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It’s no secret that stocks in the railroad space are witnessing good times courtesy of a number of tailwinds led by the improvement in scenario pertaining to coal, which is responsible for generating a significant chunk of revenues for Class I railroads in the U.S. President Trump is also a boon for this key revenue-generating commodity for railroads. The prospect of improvement in coal demand under the new administration definitely bodes well for stocks in the space.

Trump has been advocating the case of fossil fuels instead of renewable energy and has raised questions regarding climate change and its expected widespread impact. He has started to act on his pre-election promises and taken measures to repeal the Clean Power Plan. Moreover, Trump walked out of the Paris Climate Agreement.

A thriving and improving economy also supports the bullish case for railroads as it implies that more goods are being transported across the U.S. via rail.

Coal Improvement Drives Q2, Will the Bullish Scenario Continue?

True to the health of railroads, most sector participants performed impressively in the second quarter of 2017. Jacksonville, FL-based CSX Corp. (CSX - Free Report) provided a solid start to the major railroads in the current reporting cycle.

This Zacks Rank #3 (Hold) company reported better-than-expected earnings per share and revenues in the second quarter, riding on the step-up in coal. Coal revenues surged 27% year over year to $530 million due to a 7% expansion in volumes. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Another major railroad operator – Union Pacific Corp. (UNP - Free Report) – based in Omaha, NE, also outperformed in the quarter on higher freight revenues. The uptick was owing to volume growth and increased fuel surcharge revenues, among other factors. Although growth was witnessed across all key segments, coal was again the star performer with freight revenues from the commodity increasing 25% on 17% growth in business volumes.

Kansas City Southern (KSU - Free Report) , based in Kansas City, MO, also reported better-than-expected revenues and earnings per share in the second quarter. Results were aided by a 6% rise in overall carload volumes. The energy segment impressed in the quarter, with utility coal boosting segmental results. Norfolk, VA-based Norfolk Southern Corp. (NSC - Free Report) also saw a significant uptick in coal revenues during the quarter. Norfolk Southern expects coal revenues to continue improving in the third quarter as well.

In fact, the U.S. Energy Information Administration (EIA), has predicted that U.S. coal consumption will increase from the projected 2017 levels of 729.3 million short tons (MMst) to 744.2 MMst in 2018. Any positive development on coal is good news for railroads not only because it is a key revenue generator but also because coal-related headwinds were primarily responsible for the struggles of the sector participants over the last few quarters.

Rebound in Intermodal Volumes – Another Positive Catalyst

Apart from the improvement on the coal front, intermodal volumes also improved for key railroads, driving second-quarter results. In fact after the disappointing 2016, which was witness to declining intermodal volumes, the scenario has turned around for the better this year.

According to the Intermodal Association of North America (IANA), intermodal volumes improved 2% year over year in the first quarter of 2017. The scenario improved further in the second quarter with the measure rising 4.5%. In fact, this was the highest growth rate recorded in almost three years. The positive readings certainly support the air of optimism surrounding railroads.

Other Positives Driving the Industry

Railroads are investing substantially in enhancing safety, which is highly encouraging. For example, Union Pacific has announced a $3.1 billion capital plan for 2017. The plan is in line with the company's efforts to promote safety and enhance productivity. Union Pacific’s crossing accident rate improved to 2.27 in the first half of 2017 compared with 2.4 recorded in the first half of 2016.

Moreover, efforts of railroads to drive the bottom line through prudent cost management also raise optimism as far as this sector is concerned. For example, Norfolk Southern is on track to deliver annual productivity savings to the tune of $650 million by 2020 ($250 million reached in 2016 with an additional savings in excess $100 million projected this year). It also registered a record operating ratio (defined as operating expenses as a percentage of revenues) of 66.3% in the second quarter of 2017. The metric improved 230 basis points from the year-ago quarter. The company aims to achieve an operating ratio of below 65% by 2020 or even earlier.

Moreover, the dividend hikes announced by the likes of Canadian National Railway (CNI - Free Report) , Canadian Pacific Railway (CP - Free Report) and CSX this year signal financial strength and prosperity for railroads. In another shareholder friendly move, Norfolk Southern recently increased its full-year 2017 target pertaining to buybacks from $800 million to $1 billion.

Bullish Zacks Industry Rank

The Zacks Industry Rank of 9 (out of 265 groups) carried by the Transportation-Rail Industry further highlights the attractiveness of railroads as an investing option on the back of the tailwinds mentioned above. The favorable rank places the companies in the top 4% of the Zacks industries.

We put our X industries (all 265 of them) into two groups: the top half (i.e., industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than 2 to 1.

Click here to know more: About Zacks Industry Rank

Valuation Signals Upside

When valued according to the forward price-to-earnings (P/E) ratio for the next financial year (F2), the Zacks Rail Transportation industry does not appear too expensive as it is trading at 16.41x P/E multiple. The reading appears favorable when compared with its own traded multiple (trading lower than its high end of 17.56x and median of 16.84x) in the last 12 months as well as the S&P 500 (17.67x). The industry’s lower-than-market positioning calls for more upside.

The story is not dissimilar when the industry is valued according to the EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation and amortization) multiple. The industry currently has a forward 12-month (F12) EV/EBITDA ratio of 10.25x, which is better than what the industry saw in the last year with the ratio near the low end of the one-year range, and lower than the high end of 11.08x. The reading is also lower than that for the S&P 500 (10.40x).

Some Roadblocks to Beware

Despite the above-mentioned tailwinds, there are some challenges that one needs to be mindful of before putting hard-earned money into stocks in the space. The disappointing outlook issued by the likes of CSX and Norfolk Southern on their respective automotive units for the latter half of 2017 is concerning. With the automotive sector accounting for a significant chunk of their revenues, softness in automotive volumes will hurt railroads big time.

Moreover, regulations like revenue adequacy, forced switching and limit price tests have the potential to hurt railroads big time in the event of being implemented. Moreover, any unfavorable development on North American Free Trade Agreement (NAFTA) – the trade pact inked in 1994 between the U.S., Canada, and Mexico – may hurt railroads like Kansas City Southern (KSU - Free Report) significantly as they have significant Mexican exposure.

Bottom Line

The sector’s attractive valuation, an improving economy, President Trump’s pro-coal stance, improvement in intermodal volumes and other positives make us believe that despite some headwinds, good times will continue for railroads over the next few months.

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