Unfortunately, coal is in a secular decline. It now accounts for about 38% of electricity generation in the U.S., down from nearly 50% just six years ago. New discoveries and the widespread use of hydraulic fracturing to economically produce America’s natural-gas reserves have driven down the price of the clean-burning fuel, making it an attractive substitute to coal.
It is unclear how railroads that rely on coal transportation will replace lost revenue because pipelines are the most efficient way to move natural gas. As a result, investors should be wary of investing in railroads that rely on coal for a large portion of overall revenue.
Rails that rely on coal
CSX Corporation (NYSE:CSX) is in the most worrisome position among the North American railroads. Coal accounts for 20% of the company’s revenue. The company faced significant headwinds when the price of coal collapsed in 2009 amidst a sharp recession, which would have caused its operating margin to collapse were it not for an improving operating ratio thanks to cost improvements in all parts of the business.
Even though more than one-fifth of CSX Corporation (NYSE:CSX)’s revenue will eventually disappear, the stock trades at 14.4 times earnings. This is likely because the company is growing its share of export coal; export coal now represents about 6% of revenue, compared to hardly any just seven years ago. Although export coal may temporarily offset the decline in domestic coal volume, the inevitable mass export of U.S. natural gas will lead to the demise of all of CSX Corporation (NYSE:CSX)’s coal revenue. Therefore, investors should avoid including coal revenue in the stock’s valuation.
Norfolk Southern Corp. (NYSE:NSC) is the other U.S. railroad with significant exposure to coal; the commodity represents roughly one-quarter of the company’s revenue. Coal volumes have been falling each year since the recession and rates have fallen at an even quicker pace. Norfolk Southern Corp. (NYSE:NSC)’s concentration on the East Coast of the United States further exposes the railroad to the region’s weak electric demand.
Although electric demand is fickle, coal’s secular decline is too much of a headwind for a company with a 13.3 earnings multiple. Like Intel’s revenue problem due to a declining PC market, Norfolk Southern Corp. (NYSE:NSC) faces an insurmountable revenue problem in its key industry.
Like CSX Corporation (NYSE:CSX), Norfolk Southern Corp. (NYSE:NSC) has buoyed its decline in domestic coal by ramping-up shipments of export coal. However, coal volumes still experienced a net decline compared to the year-ago quarter — falling 4%. Therefore, it is clear that the increases in export coal will not be enough to offset the decline in domestic coal volumes — not even temporarily.
Better in Canada?
Compared to U.S. railroads, Canadian railroads do not transport substantial coal volumes. Coal accounts for just 7% of Canadian National Railway (USA) (NYSE:CNI)’s revenue, making it relatively immune to the natural-gas revolution.
However, despite avoiding major exposure to coal, Canadian National Railway (USA) (NYSE:CNI) derives 14% of its revenue from forestry products, which are in a secular decline. Taken together, coal and forestry account for over one-fifth of the company’s revenue, which could lead to a major earnings disaster in the future.
But, with an industry-best operating ratio and ample free cash flow production, Canadian National Railway (USA) (NYSE:CNI) has much more room for error than CSX Corporation (NYSE:CSX) and Norfolk Southern Corp. (NYSE:NSC). At a 17.9 earnings multiple, Canadian National Railway (USA) (NYSE:CNI) is much more attractive than either of the coal-dependent railroads due to its track record of low-cost operation and high returns on assets; the company earned a 10% return on assets in 2012, a figure virtually unheard of in an industry where debt usually drives return on equity.
Bottom line
The transition from coal to cheaper and cleaner fuels will occur in a drawn-out process that will take many years — maybe even decades. However, the headwinds that it creates for companies like CSX Corporation (NYSE:CSX) and Norfolk Southern Corp. (NYSE:NSC) will be a constant reminder of each company’s inability to generate substantial revenue growth. Investors in all railroads — but especially those that rely heavily on coal — should be mindful of the inevitable decline of coal.
The article The Single Biggest Risk Facing Railroads Today originally appeared on Fool.com and is written by Ted Cooper.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Canadian National Railway. Ted is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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