(The following article by Desiree J. Hanford was circulated by Dow Jones Newswires on September 19.)
CHICAGO — Railroad companies and Wall Street analysts are optimistic that the industry can weather a slowing economy, but that optimism hasn’t been reflected in rail sector stock prices.
The U.S. economy grew at an annualized rate of 2.5% in the second quarter, down from 5.6% in the first quarter, and recent indicators point to continued sluggishness. Railroad companies, however, say prospects remain bright for the remainder of this year and in 2007 thanks to continued strong demand by customers and solid pricing.
Nonetheless, stock prices for major rail companies have declined in recent months précisely on fears of an economic slowdown more than on fact, Morningstar analyst Peter Smith said.
If investors look out for the next 12 months, they’ll see that the railroads are in better shape than they expect and are in better shape than the trucking companies, Smith said.
The railroad sector is trading at 13 times the next 12 months earnings, and historically it has traded between 11 times and 15 times, UBS analyst Rick Paterson said.
“They’re trading exactly the same way they have in the past, based on the economy,” he said. “Every single financial metric is better. Investors view them as cyclical stocks.”
Following the release of data indicating continued weakness in the economy, especially in the housing sector, railroad stocks were in the red Tuesday. The downward movement came despite bullish comments by Citigroup analyst John Kartsonas, who initiated coverage of the sector Tuesday with a “positive view.”
Kartsonas started coverage with buy ratings on Burlington Northern Santa Fe Corp. (BNI), Norfolk Southern Corp. (NSC), CSX Corp. (CSX) and Canadian Pacific Railway (CP). He initiated coverage of Union Pacific Corp. (UNP) and Canadian National Railway (CNI) with hold ratings.
The stocks have “performed impressively” since 2003 because of “robust” earnings growth and solid margin expansion, Kartsonas said in his note.
“Today, railroad stocks attract investors’ interest not only as a cyclical play, but more importantly, as a sector with strong secular growth prospects, innovative operations and improving financial performance,” Kartsonas said.
Stifel Nicolaus analyst John Larkin on Tuesday reiterated buy ratings on Burlington Northern Santa Fe, CSX, Union Pacific, Norfolk Southern and Canadian National Railway. He has a hold on Canadian Pacific Railway.
Clearly railroads will never sever ties to cyclical industries. Slowing demand for housing, for example, led to an 18.5% decline in primary forest products carload freight for the week that ended Sept. 9, compared with the year-earlier period, according to the Association of American Railroads. Lumber and wood products carload freight declined 16.6% for the same period.
Production cuts at U.S. auto makers led to a 13.5% decline in motor vehicles and equipment for the period.
But analysts point out that the other freight groups are in good shape. Grain carload freight rose 17% for the week that ended Sept. 9, and coal increased 3.7%.
“Railroads are tied to cyclical freight groups but a little more than half the business is defensive, such as agricultural products and coal,” Morningstar’s Smith said. “So secular trends going on in those two trump the economic business cycle.”
Norfolk Southern Chairman, President and Chief Executive Charles Moorman told Dow Jones Newswires last week at a railroad conference in St. Louis that there’s been an “underlying change” in the industry’s business that tends to insulate the sector from economic cycles more now than in the past.
For example, Moorman pointed to demand for coal by electric utilities not being tied to the economy. While demand for goods from China may slow if the economy softens, there will always be a need for those types of products, he said.
“We just think the business has changed,” Moorman said.
With railroads having more dependence on services that are less and less cyclical, “railroads today should have better control over their network flow and, as a result, over volumes and pricing,” Citigroup analyst Kartsonas said in his research note.
None of the analysts own shares of the railroad companies.
Morningstar and Citigroup don’t do investment banking work for the companies.
UBS has done investment banking work for CSX.
Stifel Nicolaus has done and will seek investment banking work during the next three months from Norfolk Southern. It expects to seek that work in the next three months from Canadian Pacific Railway.