The railroad industry has gained attention from analysts and investors over the last couple of years, even investing superstar Warren Buffett made a big move in this sector by purchasing Burlington Northern in 2010 for nearly $44 billion. In case you were wondering, it´s not too late to hop on the train.
1. Competitive Advantages
If there is one thing Buffett likes to see in a company is a strong and durable competitive advantage, and the railroad business is as good as it gets from that perspective. Nobody would build a new railroad near an existing one, costs would be enormous and there would probably not be enough demand for both companies to operate profitably.
Trains compete against trucks and airplanes, but they have a big advantage in fuel efficiency that make them the obvious choice when it comes to freight transport in areas like commodities. They have also made some remarkable improvements in efficiency since the industry was deregulated in the eighties.
The sector has streamlined operations, solved labor disputes, and implemented technological advancements; they now have sensors to detect mechanical issues before they cause delays or accidents. Work related injuries have been declining over the last years and punctuality, a critical factor, has been materially improved.
2. Macroeconomic Tailwinds
Railroads have been capitalizing on the US energy boom through different ways, even for oil transportation. Pipelines create connections between two fixed points, but trains can take the product where demand and prices are higher, so producers have been using railroads to take advantage of pricing spreads in different regions.
The US industrial is witnessing a big renaissance lately, caused not only by the local energy boom, but also by higher costs and other problems in countries like China. This has increased demand from industries like chemicals, automotive, and steel among others.
Some companies like Burlington Northern and Canadian National Railway (USA) (NYSE:CNI) are experimenting with natural gas as a cheaper alternative to diesel. Many of these companies consume nearly 1 billion gallons of diesel annually, and considering that the fuel is selling for $1 or $2 more per gallon than an equivalent amount of gas, the cost savings could be substantial.
The transition would be expensive, to make the switch to natural gas, a railroad would have to modify its diesel-electric locomotives, a process which costs somewhere around $600,000 and $1 million according statements by Normand Pellerin from Canadian National, which is running a test with a gas fueled train in Alberta.
But as long as natural has remains cheap enough, making the change sounds like a reasonable idea, it looks like the transition may be viable once all the tests and pacifications are finished. This would provide further efficiencies in such a critical aspect as fuel cost.
3. Strong Fundamentals
When analyzing financial statistics and valuation ratios for the major railroads like Canadian National Railway (USA) (NYSE:CNI), Canadian Pacific Railway Limited (USA) (NYSE:CP), CSX Corporation (NYSE:CSX), Norfolk Southern Corp. (NYSE:NSC) and Union Pacific Corporation (NYSE:UNP), the numbers look quite solid.
There are important differences among specific names, of course, and it´s important to notice that the numbers regarding Canadian Pacific are reflecting temporary issues like restructuring and asset-impairment charges. But the main take away is that the five companies are pretty profitable and trading at moderate valuation levels.
Operating margins in the area of 30% are more typical in industries like software than in the transportation business. And the same goes for return on equity – ROE – ratios showing that these companies are compounding shareholder´s wealth at a nice speed. Big profitability in a sector with amazing competitive advantages, no wonder Warren Buffett likes the railroad business.
And the valuations look quite reasonable too. With forward P/E ratios in the range of 12 to 17 we could hardly call the sector overvalued. If the sector continues capitalizing the opportunities created by favorable trends like the energy boom and the industrial recovery in the U.S., these stocks have room to run further.
In addition to that, railroad companies have a solid trajectory of regular dividend increases over the last decade, and this should be a source of additional returns for investors.
Individual Names
Canadian National Railway (USA) (NYSE:CNI)’s railway spans Canada from coast to coast and extends through Chicago to the Gulf of Mexico; this top notch operator is the envy of the industry when it comes to profitability. The company has considerable exposure to forestry products, around 20% of sales, and this should be a positive factor if the housing recovery continues on its way. Not the cheapest one in terms of valuation, but one of the best companies in the sector.
Canadian Pacific operates on nearly 14,800 miles of track across most of Canada and in the Midwestern and Northeastern United States. The company is heavily focused on intermodal and it´s in the midst of a big shakeout with activist investor Pershing Square pressing for changes in management in order to increase those subpar levels of profitability.
A new board of directors and a new CEO were appointed last year because of those pressures. Hunter Harrison, the new CEO, has a promising pedigree as the ex-CEO of Canadian National, so he deserves some credit. Canadian Pacific could be a nice turnaround play if the new management team leaves up to expectations.
CSX´s transportation network spans approximately 21,000 miles, with service to 23 Eastern states and the District of Columbia, and connects to over 240 short line and regional railroads and more than 70 ocean, river, and lake ports. The stock is cheap, but the company makes 38% of volume from local coal demand, which has been declining due to higher natural gas usage, so prospects don´t look very exciting in the middle term.
Norfolk operates 21,000 miles of track in the Eastern United States region, the company hauls shipments of coal (26% of consolidated revenue), intermodal traffic (20%), and a diverse mix of automobile, agriculture, metal, chemical, and forest products (each 7% to 13%). Coal exposure is considerable, but not as big as in the case of CSX. Besides, it has the highest dividend yield in the group.
Union Pacific Corporation (NYSE:UNP) is the largest public railroaded in the US, operating on 32,000 miles of track in the Western region. The company also owns 25% of Mexican railroad Ferromex and generates around 10% of sales from freight between the U.S. and Mexico. The coal that Union Pacific Corporation (NYSE:UNP) hauls from the Powder River Basin is substantially cheaper than coal from other regions, so the company isn´t as exposed to coal substitution by natural gas as other railroads.
Bottom Line
Railroads have rock solid competitive advantages, and they have come a long way in terms of investing for efficiency and profitability. The sector is benefitting from important secular tailwinds, and corporate fundamentals are looking quite strong. The railroad industry is on the right track.
The article 3 Reasons to Invest in Railroads originally appeared on Fool.com is written by Andrés Cardenal.
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