Investing in railroads: where to put your money

(Photo: Pablo Martinez Monsivais/Associated Press)

Canadian Pacific Railway’s management likely didn’t know it at the time, but Sept. 23, 2011, was the beginning of the end for them. That day, New York–based Pershing Square Capital Management purchased $1.4 billion of the railroad company’s stock and became its largest shareholder. Over the next seven months, a bitter proxy battle ensued. Pershing’s CEO, Bill Ackman, eventually ousted CP’s CEO and appointed Hunter Harrison, rival CN Rail’s former boss, in his stead. But Ackman didn’t just see value to be realized in a regime change. He saw it in the whole railroad sector.

Most North American railroads have been around over a century, but the past decade has seen the sector generate some of its best returns for investors. In 2002, the industry started consolidating, leaving behind a few big players that could get better pricing and didn’t have to worry as much about competition. Profits, and share prices, quickly climbed for the remaining operations. The recession hurt the sector as railcar volumes sank, but many of these companies remained profitable. Now, volumes have returned to their pre-recession levels, and companies are in better shape than they’ve ever been. They’re targeting new markets and slowly seeing their more traditional clients, such as automotive and lumber suppliers, increase shipments as the economy improves. Add in yields between 1% and 3%, and it’s no wonder Ackman wanted to play engineer.

 

The recent recession was by no means the rest the industry has been through, which is one reason why T. Rowe Price equity analyst Andrew Davis likes the sector. “These companies will never go away,” he says. It’s also almost impossible for a new company to start up and steal market share—the incumbents have hard-to-replicate rights of way set up across North America.

Railcar volumes are also growing. Railway companies make more money when more cars ride the rails. They also increase pricing every year by inflation plus 1% or 2%. What’s impressive, though, is that volumes have improved despite a slow-growing economy. Davis points out that trains are between twice and four times as fuel-efficient as trucks, depending on distance, so rail has become more competitive as fuel has become a bigger part of the cost equation. The sector is also benefiting from the growth of crude oil production within North America. Oil producers have turned to trains to transport their increased supply from the Canadian oilsands and North Dakota’s Bakken formation to refineries clustered on the U.S. Gulf Coast while the necessary pipeline infrastructure remains unbuilt. According to the U.S. Energy Information Administration, oil and petroleum rail deliveries rose 40% in the first half of 2012. BNSF Railway, a private company owned by Berkshire Hathaway, says it will soon be transporting a million barrels of oil a day, a volume equivalent to the proposed Keystone XL and Northern Gateway pipelines combined.

Freight traffic will also increase when other sectors, such as autos and housing, return to more normal levels. John Smolinski, a portfolio manager with TD Asset Management, points out that U.S. housing starts are still well below where they were pre-recession, but the outlook is improving. As the sector comes back, more lumber and plywood will ship on trains. The sector is already seeing volume increases. Between Jan. 1 and Sept. 24, shipments of lumber rose 12.7% over the same period last year.

The auto sector is another big user of railroads. It ships parts and cars across North America. While the industry has made an incredible recovery, it’s still selling three million fewer cars than it did before the recession. As it is, U.S. auto-related shipments are up 19.4% year-to-date.

Investors have to be choosy in this market. What you buy will depend on your investing style. Valuations range from a cheap 11 times earnings to 21 times, and each company has different characteristics. Value investors may want to look at eastern U.S. operations, such as Norfolk Southern and CSX, which are trading at the low end. These companies typically ship a lot of thermal coal to power plants, but over the past year utilities have started using more natural gas. Coal shipments were down 9.3% year-over-year between Jan. 1 and Sept. 24. The declining coal volume spooked investors, who exited these stocks. Still, these are well-run businesses that will benefit from the sector’s other, positive trends.

Growth investors may want to look at Kansas City Southern, a small railroad that ships a lot of goods to and from Mexico. It has the highest price-to-earnings ratio, at 21 times, but it’s also growing earnings in excess of 25% a year, about twice as fast as its peers. Turnaround investors should consider CP. Over the next ve years, its focus will be on improving operating margins, which is a crucial metric for rail companies. Most railroads have an operating margin of at least 30%; CP’s is closer to 20%. The company has said that it can get its margins up to 35%. “That would imply substantial earnings growth regardless of the GDP outlook,” says Davis.

Finally, investors who want to own large and stable operations should look at Union Pacic and Canadian National. These companies are the top dogs and will continue to see earnings growth thanks to an improving economy and increasing volume growth. Davis points out that these companies, especially CN, have less room to grow than the others. “One thing you have to think about is how much better can CN really get?”

When deciding what to buy, look at a company’s return on equity (ROE). In 2012, the sector had a healthy 19% ROE. A good company will have an industry-average ROE, if not better, says Fadi Chamoun, an analyst with BMO Capital Markets. He also looks at free cash ow yield, which is around 4.5% for the sector, and the dividend payout ratio, which is in the range of 30% to 35% of earnings. He wants companies to grow their dividend faster than their earnings. He also likes to see share buybacks. “Any company repurchasing 3% to 5% of their shares is outstanding,” he says.

Davis makes sure to look at the exposure each company has to different end markets. Having diversified exposure is always good, but if you want to play a particular theme, such as the housing rebound, buy a company that has more exposure to lumber. Other metrics to consider include price-to-earnings, price-to-book and debt-to-EBITDA. Most companies carry some debt—around two times debt-to-EBITDA—but that’s ne, says Davis, because these businesses generate a lot of cash. Make sure the company doesn’t have a debt ratio that exceeds that number, he says.

Besides the growth potential, trains remain something you can count on. “These are solid, core holdings that you can sleep well at night with,” says Davis. “And you still have a chance to beat the market.”