(The following column by Jim Jubak appeared at MSN.com on April 14.)
NEW YORK — While the stock market looks for direction, railroad stocks just keep chugging along. And why not?
The sector’s fortunes are closely tied to U.S. economic growth, still a robust 3.8% at last count. Railroads get a big bang for the buck since they carry exports and imports. So news that the U.S. trade deficit hit $61 billion in February, as imports climbed to $162 billion and exports stayed steady at $101 billion, was actually good news for railroads. Just about all industries, except autos, that make the bulky stuff that railroads ship best are projected to ship higher volumes this year than last.
And the railroad industry is one of the few non-energy industries that benefit from rising energy prices. Sure, higher fuel costs bump up operating costs, but growing revenue from shipping coal, the cheapest domestic fuel now, more than makes up the difference.
In my regular 11:20 a.m. ET Wednesday appearance on CNBC’s “Morning Call” I picked three railroad stocks for the next six months.
When bad is good
— CSX has been a truly badly run railroad, which is why the stock looks interesting as an investment in 2005. Slow trains and poor service have kept CSX, the operator of the largest rail network in the eastern United States, from showing the revenue gains of its peers. But profit margins look like they’ll improve this year and next as the company improves operations and cuts a projected $90 million by slashing managerial jobs.
After anemic earnings growth of 5.7% annually on average over the last five years, Wall Street is projecting a pickup to 9.8% growth over the next five years. The stock’s high trailing price-to-earnings ratio of 27.8 anticipates a pickup in earnings growth to 24% in 2005 and 16% in 2006. On projected 2005 earnings the P/E ratio is a more modest 16.1. Our StockScouter rated the stock a 9 out of a possible 10 on April 13.
Shipping coal
— Canadian Pacific Railway, like CSX, is using cost cutting to push its margins higher, but the real story for this Canadian railroad is coal, which accounted for 14% of revenue in 2004. Canadian Pacific has signed major new contracts to export coal, such as the deal with Fording Canadian Coal Trust (FDG, news, msgs) to export metallurgical coal from the company’s mines to Vancouver for export. (In addition, many analysts are expecting grain shipping volumes to pick up this year from the drought-reduced levels of 2004.)
In a sign of railroads’ pricing power in the current market, in the Fording Coal Trust deal Canadian Pacific was able to add a fuel-cost surcharge for the last two years of the contract that’ll let the railroad pass along part of any increase in energy costs. Wall Street expects the company to grow earnings per share by 11% annually on average over the next five years. The stock trades at a trailing 12-month P/E ratio of 16.1. Our StockScouter rated the stock an 8 on April 13.
Gaining market share
— Norfolk Southern is one of the industry’s best-run railroads. Investors buying the stock can’t look for a pickup in profit margins from improvements in service as with CSX. Instead the forecast is for Norfolk Southern to reap the rewards of its superior service in the form of gains in market share.
Norfolk Southern is already one of the industry’s largest shippers of coal (coal accounted for 23% of the company’s revenue in 2003), and the company looks set to pick up market share in that sector this year. Along with more volume, Norfolk Southern’s superior speed to market should result in more pricing power for the railroad.
The Wall Street consensus calls for almost 12% earnings growth annually on average over the next five years. That’s a drop from growth in the last five-year period but still solid for a stock trading at just 15.3 times trailing 12-month earnings per share and works out to a PEG (price-to-earnings-to-growth rate) ratio of just 1.3. Our StockScouter rated the stock a 9 on April 13.
I always give CNBC.com on MSN readers two exclusive picks that I didn’t mention on air.
Exclusive picks
— Canadian National Railway is very optimistic about its prospects. At least that’s what the 28% increase in the company’s first-quarter dividend argues. A substantial dividend increase like that is a huge sign of insider confidence since boards don’t raise dividends if they aren’t 100% sure they can keep paying at that level.
If you look at the company’s cash flow, you’ll see the source of that confidence. Analysts project that the company will generate about $1.4 billion of free cash flow this year. Much of that will find its way into dividends since railroad companies have only limited opportunities to reinvest their capital in new opportunities. Limited, yes, but Canadian National did acquire about 1,800 miles of track in its 2004 acquisitions of Great Lakes Transport and BC Rail that’ll contribute a full year of revenue in 2005.
Wall Street analysts project average annual earnings growth of 11.3% over the next five years. The shares trade at a trailing 12-month P/E ratio of 16.6. Our StockScouter rated the stock a 9 on April 13.
— Burlington Northern Santa Fe puts it all together in one railroad package for investors. The company is a strong operator that’s gaining market share by adding new customers, especially among coal-burning utilities. Revenue grew by 16% in 2004. At the same time, the company still has room to improve margins, thanks to higher volumes and cost cutting. The railroad looks to be in a strong-enough competitive position to see price increases of about 3% this year and for its fuel surcharge to stick.
Wall Street expects earnings per share to leap by almost 23% this year, which explains the 12-month trailing P/E ratio of 25.1. The P/E ratio based on projected 2005 earnings per share is just 15. Wall Street projects average annual earnings growth of almost 11% for the next five years. Our StockScouter rated the stock a 6 on April 13. (Burlington Northern was a Jubak’s Picks in my portfolio Jan. 11.)