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Railroad Industry Outlook: Soft Freight a Near-Term Hurdle

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The Zacks Transportation - Rail industry consists of railroad operators that transport freight (such as agricultural products, industrial products, coal, intermodal, automotive, consumer products, metals and minerals) primarily across North America. While freight constitutes the major chunk of revenues, some of these companies also derive a small portion of their top line from other rail-related services that include third-party railcar and locomotive repairs, routine land sales, and container sales among others.

Let’s take a look at the industry’s three major themes:

  • In order to boost profits, railroad companies are increasingly transitioning to the precision scheduled railroading model, an operating structure that reduces costs, enhances services and leads to optimal asset utilization. Notable players that have adopted this model include CSX Corporation CSX, Union Pacific Corporation UNP, Norfolk Southern Corporation NSC, Canadian Pacific Railway Limited CP and Canadian National Railway Company (CNI - Free Report) . With increased efficiency and reduced costs, these railroad players have shown consistent improvement in operating ratio (operating expense as a percentage of revenues), and hope for even better in the near future. While CSX aims to achieve an operating ratio of below 60% (60.3% reported in 2018) this year, Union Pacific targets an operating ratio of below 61% this year compared with 61.6% achieved in 2018. Meanwhile, Norfolk Southern expects this key metric to improve at least 100 basis points this year compared with 65.4% achieved in 2018. The lower the value of this efficiency measure, the better it is.

  • The railroad players’ sustained cost-reduction efforts should continue to foster growth through streamlined operations. While the precision scheduled railroading model lays significant emphasis on cost-cutting initiatives, those companies that are yet to implement the business model are finding other ways to lower operating costs. For instance, during the first quarter, Genesee & Wyoming GWR undertook several cost reduction initiatives in three of its geographic segments that are projected to drive growth by generating annualized savings of approximately $5 million.

  • A sluggish freight scenario amid U.S.-China trade tensions is a major headwind for the industry and has been squeezing profit margins of the companies. Per the Association of American Railroads (AAR), rail traffic has been down for four consecutive months this year due to trade-related uncertainty, severe weather conditions in the Midwest and some other factors. Railroad major Union Pacific’s second-quarter results are likely to be affected due to this weak freight environment. Notably, at the Wolfe Research 12th Annual Global Transportation Conference, the company stated that its second-quarter volumes declined 2% (as of May 19) on a year-over-year basis due to below-par performances of the Energy and Premium divisions.

Zacks Industry Rank Indicates Bleak Prospects

The Zacks Railroad industry housed within the broader Zacks Transportation sector, currently carries a Zacks Industry Rank #215. This rank places it at the bottom 16% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates dull near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the bottom 50% of the Zacks-ranked industries is a result of negative earnings outlook for the constituent companies in aggregate. The groups’ current-year EPS estimate has decreased by 3 cents since March.

Despite the pessimism, we will present a few noteworthy stocks. But, before that, it’s worth taking a look at the industry’s shareholder returns and current valuation.

Industry Outperforms Sector & S&P 500

The Zacks Rail industry has outperformed both the broader Transportation sector and the Zacks S&P 500 composite over the past year.

Over this period, the industry has rallied 22.7% compared with the S&P 500 index’s 8.1% appreciation. Meanwhile, the broader sector did not show any change.

One-Year Price Performance



 

Industry’s Current Valuation

On the basis of trailing 12-month price-to-book (P/B) ratio, which is a commonly used multiple for valuing railroad stocks, the industry is currently trading at 5.55X compared with the S&P 500’s 4.08X. It is also above the sector’s P/B ratio of 3.37X.

Over the past five years, the industry has traded as high as 5.61X, as low as 2.22X and at the median of 4.31X as the chart below shows.

Price-to-Book Ratio

 

Price-to-Book Ratio



 

Bottom Line

Benefits from the precision scheduled railroading model and consistent cost-cutting measures should keep the railroads afloat going forward. However, with railroads banking primarily on freight for revenues, the near-term outlook for the industry seems grim thanks to soft freight demand since the beginning of this year. The scenario is unlikely to change anytime soon especially with continued trade tensions between the United States and China.
 
Nevertheless, below we present one stock with a Zacks Rank #2 (Buy) that is poised to grow despite challenges. There are also two more stocks with a Zacks Rank #3 (Hold) that investors may currently hold on to. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Canadian Pacific is a Calgary, Canada based company operating a transcontinental railway network in Canada and the United States. The Zacks Consensus Estimate for this Zacks Rank #2 company’s current-year EPS has been revised upward nearly 1% in the last 60 days. The company has expected earnings per share growth of 11.3% over the next five years against the industry’s 9.6%.

Price and Consensus: CP



 

Canadian National is a Montreal, Canada based company engaged in the rail and related transportation business. The company has an impressive earnings history having outperformed the Zacks Consensus Estimate in three of the trailing four quarters, with an average beat of 3.7%. It also has an expected earnings per share growth of 10.3% over the next five years against the industry’s 9.6%.

Price and Consensus: CNI



 

Norfolk Southern based in Norfolk, VA controls a major freight railroad, Norfolk Southern Railway Company. The company surpassed earnings estimates in each of the preceding four quarters, with an average beat of 9.7%. It also has an expected earnings per share growth of 11.7% over the next five years against the industry’s 9.6%.

Price and Consensus: NSC


 

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