With Q1 earnings season upon us, companies like Zacks Rank #2 (Buy)-rated CSX Corp. (CSX - Free Report) and Canadian Pacific Railway Ltd. (CP - Free Report) are kick-starting the earnings season for the Railroads sector tomorrow, Apr 19. With stocks in the space having struggled over the past few quarters, mainly due to coal-related headwinds, we wait to see if the sector displays an improved performance this time around. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
Nevertheless, the positive sentiment surrounding the space mainly due to the favorable scenario regarding coal volumes in 2017 raises optimism. Given that coal is a key revenue generator for railroad operators, the commodity is the primary determinant of the fate of the sector participants. Impressive industrial volume growth should boost results in the coming periods as well.
Will Railroads Gain from Trump’s Victory?
Key railroads like Norfolk Southern Corp. (NSC - Free Report) , CSX Corp. and Union Pacific Corp. (UNP - Free Report) have seen a surge in their stock prices following the election of President Trump. Trump’s pro-coal stance and promises to revive the coal industry were big contributors to the upside as is the expectation of an overall pro-growth fiscal and regulatory policy regime.
The new administration’s pro-coal policy stance is expected to help the commodity’s demand. Trump’s skepticism of climate change issues and focus on reviving the country’s manufacturing base is a potentially long-term positive for fossil fuel-based electricity generation. Trump’s recent executive action rolling back the preceding administration’s environmental stipulations about carbon emissions are a practical manifestation of this policy stance. Other plans include doing away with the ban on coal leasing on federal lands, scrapping regulations to limit methane emissions from oil and gas production, and reconsidering the "social cost" of carbon emissions in all regulatory actions.
Coal-fired plants are likely to gain the most from these actions. With coal accounting for over 15% of the revenues for Class I railroads in the U.S., any favorable development pertaining to the commodity is a positive for these companies.
We are positive on the efforts of railroads like Norfolk Southern and Union Pacific to cut costs in order to boost their bottom line. Norfolk Southern is on track to generate annual savings to the tune of $650 million by 2020. The company’s operating ratio (operating expenses as a percentage of revenues) improved 510 basis points to 69.4% in the fourth quarter of 2016. Operating ratio of below 65% is targeted by 2020. The efforts of key railroads to reward shareholders through share repurchases and dividends also impress. In fact, railroads like Canadian Pacific Railway Ltd. (CNI) have recently hiked their quarterly dividend payouts.
We believe that the raised dividends highlight the commitment of these companies to create value for shareholders as well as underscore their strong financial condition and bright prospects. Additionally, the decision of major railroads to make significant investments to boost safety and productivity raises optimism.
The Zacks Rail Transportation industry is up +8.9% in the year-to-date period, outperforming the +4.9% gain for the S&P 500 index in the same time period. The industry is up +27.4% over the past year vs. +11.4% for the index as a whole.
As a result of this strong performance, the industry’s valuation is no longer cheap. The Zacks Rail Transportation industry is currently at 18.3X the consensus forward 12-month EPS estimates, which is towards the high end of the 5-year trading range of 12.8X to 18.7X. The 5-year median forward 12-month PE multiple is 15.6X. The industry was trading at a discount to the S&P 500 index based on this multiple since February 2015, and has shifted to a premium since the start of the year.
While there are plenty of reasons to be bullish about railroads, the space is not entirely bereft of headwinds. Although Trump inked an executive order to repeal the Clean Power Plan, many market watchers believe that it will not be easy for the new administration to eliminate the plan. Not only will the process be extremely time consuming, but will also necessitate the formulation new rules.
Moreover, the revival of coal may not be as expected. According to a Forbes report, the share of coal in total electricity generation is projected to decline to 26% in 2040 from 33% in 2015, even if the Clean Power Plan is scrapped.
Last month, Trump proposed a 13% reduction in federal funding for transports in the 2018 budget. Per the proposal, spending for this sector will be reduced by $2.4 billion from $18.4 billion outlined in the 2017 budget. One of the important features of the proposal is to stop federal funding for long-distance Amtrak trains. Although it remains to be seen up to what extent railroads will be hurt by the spending cut, many market watchers believe that the Chicago area would be the worst hit if the proposals are accepted. This might hurt railroads like Union Pacific. We note that Union Pacific currently serves five facilities in the Chicago area.
Moreover, the opening of the expanded Panama Canal last year might impact the business of western railroads like Union Pacific as it there may be a reduction in freight volumes. Additionally, Trump’s policies pertaining to Mexico might adversely affect key railroad players like Kansas City Southern (KSU - Free Report) , which has significant Mexican exposure. Given that Trump has been critical about free trade with the nation, business relationships with Mexico might take a hit over the next few years. This will hurt Kansas City Southern big time.
Early Prediction for Q1 Earnings Season
Our Earnings Preview report paints a disappointing picture for the S&P 500 members of the broader transportation sector – one of the 16 Zacks sectors including railroads – in the Q1 earnings season. High costs are likely to hurt the bottom-line for transports in this earnings cycle. According to the report, earnings for this highly diversified sector are projected to decline 21.7% year over year. The picture is much better with respect to the top line, which is expected to expand 5.9%.
What the Zacks Industry Rank Indicates
The bearish Zacks Industry Rank of # 228 carried by the 10-member Transportation-Rail industry further highlights the fact that railroads, despite the optimism, are not out of the woods yet. The bearish rank places the industry in the bottom 11% of the 250-plus Zacks classified industries.
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