermodal franchise has allowed it to earn higher-than-normal returns. Meanwhile, it has successfully grown sales about 2.5 percentage points faster than tangible assets, which means it essentially earns a 10% return on tangible assets (2.5 + 7.6).

Investment Considerations

When you buy a railroad, you should think of it as though you were buying its tangible assets. If you want a 5% annual return on your investment, you should pay 2x tangible assets for a railroad that earns a 10% return on tangible assets. Don't think about book value or earnings per share -- concentrate on return on tangible assets.

Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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!

blog comments powered by Disqus