Ride the Rails
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For nearly a century, America's railroads were our critical economic and social links. Almost everything shipped over the rails as the country expanded westward, and our industrial base grew into the largest in the world.
The rails are still important highways today. But cheap gasoline, inexpensive automobiles, superhighways and the rise of airlines ended their dominance in both the freight and passenger businesses. Many once-venerable names can only be found on a Monopoly board and vast networks have been allowed to fall into decrepitude.
Today, America's train system is less efficient than much of the world's. And as any college student abroad knows, comparing Amtrak—now the country's only major passenger service—to the networks of Europe and Japan is laughable.
Even at a time of record oil and natural gas prices, rails have few friends in Washington. Armies of lobbyists representing railroads' chief historical adversaries—the oil, automobile and airline industries—scored big from this summer's energy bill.
In contrast, all the railroad industry is getting is the best efforts of oil industry supporters like Representative Ernest Ishtook (R-OK) to put Amtrak out of business.
Ironically, despite these challenges, railroads are decidedly on an upturn, particularly in the shipping business. As we pointed out last issue, shipping rates and cargo demand are both on the rise.
Out West, private enterprise is rebuilding and upgrading much of the long haul network. Most important, though they too use petroleum products to run, rising gasoline prices are building a cost advantage for the rails.
The rails' comeback is still in its early stages. But with the US importing ever greater amounts of oil and now liquefied natural gas (LNG), their ultimate re-ascendancy looks assured, from shipping coal to power plants to the increasingly dire need for a workable national mass transit system.
The remaining players in the sector are a hearty bunch, having had to endure literally generations of lean years. But for the first time in a long while, rail investors can look forward to real, long-term growth as the infrastructure is renewed. And the stocks are cheap, too.
Blue Chip Plays
The product of the merger of 390 rail lines during the past 150 years—as well as the profitable spinoff of natural gas producer Burlington Resources, Burlington Northern Santa Fe is the biggest US railroad by market value. Its network now extends to 28 states and transports a massive number of agricultural, automotive, chemical, consumer, construction and plastics products serving a vast range of industries.
As we pointed out last issue, the company is more leveraged to the coal business than other rails, a benefit that helped spur a 47 percent first quarter profit boost on a 15 percent jump in freight revenue. See Advantage Portfolio for trading advice.
Union Pacific is America's largest railroad by size, with 33,000 miles of rail in the western two-thirds of the US. The company is also the only railroad to serve all six gateways to Mexico. Like Burlington, the railroad transports virtually every type of movable product, with a particular focus on petrochemicals from the Gulf Coast and coal from the West.
Union is currently building out its network to handle more of the black stuff, much of which will likely be exported via the company's number one customer, APL Limited, a steamship company operating in the Pacific.
Despite its exposure to areas hit hard by Hurricanes Katrina and Rita last month, Union Pacific expects little earnings impact. That should open the door for more strong results ahead, such as the 46.7 percent second quarter profit boost. Growth in commodity shipments (19 percent) continued to lead the way but is mirrored by growth in other segments. Buy Union Pacific up to 72.
CSX and Norfolk Southern are also benefiting from rising coal volumes for shipment. CSX—which runs 22,000 miles of rail in the eastern US, as well as trucking and terminal operations—reports it will take a $25 million hit from hurricane damage and lost business.
That's the most of any major railroad, but it won't stop the company from reporting strong earnings this year, such as the 39 percent profit boost reported in the second quarter. The key was a 22 percent jump in coal shipments.
Norfolk Southern also expects an earnings hit from higher costs sustained in the wake of the hurricanes, which included lost business from the shutdown of its truck/train transfer terminal operations.
As the country's largest shipper of automotive parts and finished vehicles, the company's 21,300 mile network is vulnerable to an economic slowdown. Nonetheless, coal shipments continue apace, with revenue up 36 percent in the most recent quarter. That keyed a 39 percent jump in income from railway operations, not including several one-time items.
With both US and foreign demand still robust for North American coal, this part of the business should remain healthy for both companies. Meanwhile, both are keeping a tight grip on costs in a rising fuel price environment. That should add up to strong performance for the pair at least through 2006. Both stocks are cheap at less than twice book value and P/Es in the low double digits. Buy CSX up to 47 and Norfolk Southern under 42.
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