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Railroads Should Continue to Prosper on Multiple Tailwinds

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After being laid low by declining coal shipments for the last few years, stocks in the railroad space performed well over the past year. The outlook for coal shipments has notably improved, given the favorable regulatory backdrop under the current administration.

The improvement can be made out from the impressive performances of most sector participants with respect to this key revenue-generating commodity in the final quarter of 2017. For example, at Norfolk Southern Corp. (NSC - Free Report) coal revenues (freight) increased 5.7%, while the same at CSX Corp. (CSX - Free Report) rose 4% year over year. At Kansas City Southern (KSU - Free Report) , revenues improved 115% at the energy segment on the back of impressive performances at Frac Sand and Crude Oil units.

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Railroads are expected to perform well in the first quarter of 2018 as well with coal continuing to show improvements. In fact, under the Trump administration, the coal industry is seeing better days. In a bid to revive the industry, the President has made it clear that he intends to relax regulations that were detrimental to its prospects.

Rising natural gas prices also bode well as far as demand for coal is concerned. Since revenues from coal account for a significant portion of railroads’ top line, any positive development toward the commodity augurs well for the sector.

Intermodal Strength Augurs Well

The intermodal unit is another key source of revenues for railroads. In the fourth quarter of 2017, the intermodal unit performed reasonably well for the key railroads. For example at Union Pacific Corporation (UNP - Free Report) , freight revenues from the segment increased 4% year over year. At Norfolk Southern, intermodal revenues rose 14.5% year over year. At Canadian Pacific Railway Company (CP - Free Report) , intermodal revenues increased 7%.

In fact, intermodal volumes increased significantly in 2017 after a lackluster 2016. According to the Intermodal Association of North America (IANA), intermodal volumes improved 5.8% year over year in the final quarter of 2017. Growth on the international front contributed to the impressive performance of this key segment in 2017.

In fact, according to many market watchers, the segment is expected to perform strongly in the current year as well driven by a significant rise in international business.

New Tax Law a Huge Positive

On Dec 22, 2017, Trump signed the much-anticipated tax bill into law (Tax Cuts and Jobs Act). Under the $1.5 trillion tax overhaul package, corporate tax rates have been slashed significantly. The significant reduction in corporate tax rate is likely to boost cash flow, which in turn will aid earnings of transportation stocks.

Apart from the significant drop in corporate tax rate, the new law allows these companies to deduct their capital expenditures from taxable income in the year of their occurrence, which was not allowed earlier. This aspect hugely favors railroads as they invest substantially in capital expenditures.

As a result, their annual tax bills would be lowered significantly due to higher deductions. For example, Norfolk Southern expects the effective tax rate to come down to around 24% from 35.4% recorded in 2017.

Uptick in Shareholder-Friendly Activities Likely

The likes of Union Pacific, Norfolk Southern and Canadian National Railway Company (CNI - Free Report) have already announced dividend hikes this year. A further increase in shareholder-friendly activities (dividends as well as buybacks) is likely in the wake of the massive savings prompted by the Tax Cuts and Jobs Act.

Due to the significant reduction in their tax bills, more cash is expected to remain in the hands of these companies to fund their capital expenditures, acquisitions and share repurchases among others.

Improvement in Operating Ratio Another Positive

Operating ratio (defined as operating expenses as a percentage of revenues) is an important metric to gauge the performance of railroads. The lesser the value of operating ratio the better, as it implies that more cash is available to the company to reward shareholders through hike in dividends or share buybacks.

In fact, many key railroads witnessed improvement with respect to the metric in the final quarter of 2017. At Norfolk Southern, the metric improved 150 basis points last year on a year-over-year basis. Norfolk Southern aims to achieve an operating ratio of below 65% by 2020 or even earlier. Annual productivity savings in excess of $650 million are expected by 2020.

Further, efforts of railroads to drive bottom-line growth through cost-cutting measures raise optimism in stocks from this space. Moreover, the significant investments made by railroads to promote safety and enhance productivity are also encouraging.

To Conclude

We expect railroads to perform well going forward on the back of these positives. Moreover, a strong U.S. economy supports the bullish case for railroads, as it implies that more goods are being transported across the country.

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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