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Rebounding Coal Bodes Well for Railroads: Here's Why

Zacks Equity Research

Since coal is a key revenue-generating commodity for railroad operators, the sector participants are largely dependent on factors related to the commodity. Declining coal shipments have been hurting railroad stocks for quite some time.

However, the probability of higher coal demand bodes well for railroads. Even in the fourth quarter of 2016, coal revenues at CSX Corp CSX - a key sector participant - surged 23% year over year to $551 million due to an 8% improvement in volumes. CSX currently has a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

In fact, Moody's Investor Service, the rating services arm of Moody's Corporation raised its outlook for the North American Coal Industry from negative to stable in November, last year. Moreover, the firm has a stable view on North American Railroads for 2017.

Railroads to See Brighter Days Under Trump?

The victory of Donald Trump in the U.S. presidential elections in November turned out to be a positive for the sector. This is because during his election campaign, Trump had taken a pro-coal stance and emphasized the need to revive the beleaguered coal industry. In his very words, “Coal will last for 1,000 years in this country.” Additionally, coal is by far the most stable source of energy and the industry provides jobs to thousands of Americans.

In fact, the President is in favor of fossil fuels instead of renewable energy and has raised questions regarding climate change and its impact. Hence, it is quite likely that the use of coal will see a surge in his tenure. Also, Trump advocates increasing jobs in the coal sector and possibly relaxing regulations. Additionally, if industrial production starts growing, coal volumes are expected to increase further.

The positive impact of Trump’s victory on the sector is further augment as the Zacks categorized Transportation- Rail industry has gained 21.2% since Nov 8 handily outperforming the S&P500 index, which appreciated 8%.

Naturally, key sector participants like Norfolk Southern Corp. NSC, CSX Corp and Union Pacific Corp. UNP have seen an upsurge in their stock prices in the post-election period.

Railroads: Prosperity Ahead?

According toWells Fargo, the improvement in coal prices should benefit railroads immensely. According to the firm, “Eastern Rails” like Norfolk Southern are likely to benefit more in this scenario. Moreover, the firm seems to be bullish on railroads like Canadian Pacific Railway Limited CP and CSX.

We are also impressed by the efforts of railroads like Canadian National Railway Company CNI, Union Pacific, Kansas City Southern KSU and Norfolk Southern toward controlling costs as they aim to drive bottom-line growth. For example, operating ratio (operating expenses as a percentage of revenues) at Kansas City Southern improved to 64.9% for full-year 2016 from 66.4%, recorded in 2015.

Wells Fargo believes that Norfolk Southern is best positioned to bring about an improvement in operating ratio over the next few years. In fact, Norfolk Southern intends to cut costs by an additional $100 million in 2017. Furthermore, the company is on track to deliver annual savings to the tune of $650 million by 2020. The company’s operating ratio also improved 510 basis points to 69.4% in the fourth quarter of 2016. Moving ahead, coal volumes are projected to increase in 2017 on the back of favorable conditions.

Apart from the likely improvement in coal prices, the inauguration of the expanded 102-year old Panama Canal last year seems to bode well for eastern railroads. This is because an expected increase in container traffic at the ports on the East Coast. Historically, imports from Asia have followed the sea route up to the West Coast and then transported by road to the East Coast.

We are also impressed by the efforts of major railroads to reward shareholders. Earlier in the year, railroads like Canadian National and Norfolk Southern had hiked their respective quarterly dividend payouts. And last year, Union Pacific had also done the same. Additionally, the decision of major railroads to invest significantly to promote safety and enhance productivity also raises optimism.

Bottom Line

In view of the above positives, led by the probable coal rebound, it can be stated that 2017 should see railroads performing well after lackluster performances over the past few years. Consequently, we believe that investors should look at this sector with renewed interest, going forward.

 

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Kansas City Southern (KSU): Free Stock Analysis Report
 
CSX Corporation (CSX): Free Stock Analysis Report
 
Union Pacific Corporation (UNP): Free Stock Analysis Report
 
Canadian National Railway Company (CNI): Free Stock Analysis Report
 
Norfolk Souther Corporation (NSC): Free Stock Analysis Report
 
Canadian Pacific Railway Limited (CP): Free Stock Analysis Report
 
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