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3 Top Railroad Stocks to Buy

Lee Samaha, The Motley Fool

For most investors, the key to investing in railroad stocks is the promise of a lifetime of income from dividends from a relatively safe industry. Technologies and fads will come and go, but as long as physical goods need to be transported across North America, then there will be railroads to do it. The industry is the lifeline of the U.S. economy -- so much so that the largest North American railroad (BNSF) is owned by none other than Warren Buffett's Berkshire Hathaway (NYSE: BRK-B)

Traditionally, U.S. railroads operated in a way that suits risk-averse investors looking for the security that comes with buying into businesses with stable market positioning. In addition, if you believe in the long-term prospects for the U.S. economy (as Buffett does), then you probably also believe in prospects for the railroad industry. 

All that being said, there is a significant transformation going on in the U.S. railroad industry at the moment. This transformation is creating some short-term stock volatility but should enhance its long-term earnings (and dividend) growth prospects, and that's great news for investors. 

A freight train.

Image source: Getty Images.

What is driving the railroad industry transformation?

There's no way to avoid it. The single biggest earnings driver in the railroad industry right now is something called precision scheduled railroading (PSR) and its widescale adoption by nearly all the Class I railroads in North America

The management methodology used by PSR is likely to change the investment landscape significantly, and it's also the major reason why relatively recent PSR adopters like Union Pacific (NYSE: UNP), Norfolk Southern (NYSE: NSC) and Kansas City Southern (NYSE: KSU) are the best-positioned railroad companies to benefit.

As the name suggests, PSR is an operating methodology that emphasizes running trains between two points on a network on a fixed schedule. This is distinct from the traditional hub-and-spoke model whereby rail cars enter a hub on one train and can be dispatched to their final destination pulled by another train.

One of the key characteristics of PSR is that trains run on fixed schedules and it's up to the sales and marketing staff to adjust pricing in order to maximize carload revenue and also increase train length. Another is that there doesn't tend to be a mismatch at two ends of the networks in terms of rail cars -- something that can happen under the hub-and-spoke model.

In this way, railroads operating under PSR tend to require less railway equipment and can shut down hubs that are no longer necessary. Some of the operational benefits of using PSR include cost savings from the need for fewer hubs, reductions in terminal dwell, and increases in train velocity and train length. There's more on these metrics below.

Precision scheduled railroading works

All the evidence suggests that PSR, developed and implemented by legendary railway CEO Hunter Harrison, helps improve railroad profitability and asset utilization. Indeed, Harrison generated significant improvements in the operating ratios (ORs) of the Canadian National Railway (NYSE: CNI) and Canadian Pacific Railway (NYSE: CP) during his tenure as CEO. The OR is a commonly used metric in the railroad industry and represents expenses divided by revenue -- a lower percentage figure is better for the company's bottom line.

Chart showing Hunter Harrison's impact on operating ratios at leading railroads.

Data sources: Company presentations. Blue bars represent operating ratio in the year before Harrison's tenure and red bars show Harrison's OR in the last year of tenure at the respective company. *Harrison died in late 2017; his psr plans were continued into 2018.

As a consequence of Harrison's success at the Canadian railroads and CSX (NASDAQ: CSX), nearly all the largest railroads in North America have now adopted PSR.

Although the shift in methodology will inevitably create some near-term friction -- not least with customers used to previous scheduling norms -- its widescale adoption by the industry is proof enough that PSR works over the long term. 

What is unique about buying railroad stocks?

We won't go into a lot of explanation here about how to evaluate railroad stocks. It's easier to click on the "How to Invest in Railroad Stocks" link to learn what you need. What's important to remember from that report is that long-term investors in railroads need to accept that revenue is going to fluctuate in parallel with the economy.

As railroad revenue and earnings margins follow the overall economy, it's a good idea to try and approximate what the average earnings margin will be over a long-term cycle. That leads to the key point for investors: What if the adoption of PSR leads to a positive step change in the assumptions of long-term ORs and therefore earnings margin?

In other words, if investors/analysts were assuming an OR of, say, 65% over the cycle (and therefore a 35% operating income margin) and the new assumption is that PSR will lead to an average OR of 60% over the cycle (therefore an operating income margin of 40%), then it implies significantly enhanced profitability in the future -- great news for investors. 

A freight train next to a stream and snowy forest

Image source: Getty Images.

Indeed, that appears to be exactly what happened. Referring to the chart above, the best-performing stock of the six major public railroads operating in the 2002-2009 period was Canadian National Railway with a 238% return. The rest averaged 160% (in case you are wondering). Similarly, Canadian Pacific's 120% return between 2012-2016 made it the second-best performer during the period (Union Pacific was slightly better), and the other four returned 80% on average. 

Moreover, CSX has started to significantly outperform its peers in terms of its operating metrics because it was a relatively early adopter of PSR among the U.S. railroads. 

Armed with this background knowledge, let's turn to why the three selected stocks are so attractive.

1. Union Pacific

The second-largest public railroad in terms of revenue -- slightly behind Berkshire Hathaway-owned BNSF -- Union Pacific has some big ambitions. Following the adoption of PSR in late 2018, the company is working to lower operating ratio below 61% in 2019 and then below 60% by 2020 on the way to ultimately hitting as low as 55% at some point down the line. Union Pacific's OR was 62.7% for 2018.

If the company can achieve its aims, there's substantial upside potential for the stock. We've already seen the positive impact of PSR on the stock prices of the Canadian railroads as the process lowered the companies' operating ratios. It's likely we will see the same thing from Union Pacific in the coming years as PSR takes hold.

Of course, it's one thing to aim for a lower operating ratio and it's another thing to actually achieve it. Also, investors should note that there will likely to be upward pressure on the operating ratio if the U.S. economy has a downturn and Union Pacific's revenue goes down with it.

Moreover, Union Pacific generates around 15% of its revenue from coal delivery -- an industry seemingly in a long-term slump due to the declining use of coal as a source for electricity production. That said, Union Pacific's exposure to relatively cheap-to-produce coal from the Powder River Basin in the Western U.S. means it's likely to be less affected than East Coast railroads that have exposure to Appalachian coal.

What Union Pacific has going for it

A key factor in favor of Union Pacific's OR efforts was the appointment of Harrison's protege, Jim Vena, as chief operating officer in January 2019. Vena is a seasoned PSR veteran with 40 years at Canadian National, where he oversaw "the North American rail industry's best operating ratio," according to Union Pacific.

Vena started with an advantage, as Union Pacific generates very good revenue per carload, leaving him to focus on improving efficiency. Union Pacific tends to generate significantly more revenue per carload than key rival BNSF (a PSR holdout). Similarly, when compared to the next-biggest railroad -- PSR adopter CSX -- Union Pacific also does better on revenue per carload, but its OR is not as efficient. It appears Vena has a good opportunity to cut expenses to get Union Pacific's OR in line with CSX's.

Railroad

Revenue per Carload

Operating Ratio

BNSF

$2,110

66.2%

CSX 

$1,907

60.3%

Union Pacific

$2,400

62.7%

Data source: Company presentations.

What an improving OR means for Union Pacific's valuation

Railroad stocks are often favored by income-seeking investors, as they offer a steady stream of dividends while having very stable market positioning. Railroads lie at the heart of the economy. As long as goods need to be transported, railroads will be a part of it. Moreover, the Class I railroads are effectively duopolies, with Union Pacific and BNSF controlling the Western two-thirds of the U.S. and Norfolk Southern and CSX controlling the East. Because of these factors, many investors focus on dividend income as the differential and consider railroad stocks as a bond-like investment.

Let's conservatively assume 2018 is a cyclical high for Union Pacific and revenue over the next decade will revert to the annualized growth rate of 2.4% that it was between 2009-2018. During the 2009-2018 period, Union Pacific's average OR was 65.7%. The company is working to reduce this OR rate to something between 63% and 58% over the decade.

The chart below assumes the company reduced its OR to 60% in 2020 (as per the company's plan) and 55% by 2028. If it hits its marks, a conservative estimate for annual earnings growth (normalized to include cyclicality of revenue and OR) gives an annual growth rate in earnings (and therefore dividend) of 2.3% to 3.7%.

Chart showing Union Pacific's theoretical operating income.

Data source: Union Pacific presentations. Author's analysis. Chart by author.

All told, if the current dividend yield on Union Pacific stock is higher than the 10-year U.S. bond yield rate, then there is a strong case for income-seeking investors to buy Union Pacific stock instead and enjoy a higher and growing yield.

2. Norfolk Southern

In common with Union Pacific, the key argument behind buying the Eastern U.S.-focused railroad Norfolk Southern is that its adoption of PSR should lead to a reduction in its OR over an extended period. In addition, the case for Norfolk Southern is made stronger when considering that it has an opportunity to play catch-up with key rival CSX.

The possibility of getting on the same level a key competitor is an important concept in one form of value investing, whereby a company's stock is bought for its potential to raise its performance to that of a rival or industry benchmark. It's particularly relevant in a relatively simple industry like railroading, and definitely in the case of Norfolk Southern and CSX, the two dominant players in their geography.

There should be a good opportunity for Norfolk Southern to improve its operating ratio in the coming years. Management's plan calls for a reduction to 60% from the 65.4% reported at the end of 2018.

Norfolk Southern metrics to watch

There are other key metrics where Norfolk Southern can improve relative to CSX. As you can see below (from a 2018 snapshot), Norfolk Southern's operating ratio trails its main rival. As previously mentioned, terminal dwell and train speed are key operational metrics for PSR practitioners. Unfortunately, the railroads report this data in different ways, but one way to make an apples-to-apples comparison is to use data the Class I railroads must submit to the Surface Transportation Board.

Operating Metric

CSX

Norfolk Southern

Note

Average train speed (mph)

22.5

19.0

Higher is better

Average terminal dwell time* (hours)

20.9

27.8

Lower is better

Adjusted operating ratio

60.3%

65.4%

Lower is better

*Terminal dwell time excludes cars on run-through trains. Data source: Surface Transportation Board.

On this basis, Norfolk Southern has ample opportunity to improve its OR to at least match CSX, although CSX is also trying to improve its OR. Moreover, CSX's efforts to implement PSR will likely cause potential short-term disruptions that can affect performance and create a moving target for Norfolk Southern to match.

Just as with Union Pacific, a decrease in the operating ratio will lead to a low-single-digit annual increase in Norfolk Southern's operating earnings over the cycle. However, given that its OR goals are more ambitious those of Union Pacific's, Norfolk Southern has greater growth potential. And as with Union Pacific, income-seeking investors might favor buying Norfolk Southern stock if its current yield is more than the 10-year yield of the government Treasury note.

3. Kansas City Southern

The odd man out among the largest U.S. railroads, Kansas City Southern's revenue tends to be less than an eighth of Union Pacific's and less than a quarter of Norfolk Southern's. In addition, its extensive exposure to cross-border U.S.-Mexico trade -- the railroad has the right to operate 3,300 route miles in Mexico -- makes it a key play on the future of trade within NAFTA.

Moreover, the still-unratified U.S.- Mexico-Canada Agreement (USMCA) removes uncertainty over future trading conditions between the U.S. and Mexico. This is good because it provides a working framework within which companies can invest on both sides of the border -- something that should further cross-border trade. 

A rail track.

Image source: Getty Images.

However, Kansas City Southern certainly isn't the odd man out in terms of PSR. Management decided to embrace and aggressively implement the operating methodology in 2019. The move makes sense, partly because its biggest interchange partner, Union Pacific, is also implementing PSR (as noted above), and partly because Kansas City Southern needs to improve its service level as well as its operational metrics. PSR is more than an attempt to improve the bottom line, it's also intended to help the railroad better deal with operational challenges like the occasional (and sudden) surges of volume that can occur in cross-border traffic -- something that occurred in 2018

In addition, just as Union Pacific appointed PSR veteran Jim Vena as chief operating officer, Kansas City Southern has appointed another seasoned PSR practitioner, Sameh Fahmy, as executive vice president of precision scheduled railroading. Fahmy has 23 years of experience at Canadian National and worked as a consultant at CSX as it began implementing PSR in 2017.

Management's plan is to reduce its OR to the low end of the 60%-61% range by 2021 from an adjusted OR of 64.3% in 2018. In common with Norfolk Southern, the planned OR reduction is significant. It's also in keeping with Kansas City Southern's efforts to remain the fastest-growing of the big U.S. railroads.

Chart showing railroad revenue growth rates.

Data source: Company presentations. Chart by author.

Kansas City Southern benefits from having the least amount of revenue from coal of all the Class I U.S. railroads. So it has relatively less exposure to a commodity seemingly in a long-term secular decline.

All told, assuming Kansas City Southern can reduce its OR in line with its expectations and it achieves an annual growth rate similar to its last 10-year cycle, it should be able to grow earnings at an annual rate of around 4% over the next decade. That makes Kansas City Southern the best-placed railroad to grow earnings in the next 10 years.

Chart showing Kansas City Southern's projected growth rate.

Data source: Company presentations. Chart by author.

Railroad stocks to buy

It has been alluded to in this article that railroad stocks should be looked at as bond-like investments. Their wide moats, relatively stable market positioning, and history of paying dividends make them seen as such. It's also worth noting that railroad stocks tend to perform well in benign periods of economic growth and falling interest rates, but they might not do so well in a rising rate environment -- even though that implies greater economic expansion, which should help boost revenue growth. 

For income-seeking investors, railroad stocks represent a relatively safe way to get income plus the prospect of inflation-busting growth in dividends, and for those reasons alone they are attractive investment options. Throw in some long-term margin expansion from PSR initiatives, and they are even more attractive for income-seeking investors.

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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares) and Canadian National Railway. The Motley Fool has the following options: short January 2021 $200 puts on Berkshire Hathaway (B shares) and long January 2021 $200 calls on Berkshire Hathaway (B shares). The Motley Fool recommends Union Pacific. The Motley Fool has a disclosure policy.

This article was originally published on Fool.com