(Reuters circulated the following article by Nick Carey on August 7.)
CHICAGO — When railroads reported second -quarter earnings last month, their stocks took a battering.
Not because they missed expectations — in some cases, they outperformed — but because investors feared a coming economic slowdown could hit their future earnings.
But the idea that railroad fortunes move in lock-step with the economy could be outdated. Some say railroads will continue to grow even if the economy weakens, boosted by rising imports from China, soaring demand for coal and ethanol, plus pricing power not seen for decades.
“We are far less dependent on the economy than we were a decade ago,” said Wick Moorman, chief executive of railroad Norfolk Southern Corp.
Shares of Union Pacific Corp.
Worries of a U.S. economic slowdown had many investors scrambling to sell. Conventional wisdom has it that the railroads are a bellwether of the U.S. economy. If economic activity slows, fewer goods move by train.
But that thinking may no longer apply, making railroad shares attractive buys at current valuations.
“We’re still in the middle of a rail renaissance,” said Tony Hatch of New York-based ABH Consulting. “Unfortunately, the only way to prove that the railroads will keep growing in a weakening economy is to experience a slowdown.”
HELPED BY IMPORTS, TRUCKING WOES, OIL PRICES
Hatch and others believe that as the United States shifts its manufacturing base overseas, rising imports of cheap consumer goods from developing nations such as China will continue to grow, even as the U.S. economy slows.
“If there is an economic slowdown we should see an improvement in that (import) business as people will be looking for lower-cost goods,” said Matthew Rose, CEO of U.S. railroad Burlington Northern Santa Fe Corp.
Soaring demand for coal from power plants is another source of growth for the rails, as natural gas becomes increasingly expensive. Oil prices are expected to remain high.
High fuel prices have also helped the railroads take market share from trucking companies, which are less fuel-efficient and more costly to operate. Adding to the trucking industry’s woes is a growing shortage of drivers.
Also tied to the issue of oil is ethanol; demand for the biofuel is on the rise because U.S. refiners are now using it as a cleaner gasoline additive instead of water-polluting
MTBE.
All these trends have contributed to record rail profits.
“While the railroads still carry goods such as autos and chemicals that are cyclical, more than half of what they carry cannot be considered dependent on economic cycles,” said Peter Smith, an analyst at Morningstar.
To be sure, there is still a hefty chunk of rail business that remains susceptible to economic slowdowns, but that is being offset by another crucial benefit for the rails — steadily improving pricing power.
PRICING POWER
For more than 20 years after the deregulation of the U.S. railroads in 1980, prices for hauling goods declined in real terms. Facing tight capacity and soaring demand over the past few years, in 2005 railroads hiked prices by at least 10 percent.
Fresh price hikes have followed this year and some rail executives have indicated more are in the pipeline.
“The pricing renaissance of the railroads means they have the best pricing power we’ve seen for a quarter of a century,” said Ken Hoexter, an analyst at Merrill Lynch. “Even if growth moderates, we should see that pricing story continue because of tight capacity.”
“We remain confident about these stocks,” he added, “though some investors will only be convinced by sustainable profit growth in the next few quarters despite a weakening economy.”
Believers like Hoexter and Hatch say now is a good time to buy railroad stocks because they are cheap.
Union Pacific Corp. is trading 16.7 times earnings, BNSF is trading under 15 times earnings, Norfolk Southern is at 13.3 and CSX Corp.
“These stocks are trading at near trough multiples,” Hoexter said.
In a July 27 research note Bear Stearns analyst Edward Wolfe reiterated the investment bank’s “overweight” rating on Norfolk Southern, CSX and BNSF.
“(T)his group remains near its historical low-end valuation despite the best fundamentals…,” he wrote.