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Railroad Industry Outlook - April 2018

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Stocks in the railroad space are being aided by momentum in the U.S. economy, with more goods being transported across the country.

The market is expected to continue its winning streak, banking on a rise in wages and more confident consumers. Moreover, the new tax law (Tax Cuts and Jobs Act) should boost profits further and drive stock prices of the participants of this key sector higher.

The robust financial health of railroads is reflective of the improved scenario for its players. The rebound has been aided by the much-improved scenario pertaining to the intermodal unit, a key revenue generating sector for railroads.

The sector has bounced back after a disappointing 2016. Intermodal revenues are likely to grow this year as well. In fact, intermodal shipments are expected to expand 4.2% in 2018, strengthening the top line for railroads in turn. Improvement pertaining to another key metric — operating ratio (operating expenses as a percentage of revenues) — is another positive for railroads.

In view of the above tailwinds, the fourth-quarter earnings season had been a good one for railroad stocks. Notwithstanding a few headwinds including some lingering impacts of devastating hurricanes, railroad companies continued the earnings momentum in the December quarter. We note that a number of companies in the space — including prominent names such as Norfolk Southern Corp. (NSC - Free Report) , CSX Corp. (CSX - Free Report) , Kansas City Southern (KSU - Free Report) and Genesee & Wyoming, Inc. (GWR - Free Report) — delivered an earnings beat in the quarter.

Volume Growth Likely to Drive Railroads in Q1

The stocks are likely to perform impressively in the first quarter of 2018 driven by volume growth. For example, the Zacks Rank #3 (Hold) railroad — Union Pacific Corp. (UNP - Free Report) — expects volume growth in the soon-to-be-reported quarter to increase in the low single-digit range. Strong performance at the intermodal unit is expected to aid results. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Efforts of railroads to check costs should boost their bottom lines further. For example, at the 2018 Investor Conference held in March, CSX stated that its transition to precision scheduled railroading is progressing well. The new model will lead to top-line growth on the back of volume and pricing gains from the merchandise and intermodal segments. Moreover, scheduled railroading is anticipated to provide greater agility to the coal markets. This, in turn, will drive growth.

Railroads should continue to see operating ratio-related improvements in the first quarter of 2018. The lesser the value of operating ratio the better, as it implies that more cash is available to the company to reward shareholders through dividends/buybacks.

In fact, the transportation sector, which includes railroads, is expected to see double-digit year-over-year earnings growth in the first quarter. For more details about the earnings of this sector and others, please read our Earnings Trends report.

Zacks Industry Rank Highlights Headwinds

Despite the above-mentioned tailwinds, the Zacks Industry Rank # 247 (of 250 plus groups) carried by the Zacks Rail Industry highlights that the industry is not bereft of headwinds. This unfavorable rank places the companies within the bottom 4% slot of the Zacks industries.

We classify our entire 250-plus industries into two groups: the top half (i.e. industries with the best average Zacks Rank) and the bottom half (industries with the worst average Zacks Rank).

Using a week’s rebalance, the top half beat the bottom half by a factor of more than 2 to 1 over the last decade.

Click here to know more: About Zacks Industry Rank

The Concerns

It is a well-documented fact that the fortunes of railroads are tied to coal, since the latter is an important revenue-generating commodity for the sector. Despite President Trump’s pro-coal attitude, the coal industry is not yet out of the woods. In fact, according to the U.S. Energy Information Administration (“EIA”), coal production is expected to be 736 million short tons (MMst), down 5% year over year.

The primary reasons for this are a drop in U.S. coal exports and a decline in usage of coal in electricity generation in the United States. The struggles related to coal are likely to hurt railroads in the first quarter. For example, Norfolk Southern stated at the J.P. Morgan Aviation, Transportation and Industrials conference that coal volumes had declined 6% as of Mar 10. Naturally, any negative development for the commodity does not bode well for railroad operators.

Declining automotive volumes due to sluggish vehicle production in the United States, have been hurting railroads for the past few quarters and the story is unlikely to be different in the first quarter. Union Pacific on its fourth-quarter conference call said that light vehicle sales for full-year 2018 are projected at 16.9 million units, reflecting a 2% decline from the 2017 levels.

Moreover, service issues represent a major headwind for the sector and may hurt its customer base unless resolved quickly. CSX was badly hurt by such issues last year. Canadian railroad operator — Canadian National Railway Co. (CNI - Free Report) — is the latest victim of operational problems, which are likely to hurt its first-quarter results.

Moreover, uncertainty regarding the North American Free Trade Agreement (NAFTA) represents a major overhang on shares of railroads, particularly those like Kansas City Southern, which generate a significant portion of revenues from U.S.-Mexico shipments. Other factors, like the weather-related disruptions — like the ones last year which resulted in freight costs skyrocketing — and the dispute regarding the proposals concerning reciprocal switching, are further challenges for railroads.

Valuation Picture

The Zacks Rail industry is up 17.1% over the past year, modestly outperforming the S&P 500 index’s 15.5% gain in the same time period. The industry has struggled since January 9th, likely reflecting the NAFTA uncertainty.

The industry’s valuation picture remains attractive, with multiples becoming a lot more reasonable following the recent sell off. The Zacks Rail industry currently trades 16.4X forward 12-month consensus EPS estimates, which is down from 19.4X back in December 2017. This compares to the current forward 12-month P/E multiple of 17X for the S&P 500 index.

Over the last 5 years, the industry has traded as high as 19.4X forward 12-month consensus estimates and as low as 13.4X, with a 5-year median of 16.4X. In other words, the industry is trading at the same level as the 5-year median. 

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