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Coal Revival: A Blessing for Railroads

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Stocks in the railroad space are psyched up after years of struggle. The main reason for the struggles of the sector was weakness in domestic coal shipments. However, things are looking up now for this a key revenue-generating commodity for railroad operators. 

Coal Prospects Brighten in the Trump Era

It is a well-documented fact that coal as a fuel source lost much of its relevance during President Obama’s tenure. However, the election of President Trump late last year has been a blessing for this industry, which is a vital source of employment in the country. The President is in favor of increasing employment in this industry apart from relaxing regulations. As coal accounts for more than 15% of revenues for railroads in the U.S., it is natural that any bullish development pertaining to the commodity is a boon for railroads.

Trump’s repeated emphasis on the need to revive the coal industry bodes well for the railroad industry. He is a bigger fan of fossil fuels compared to renewable energy, and has started to act on his pre-election promises and taken measures to repeal the Clean Power Plan. Trump also walked out of the Paris Climate Agreement. Both have similar objectives of lowering emission levels.

Given this backdrop, we expect a surge in the usage of coal during the Trump regime. Naturally, sector participants like Union Pacific Corp. (UNP - Free Report) , Norfolk Southern Corp. (NSC - Free Report) and CSX Corp. (CSX - Free Report) stand to benefit substantially if the President successfully resurrects the coal industry.

Union Pacific carries a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

An improving economy also means good news for railroads as it implies that an increased volume of goods are crossing the country on the rails. Additionally, coal volumes will be positively impacted in the event of higher industrial production. The bullishness surrounding railroad operators is clear from the 10.61% year-to-date increase witnessed in the Dow Jones U.S. Railroads Index.

Impressive Q2

In view of the positive sentiment surrounding the space and the improvement of coal volumes, it is of little surprise that railroads fared well in the Q2 earnings season. The railroad space saw major players like Norfolk Southern, Kansas City Southern (KSU - Free Report) , Union Pacific, Genesee & Wyoming Inc. (GWR - Free Report) and CSX report earnings beats.

Apart from reporting better-than-expected earnings, companies like Kansas City, Union Pacific and CSX also outperformed on the revenue front. The vast improvement in coal revenues led to the turnaround in fortunes of the sector participants.

For example, at Union Pacific, coal revenues (freight) increased 25% while the same at CSX improved 27%. The intermodal unit has also performed well in the quarter.

Union Pacific’s expectation that its business volumes will improve further in the second half of the year raises further optimism.

Operating Ratio Improvement: A Key Positive

In the second quarter, Union Pacific’s operating ratio (defined as operating expenses as a percentage of revenues) came in at 61.8%, reflecting an improvement of 340 basis points on a year-over-year basis. The metric benefited from higher fuel prices.

The company is on track to achieve its guidance of around 60% by 2019. Operating ratio of 55% is targeted beyond 2019. We are also impressed by the $3.1 billion capital plan announced by the company in 2017. The plan is in line with the company's efforts to promote safety and enhance productivity. Operating ratio in the mid-60s is expected this year at CSX.

Norfolk Southern is on track to deliver annual savings to the tune of $650 million by 2020. Operating ratio of below 65% is targeted by 2020 or even earlier. CEO James A. Squires recently said that the company is on track to achieve these targets. The efforts of railroad operators to cut costs in order to drive the bottom line raise optimism.

Dividend Hike/Buybacks Bode Well

Investors are always on the lookout for companies that have a track of consistent and incremental dividend payments. Railroads score on this aspect, as well. In May 2017, Canadian Pacific Railway Limited (CP - Free Report) raised its quarterly dividend per share by 12.5% to C$0.5625 per share. The board cleared a new share buyback program as well.

Also, during the second quarter, CSX’s board authorized an additional $500 million for the current share repurchase program (now worth $1.5 billion). The company bought back stock worth nearly $500 million in the reported quarter under the program. The likes of Norfolk Southern and Canadian Pacific Railway Ltd. (CNI - Free Report) also hiked their respective dividend payouts earlier in the year.

Additionally, the decision of major railroads to make significant investments to boost safety and productivity raises optimism. Union Pacific has announced a capital plan worth $3.1 billion 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 from 2.4 in the first half of 2016.

Moreover, the inauguration of the expanded 102-year old Panama Canal last year augurs well for eastern railroads. This is because of an expected increase in container traffic.

Bottom Line

In view of the above tailwinds, led by the improving coal related scenario, it can be stated that railroads should continue to see brighter days ahead. Consequently, we believe that investors should look at this sector with renewed interest.

Check out our latest Railroad Industry Outlook for more news on the current state of affairs in this market from an earnings perspective, and how the trend looks ahead for this important sector at the moment.

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