What the Dow Transports are Really Signaling

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

According to classic Dow Theory, any rally among industrials must be confirmed by a rally in transports. Over the decades, the U.S. economy has shifted away from manufacturing toward services, but purists maintain that the Dow Jones Transports Index, which is flat on the year, is currently signaling a warning to investors.

Transports such as FedEx (NYSE: FDX) and United Parcel Service (NYSE: UPS) have shown flat to sluggish year-over-year EPS growth, but certain segments within these companies have done well, offering hope to investors seeking confirmation.

Within FedEx, the Ground segment is a solid indicator of e-commerce. Consumer goods purchased online are usually shipped using Ground rather than Express service, and SmartPost provides online retailers, catalogers, fulfillment houses and direct marketers a solution for shipping low-weight packages. Average daily package volumes rose 4.7% for FedEx Ground and 17.6% for SmartPost over the prior year quarter, which resulted in a 9% increase in segment operating income. 

A similar story unfolded last quarter for UPS, which reports Q3 earnings October 23. The majority of year-over-year growth in U.S. domestic package volumes, according to the company, "was driven by large e-commerce customers shipping low-weight residential packages." Again we see a strong consumer.

Meanwhile, the Freight segment of FedEx, which consolidates less-than-truckload shipments, experienced a $71 million increase in revenues over the prior year quarter, while expenses grew by only $23 million. As a result, the segment operating margin doubled from 3.2% to 6.4%, and operating income more than doubled, from $42 million to $90 million. Within UPS too, the Supply Chain & Freight segment realized higher operating profits and margins despite lower revenues year-over-year.

Railroads have had a similar experience. Plummeting coal revenues, which are less influenced by industrial output than by the costs of alternative fuels, have hurt overall profits while diluting favorable results in merchandise transportation segments that reveal the true strength of the economy.

For instance, CSX Corp (NYSE: CSX), which reports earnings next Tuesday, recorded a 7% increase in EPS last quarter over Q2 2011 despite headwinds from coal. However, total revenues fell, led by a $138 million decrease in coal revenues that was only partially offset by a $99 million increase in revenues from merchandise transportation. Lower natural gas prices help explain lower coal revenues, and higher merchandise revenues help explain the rally in industrials.

The same thing happened at Norfolk Southern (NYSE: NSC), which, like UPS, reports on the 23rd of the month. Coal revenues slipped 15% to $755 million as general merchandise revenues rose 9% to $1.6 billion, resulting in essentially flat revenues overall. Hidden behind the headline numbers was a signal that confirmed the industrials' rally.

Perhaps the most compelling story among railroads comes from Union Pacific (NYSE: UNP), which reports on the 18th. Second quarter EPS was up a whopping 32% over the prior year quarter, hurt only by a 9% decline in coal revenues. Revenues were up for all other segments, with increases of 25%, 14%, 13%, and 10%, respectively, for automotive, industrial products, chemicals, and intermodal. Union Pacific captures fewer revenues per car for coal than for any other segment ex-intermodal, so the downturn in coal should help boost margins to boot.

Market rallies are ideally confirmed by transports, but it doesn't always happen in a way investors might expect. Confirmations by relevant segments can remain hidden within consolidated results. In this case, the Dow Transports can positively confirm a broader rally - even without rallying themselves.

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