North American rail freight companies are on track to continue benefiting from more efficient operations and could keep gathering steam from a strengthening economy.
After years of being "notorious destroyers of value," the rail companies around the middle of the last decade began improving their operations and started setting higher prices to support reinvesting in their networks, says Morningstar analyst Keith Schoonmaker. Before that, they had been discounting their prices heavily to gain volume.
"Operationally we are in the heyday of railroading," Schoonmaker says, adding that he sees the rail companies continuing to improve operating margins in coming years.
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The benefits of running a tight ship. Take Union Pacific Corp. (NYSE: UNP), which is one of Schoonmaker's top picks. This public railroad company, the largest in North America, has made strides in cutting costs.
Schoonmaker notes that when carloads slid 16 percent in 2009, the company cut costs faster than sales declined. He expects the company will continue improving its margins.
"UP is surprisingly nimble for a huge asset-based enterprise," Schoonmaker says. His fair value estimate for the company is $121 per share, making the stock undervalued at its current price of about $103.
Like other large railroad companies, Union Pacific benefits from being an established player in an industry where new main rail lines aren't likely to be built, although some companies may add spurs or restore abandoned lines, Schoonmaker says.
But, also like other rail companies, Union Pacific's valuation is constrained by the substantial cost of maintaining its lines, Schoonmaker says. Rail assets are outdoors where they are constantly under threat of rust and rot; not maintaining them can lead to derailments.
Another challenge for rail companies is the long-term decline of coal because of cheaper, cleaner-burning natural gas, Schoonmaker says. While coal has been a staple of rail haulage, natural gas can be transported via pipeline.
Norfolk Southern Corp. ( NSC) is also working to improve its operations. The company last year announced cost-cutting measures with the goal of saving more than $650 million a year by 2020.
Josh Duitz, a portfolio manager with Purchase, New York-based Alpine Woods Capital Investors, thinks Norfolk Southern may hit an operating ratio target ahead of schedule. Operating ratio compares operating expenses to net sales and is a key metric for rail companies because they use a big portion of revenue to keep their operations going.
The company may also be able to steal some business from competitor CSX Corp. ( CSX), which has been having issues with dissatisfied customers, Duitz says.
Duitz also likes Canadian Pacific Railway ( CP), which has already benefited from dramatically cutting costs and its operating ratio. Duitz thinks the stock is cheap.
Plus, its network can handle longer trains if the economy continues to grow, he says. Greater carloads mean bigger profits because each additional car adds little to marginal costs, Duitz says.
He thinks Canadian Pacific will gain revenue from adding customers as it invests in its sales force.
The company is also one of Schoonmaker's top picks and a steal at its current price near $153. Schoonmaker estimates Canadian Pacific's fair value at $179 per share.
A play on a growing economy. Lean operations are a foundation for rail companies to build on because even if gross domestic product continues growing a modest 2 percent, Duitz expects their earnings to increase. The rail companies are "really a GDP play with operational leverage," he says.
One potential boon to overall GDP growth would be a push from President Donald Trump to boost infrastructure projects. That would drive business to rail companies as they can generally haul heavy materials more inexpensively than trucks, says Chris Bertelsen, chief investment officer of Aviance Capital Management in Sarasota, Florida.
Bertelsen likes Kansas City Southern ( KSU). The company has improved its operating ratio and has an advantage with its operations in Mexico because it can hire cheaper labor there, he says. "They're in prime shape to be beneficiary of any infrastructure transportation," he says.
The company may also be undervalued over fears that the Trump administration will dismantle the North American Free Trade Agreement, says Bertelsen, who thinks those fears are overblown. It's more likely to be tweaked than completely overhauled, he says.
Bertelsen also thinks Kansas City Southern could be a takeover target before the end of the decade. He speculates that CSX would be a logical acquirer, and any deal would result in a premium paid to investors already holding Kansas City Southern's stock.
While infrastructure spending certainly could be a positive, it probably won't move the needle much on rail volumes, Schoonmaker says. The general health of the economy and consumer confidence are more important, he says.
In any case, because health care and taxes are a bigger priority in the Trump administration, an infrastructure push from the White House might not come until 2018, with spending trickling through in 2019 or 2020, Duitz says.
Still, railway companies aren't exactly hurting for demand now. There's already plenty of transportation and infrastructure work at the state and local level that requires heavy materials that can be hauled by rail, he says.
A more immediate reason to buy the rail companies is their recent pullback in share prices, which has provided what could be a good entry point, he says. "We think now is an opportunity to buy," he says.
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