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Railroads are riding high in 2017 after years of struggle, primarily due to declining coal shipments. The improving fortunes of railroad operators are well reflected by the 29.3% improvement in the Dow Jones U.S. Railroads Index on a year-to-date basis.

Railroads Aided by Coal Revival

Behind this revival is primarily the improving scenario pertaining to coal. In fact, President Trump’s pro-coal stance is a huge positive for railroads, given their significant dependence on the commodity for revenue generation. We note that coal had lost significance as a source of fuel during former President Obama’s tenure. 

Now, President Trump’s plans to shift focus to traditional energy businesses such as coal is expected to aid railroads, whose fortunes are tied to a great extent to coal. Moreover, in March 2017, Trump signed an order to repeal the Clean Power Plan. More recently, Trump walked out from the Paris climate agreement.

The revival of coal can be made out from the impressive performances of most sector participants with respect to the commodity in the third quarter of 2017. For example, at Norfolk Southern Corp. (NSC - Free Report) coal revenues (freight) increased 13.1%, while the same at CSX Corp. (CSX - Free Report) rose 10% year over year owing to 5% expansion in volumes. At Kansas City Southern (KSU - Free Report) , revenues improved 19% at the energy segment on the back of impressive performances at the Utility Coal, Frac Sand and Crude Oil units.

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

Intermodal Volumes Also Showing Strength

Apart from coal, the intermodal unit is also seeing good times this year after a lackluster 2016. 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 with intermodal volumes rising 4.5% in the second quarter and 6.3% in the third quarter, on a year-over-year basis. This was the highest growth rate recorded in more than three years. Volumes on the international as well as domestic fronts touched record highs during the quarter. The positive readings certainly support the buoyant picture surrounding railroads.

With the key segments performing well, it was of little wonder that overall volumes improved in the third quarter at railroads, helping them to register impressive results despite the disruption in operations due to the recent hurricanes.

Operating Ratio Improvement Highlights Effective Management

A key metric to gauge the performance of railroads is operating ratio (defined as operating expenses as a percentage of revenues). The lower the value of operating ratio the better, as it implies that more cash is available to reward shareholders through dividends/buybacks. A lower value of operating ratio is, in fact, a pat on the back for management of a railroad operator. Adding to the buoyancy in railroads, most operators registered an improvement in this key metric in the third quarter of 2017.

For example, Kansas City Southern's operating ratio came in at 64.4% compared with 66.9% reported a year ago. At Norfolk Southern, this key metric improved to 65.9% from 67.5% in the third quarter of 2016.

Norfolk Southern aims to achieve an operating ratio of below 65% by 2020 or even earlier. At CSX, operating ratio improved 90 basis points to 68.1% in the third quarter. In 2017, CSX expects operating ratio in the high end of mid-60s. The metric also improved at Genesee & Wyoming (GWR - Free Report) .

Additionally, prudent cost management of railroad operators raise optimism in the stocks. To this end, Union Pacific Corp. (UNP - Free Report) announced its decision to trim its workforce by up to 750 employees in August 2017, in a bid to increase efficiencies.

Investor-Friendly Actions Attest to Financial Health

Most railroad operators are in sound financial health as evident by their shareholder-friendly activities (dividends and buybacks). In line with its investor-friendly attitude, Union Pacific bought back 11.8 million shares for $1.3 billion in the third quarter of 2017. During the first nine months of 2017, the company returned around $4.4 billion to its stockholders through dividends/buybacks.

Additionally, Norfolk Southern’s board of directors approved a new share buyback program in October 2017. The company is now authorized to buy back an additional 50 million shares through Dec 31, 2022.

Moreover, many railroad operators including the likes of Kansas City Southern, Canadian Pacific Railway Ltd. (CP - Free Report) and Canadian National Railway (CNI - Free Report) have hiked their dividend payouts this year, in a show of financial prosperity. Additionally, the robust financial health of most railroads has prompted them to invest substantially to promote safety and enhance productivity.

To Wrap Up

Apart from the above-mentioned tailwinds, an improving domestic economy bodes well for railroads. We believe that in light of factors like better coal and intermodal volumes, Trump’s pro-coal stance and industrial growth investors should look at stocks in the space 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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