(The following article was posted on Kiplingers.com on December 15.)
WASHINGTON — Trains combine increased freight volume with higher rates for a potent mix.
On a typical day, more than 10,000 containers of freight come off ships in the ports of Los Angeles and Long Beach. These containers — most filled with consumer goods from Asia — can be trucked away on the chassis of an 18-wheeler or stacked two high on a train car. A decade ago, few retail goods moved by rail from U.S. factories. Now, just about anything you pluck from a Wal-Mart shelf may have come by train via a seaport. Because of fuel costs and a shortage of long-distance truck drivers, railroads handle more of the long hauls and trucks deliver the goods to final destinations.
You can see this economic sea change 15 miles up the Harbor Freeway from the ports. Here, Burlington Northern Santa Fe operates the world’s busiest intermodal freight terminal, and the pressure is unrelenting, says Matt Igoe, the terminal’s 33-year-old senior manager. From his perch overlooking a 243-acre expanse of truck bodies and rail cars, he lays out the bottom line: “Quit moving the freight, and three days later shelves will be empty in Chicago.” The terminal is so full, tall cranes now stack containers five high to wait to be loaded onto trains.
Recovery path
Although railroads were deregulated in 1980, they remained stuck in a dismal cycle of overcapacity and rate cutting. “It’s an old, staid industry that’s finally on the threshold of becoming a growth business,” says Don Hodges, whose Hodges fund lists BNSF as its top holding. Railroads today are in an enviable position they’ve not enjoyed for a century.
In a nutshell, rails have all the business they can handle — and a newfound ability to raise rates. Check out this leverage: In the second quarter of 2005, year-over-year volume for the six biggest railroads rose 2%, but revenues per carload rose 10%, and profits shot up 46%. The historic rate of revenue growth has been 1%, says John Barnes, an analyst at investment bank BB&T.
No wonder the Dow Jones U.S. railroad index is up 57% over the past two years. But it may not be too late to invest. Most railroads have long-term contracts with customers and haven’t raised prices (or levied fuel surcharges) on as much as half of their volume, says Morgan Stanley analyst James Valentine. So profit growth should remain strong, and share prices could rise another 15% to 30% by the end of 2006 as the industry’s improving record turns more doubters into believers, says Valentine. He expects the group’s average price-earnings ratio, now 13 times next year’s estimated earnings, to rise to 14 or 15.
Imports from Asia (what you see in the Southern California ports) should continue to fuel the intermodal business, which capitalizes on railroads’ efficiency advantages over trucks. Compared with trucks, trains use about one-third as much diesel fuel per ton of goods shipped. And railroads don’t have to contend with a driver turnover rate of 120% a year.
Still, railroads’ biggest advantage is the ability to haul bulk commodities, including coal and grain, and large objects, such as cars, that can’t be shipped as efficiently any other way. Coal, especially, has been a boon for the industry, as environmental regulations have forced many East Coast power plants to rely on cleaner-burning coal shipped from Wyoming. Coal accounts for at least 20% of revenues for each of the four biggest U.S. railroads: BNSF, Norfolk Southern, Union Pacific and CSX.
Two for the railroad
You could buy any of these four — or one of the two biggest Canadian lines, Canadian National and Canadian Pacific — and participate in the industry’s rebirth. Our favorites, though, are Burlington Northern Santa Fe (symbol BNI) and Norfolk Southern (NSC). Fort Worth-based BNSF’s 30,000-mile rail system, concentrated in the West and Midwest, puts the company in an ideal position to handle growing traffic from Asia, as well as coal and farm products. Burlington has also been far more successful than its rival, Omaha-based Union Pacific, in ramping up to meet rising demand and pushing through price increases. At $57, the stock’s up 46% over the past year, but it still trades at just 13 times next year’s expected earnings of $4.40 a share. Valentine thinks the stock will hit $68 to $73 within the next 18 months.
In the East and Midwest, Virginia-based Norfolk Southern counts on coal for 46% of its revenues, a higher percentage than any of its U.S. counterparts. But Morgan Stanley’s Valentine expects coal to be the highest-growth segment for railroads next year. Until recently, Norfolk Southern was one of the cheapest railroads to buy. At $39, the stock trades for 13 times next year’s expected earnings of $3.08 per share.
Big shifts in industry fundamentals don’t come around often. Or, as Burlington’s Igoe puts it, “We’re big, getting bigger, and that’s the way it ought to be.”