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Despite challenges posed by the recent hurricanes (Harvey, Irma and Maria), railroads performed quite well in the third quarter of 2017. In fact, key sector players like Union Pacific Corp. (UNP - Free Report) , Norfolk Southern Corp. (NSC - Free Report) and Kansas City Southern (KSU - Free Report) outperformed (both with respect to the top and bottom lines) in the third quarter on the back of volume growth.

All the above-mentioned companies carry a Zacks Rank #3 (Hold). You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

The sector’s impressive performance is not just limited to the third quarter. Stocks in the railroad space have in fact witnessed good times since the commencement of 2017 after struggling for the past couple of years. The 29.3% improvement in the Dow Jones U.S. Railroads Index on a year-to-date basis bears testimony to bullishness surrounding railroads.

Factors Contributing to the Turnaround

In fact, improvement in the prospects of key units like coal and intermodal has been benefiting railroads since the beginning of this year. 

Particularly with Trump presidency, the coal industry is seeing better days. The President is aiming to revive the industry by relaxing regulations which were hurting its prospects. He has started to act on his promises made during the campaigning phase.

The rise in natural gas prices is also favorable to demand for coal. Moreover, according to the U.S. Energy Information Administration (EIA), coal production in the United States will improve in 2017 and 2018. Since revenues from coal contribute significantly to railroads’ top line, any positive development for the commodity means good news for the sector.

Coal apart, the scenario pertaining to another key source of revenues for railroads, intermodal, has improved by leaps and bounds this year. In fact, growth relating to intermodal volumes reached the highest levels in three years, in the third quarter of 2017.

Recovery of the U.S. economy has also worked in favor of railroads. In fact, in the third quarter, the domestic economy expanded at an impressive annual rate of 3%, according to the latest report from the Commerce Department. The reading was above the consensus estimate of 2.6%, despite the turbulence caused by hurricanes.

This is also the first time since 2014 that the U.S. economy expanded at 3% or above (on an annual basis) for two consecutive quarters. This supports the air of optimism surrounding railroads. Generally, a buoyant domestic economy results in an uptick in rail shipments of goods across the United States.

Good Times Likely to Continue in Q4

Railroad operations were severely hampered in the third quarter due to the natural calamities as important rail lines were severely damaged. However, operations at railroads have returned to normal. Consequently, the stocks are likely to perform impressively in the fourth quarter of 2017 driven by volume growth. Key units such as intermodal and coal are expected to continue performing well, and thereby aid results.

Efforts of railroads to check costs should boost their bottom lines further. For example, CSX Corp. (CSX - Free Report) expects its bottom line to expand between 20% and 25% in 2017 (on a reported basis) over 2016 levels, driven by improved efficiencies.

Railroads should continue to see an improvement pertaining to another key metric — operating ratio (operating expenses as a percentage of revenues) — in the fourth quarter of 2017. Thelesser the value of operating ratio the better, as it implies that more cash is available to the company to reward shareholders through dividends/buybacks.

Riding on their solid financial health, many railroads including the likes of Union Pacific Kansas City Southern, Canadian Pacific Railway Ltd. (CP - Free Report) and Canadian National Railway Ltd. (CNI - Free Report) have hiked their respective quarterly dividend payouts this year.

Some Roadblocks to Be Careful About in Q4

Despite the positives, there are a few factors that might hurt results in the fourth quarter. Evidently, weakness in the automotive sector had hurt the results of major railroads in the third quarter, due to sluggish vehicle production in the United States.

The scenario is expected to remain gloomy in the final quarter of 2017 as well. In fact, sales of U.S. light vehicle sales for 2017 are projected at 17 million units, down approximately 3% on a year-over-year basis. With the automotive sector accounting for a significant chunk of their revenues, softness in automotive volumes might hurt railroads.

Moreover, rising operating expenses due to the uptick in fuel prices are likely to limit bottom-line growth of railroads in the fourth quarter.

Valuation Picture

The Zacks Rail industry is up 25.2% on a year-to-date basis, outperforming the 18.3% gain for the S&P 500 index in the same time period. The industry is up 24.7% over the past year versus 20.1% growth for the index as a whole.

Despite such strong price performance, the industry does not appear too expensive when valued according to the forward price-to-earnings (P/E) ratio for the next financial year (F2), as it is trading at 18.5x P/E. The reading is favorable when compared with the S&P 500 (18.8x). The industry’s lower-than-market positioning calls for more upside.

The story is, however, not the same when the industry is valued according to the price-to-book (P/B) ratio. The industry’s current P/B ratio of 4.9x is unfavorable when compared with for the S&P 500 (3.7x).

What the Zacks Industry Rank Indicates

The Zacks Industry Rank of #94 carried by the 10-member Zacks Rail industryfurther highlights the optimism surrounding railroads. The rank places the industry in the top 35% of the Zacks industries.

We put our entire 250-plus industries 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

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