Do You Really Want to Ride the Rails in 2016?

The North American railroad industry suffered large setbacks in 2015. The total return (stock price plus dividend) of the major participants was down over 25%. Union Pacific (UNP) led the way with a 33% decline while CSX (CSX) was not far behind at -27%. Norfolk Southern (NSC) avoided some of the pain due to takeover-tures from Canadian Pacific Railways (CP) but was still down 21% for the year. The driving force of the deteriorating stock prices has been poor operating fundamentals due to declining coal volumes, a sharp drop in oil drilling activity and falling merchandise volumes. Each one of these stumbling blocks looks like it will continue into 2016, which will result in difficult earnings comparisons for the group. The offset, however, is that valuations are approaching the lower end of their recent bands and the group is likely poised for some consolidation. The following gives a rundown on the pros vs. the cons for those interested in the group for 2016. Taken together, we think the group is poised for a stock price recovery this year. So we are OK with the stocks, but based on the near-term headwinds, we think investments here require a 12-month-plus time horizon. We also believe there are more timely areas for those who want to position themselves for an improving economy and/or a pickup in oil and natural gas prices. In looking at the past year, coal has been the largest drag on the group, with all reporting double-digit business declines. Low natural gas prices, falling export demand and new regulatory policies all contributed to the weakness. All of these factors will continue to weigh significantly on coal going forward. Oil drilling and transportation were another blow to the results. Record low oil prices led to significant reductions in activity. 2016 will be another soft year for the oil business, but one shouldn't expect prices to stay at these uneconomic levels forever. Lastly, the strong dollar and weak global demand weighed on manufacturing, both production and exports, but many expect these trends to be bottoming. While business fundamentals are unattractive, valuation levels are beginning to get to levels that are more enticing. There probably isn't much downside from here (barring a U.S. recession, which we don't expect). For 2016, UNP and CSX are trading at 13x earnings vs. 15x to 18x earnings in recent years. NSC is trading at a little over 16x earnings but this reflects the Canadian Pacific acquisition offer. All of the stocks pay a dividend yield between 2.8% and 2.9%, which should add to the share-price support while providing a healthy level of income. Business will be challenged in 2016. CSX may have the greatest hurdles since it has the largest coal mix. However, UNP isn't far behind, with coal also being a material contributor to earnings. UNP will also be more impacted by falling oil drilling and transportation activity than its peers since it has a bigger portion of its revenues generated in the Texas and North Dakota oil basins, which are seeing the brunt of falling oil activity. Managements are taking initiatives to offset these pressures. This is generally focused on aggressive cost reduction activities and meaningful share repurchase programs to stabilize earnings. However, the companies are also undertaking programs to boost foreign trade and move more transportation to rails from trucking. These actions along with an improving U.S. economy should result in modest earnings growth in the face of the above mentioned headwinds for the group this year. Outside of near-term fundamentals, a big wild card going into 2016 will be industry consolidation. Canadian Pacific Railways is starting the process with its bid for NSC. It would basically be merging a Northern (Canadian) and Southern (U.S.) railroad to expand their network and generate cost synergies. The next round of speculation is for one of the large Western networks, either Union Pacific or Burlington Northern (owned by Berkshire Hathaway), making a bid for an Eastern network such as NSC or CSX. The latter's valuation is not reflecting any takeover premium. CSX would be the target since it is less than half the size of its likely acquirers. If acquisitions do heat up, the stocks will turn higher well in advance of improving business trends. Even if a deal doesn't transpire, it should just be a matter of time before business begins to rebound across the railroad industry. When the recovery begins, we believe the group has good upside from current levels. Summing things up: While we feel there are better investment opportunities elsewhere and near-term fundamentals are poor, the business franchises are solid. Valuation levels are attractive and an industry consolidation could get the stocks moving this year. We will keep you posted on our thinking about the group and will put out a follow-up article if and when we become more upbeat on the timeliness of this long-term buy recommendation.

Do You Really Want to Ride the Rails in 2016?

There are pros and cons for investing in railroads this year.

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