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Will the Bull Run Continue for Freight Railroad Industry?

Nalak Das

Freight railroad operators have been witnessing strong performance in Wall Street since the beginning of this year. Substantial surge in manufactured goods, massive tax hauls and business-friendly policies of the government have fueled railroad operators’ growth.

However, U.S. stock markets have been facing severe volatility once the trade negotiation between the United States and China broke down abruptly in the first week of May. The tariff war between the two largest trading countries of the world intensified once again. At this juncture, can railroads maintain their momentum?

Strong Fundamentals of the Railroad Industry

The solid financial health of railroads bears testimony to the fact that the scenario has improved considerably for players in this industry despite coal-related headwinds. Currently, nearly 35% of the U.S. exports are shifted to the ports by freight railways. Year to date, the freight railroad industry has grown 24.8% compared with the benchmark S&P 500 index’s increase of 12.7%.

Railroad operators make consistent efforts to improve operating ratio (operating expense as a percentage of revenues) in order to boost profits. The lower the value of the metric, the better it is. To this end, the precision scheduled railroading model has been proving to be immensely beneficial. With increased efficiency and reduced costs, railroad companies have shown consistent improvement in operating ratio, a key parameter for efficiency.

Robust Intermodal Business

In February 2019, the Association of American Railroads, the industry body of the class 1 freight railroad operators, expressed optimism that rail traffic growth rate will continue in the near term. The most important growth driver will be the intermodal segment.  

Growth of intermodal volumes in recent years is anticipated to drive railroads’ top line. Volumes at this key revenue generating unit rose 5.6% in 2018, thanks to an increasing number of freight conversions from highway to rail owing to limited truck supply.

Strong intermodal volumes have been bolstering railroads’ top line and the uptrend is likely to continue going forward. Further, the railroad operators’ sustained cost-reduction efforts are anticipated to drive the bottom line going forward.

Although coal volumes have historically contributed the maximum to rail carloads, the companies have shifted their dependence to intermodal owing to dwindling coal volumes.  Notably, intermodal now reportedly dominates overall carloads. Apart from a low truck count, growing e-commerce demand is another factor fueling growth of intermodal. Consequently, the sluggish coal scenario is likely to be less of a hindrance for railroads.

Performance of Major Railroad Operators

In the last three months, stock price of six major railroad operators, Union Pacific Corp. UNP, CSX Corp. CSX, Canadian Pacific Railway Ltd. CP, Norfolk Southern Corp. NSC, Canadian National Railway Co. CNI and Kansas City Southern KSU outperformed the benchmark S&P 500. CSX carries a Zacks Rank #2 (Buy). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

The chart below shows price performance of 6 major railroads in the last three months.

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