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Volume Growth Drives Railroads in Q3; What Lies Ahead?

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The Q3 earnings season saw upbeat bottom-line performances by most railroad operators despite the recent hurricanes (Harvey, Irma and Maria). In fact, railroads seem to be recovering this year after a prolonged struggle due to coal-related issues.

The string of encouraging releases in Q3 (on the top- and bottom-lines) from key segmental players like Union Pacific Corp. (UNP - Free Report) , Norfolk Southern Corp. (NSC - Free Report) , Kansas City Southern (KSU - Free Report) reflects the improved scenario regarding railroads.

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

Factors Driving the Turnaround

Stocks in the railroad space have performed well so far this year on the back of multiple tailwinds. In fact, the improvement in the coal industry has immensely benefited stocks in the space as coal is a key revenue generator.

The commodity is likely to see even better days given President Trump’s pro-coal stance. Apart from coal, other key divisions of railroads like intermodal are also performing well. The strong performance of key sectors at railroads is leading to an uptick in overall volumes.

Another factor working in favor of railroads is the improvement in the U.S. economy. In the third quarter of 2017, intermodal volumes increased 6.3% on a year-over-year basis. This was the highest growth rate recorded in more than three years.

A buoyant domestic economy has also contributed to the turnaround at railroads. A vibrant economy implies that more goods are being transported across the United States via rail.

In fact, the likes of Kansas City Southern, CSX Corp. (CSX - Free Report) , Canadian National Railway Co. (CNI - Free Report) and Canadian Pacific Railway Ltd. (CP - Free Report) have hiked their quarterly dividend payouts this year, which further highlights the financial prosperity of the sector participants.

Operating Ratio Improvement - A Positive Catalyst

In the third quarter, Kansas City Southern’s operating ratio (defined as operating expenses as a percentage of revenues) 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 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, the prudent cost management of railroad operators raise optimism in the stocks.

Solid Price Performance

Driven by the above-mentioned tailwinds, the Zacks Rail industry has outperformed the broader market so far this year. While the S&P 500 Index gained 15.7%, the industry rallied 19.2%.

Also, a 19.3% improvement in the Dow Jones U.S. Railroads Index on a year-to-date basis, bears testimony to bullishness surrounding railroads.

Zacks Industry Rank Supports Favorable Scenario

The Zacks Industry Rank of 118 (out of 250 plus groups) carried by the Zacks Rail industry further highlights the attractiveness of railroads. The favorable rank places the companies in the top 46% 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

What to Expect in Q4?

We expect railroads to continue performing well in the fourth quarter of 2017, driven by volume growth as was the case in Q3. Key units such as intermodal and coal are also expected to aid in delivering encouraging results,.

The cost discipline of railroads might also drive the bottom line. For example, CSX expects its bottom line to expand between 20% and 25% in 2017 (on a reported basis) over 2016 levels, driven by improved efficiencies.

Currently, the valuation picture for railroads is favorable and certainly points at some degree of upside. When valued according to the forward price-to-earnings (P/E) ratio for the current financial year (F1), the Zacks Rail Transportation industry does not appear too expensive as it is trading at 19.8x P/E multiple. In fact, the reading appears favorable when compared with its own traded multiple (trading lower than its high end of 20.1x) in the last 12 months as well as the S&P 500 (20.5x). The industry’s lower-than-market positioning calls for more upside.

Despite the positives, there are a few factors which might hurt results in the fourth quarter. Evidently, weakness in the automotive sector had hurt the results of major railroads in the third quarter, consequently production declined in the Unites 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.

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