Off the Rails

 | Oct 18, 2012 | 3:30 PM EDT
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The new edition of Value Line came out this morning and I quickly checked the ranking changes before anything else. I find it informative to see which stocks are moving up or down based on recent revenue, earnings and price momentum. Often I find it helps identify sectors that are about to turn in one direction or the other.

I was pleased to see that many of my stocks are on the list of stocks moving up. Financials like First Niagara (FNFG), Cincinnati Financial (CINF) and U.S. Bancorp (USB) all received one-notch upgrades. Even my tired old shares of Callaway Golf (ELY) were bumped up from the bottom rank of the service for year-ahead performance. Glass manufacturer Apogee (APOG) is one of those stocks that never really gave a chance to accumulate the shares on a scale, so I have a tiny position as the stock has doubled. Based on strong architectural demand for its glass products, it too has received an upgrade.

The real story is in the downgrade section. I notice that several railroads have received at least a one-notch downgrade from the service. A few weeks ago, I noted that Norfolk Southern (NSC) was downgraded, and today Union Pacific (UNP) and Canadian National (CNI) fell a notch. So did GATX (GMT), the railcar-leasing company. Railroads as a group appear to be losing momentum and may be a sector to sell or avoid now. Given the possible slowdown in the economy if we indeed hit the fiscal cliff in the first quarter, aggressive traders might want to look for a short setup in the group.

Railroad earnings reports from this morning tend to reinforce my negative view of the group. Union Pacific had a decent report and showed earnings and revenue gains. It raised prices for shipping and had strong volumes in auto and chemical shipments. But coal shipments fell by more than 12% and overall shipping volumes were flat on the year. Shipments of steel and agricultural products also declined year over year in the third quarter. In the release, CEO Jack Koraleski addressed the rest of the year, telling investors, "As we look out over the next several months, the political and financial challenges in the U.S. and abroad have increased economic uncertainty." It was not a terrible quarter for the largest U.S. railroad, but I don't think it was good enough to justify an EV/EBITDA ratio over 8 and a price-to-book ratio over 3.

CSX (CSX) is far more dependent on coal and agricultural, and though it beat analyst expectation earlier this week, it lowered guidance for the rest of the year. CEO Michael Ward said that he did not see a strong economic comeback that would drive shipping volumes. Overall, shipping volumes for the railroad fell by about 1% compared with 2011. As with Union Pacific, it was not a horrible report but I do not see anything that would justify the valuation for a mature business like railroads. Absent strong earnings improvements from a booming economy, these companies should trade closer to a single-digit-earnings ratio and book value to be considered a bargain.

GATX reported a sparkling quarter this morning. The company showed solid results from strong tank-car demand and another almost spectacular quarterly performance by the steamship division. The only negative was a reference to inconsistent demand for freight cars, particularly coal carriers. But GATX needs the railroads to be performing well and generating solid cash flow and increasing railcar demand, as their highly leveraged balance sheet and high capital spending needs will not fare well in a slowdown. The earnings growth may look flashy and buyable to some, but this company has an Altman Z-Score of just 1.1, well below the level that marks a distressed corporation. It has almost $3 billion in debt due within the next five years and will run into serious financing issues should the railroads begin to cut back spending.

The downgrades tell me that momentum is slipping fast in the railroad sector. There is a great deal of uncertainty surrounding economic and regulatory issues next year that could potentially hurt the railroads and cause further volume declines. Should this occur, it will be difficult to continue to protect the bottom line through cost increases and we will see earnings miss the optimistic targets Wall Street has set for the sector.

Railroads are neither safe nor cheap now. I would avoid these stocks and sell them if I owned them.

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