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These Stocks Are Still on Track

Saturday - 4/6/2013, 5:43pm  ET

The weakness in the domestic coal industry has directly affected railroad transportation stocks. Increased substitution by natural gas in place of coal for electricity generation has decreased the overall volume of coal transported in the country. This has influenced the 2012 revenue of railroad companies, and is expected to exert some pressure in the future as well.

On the other side, there is still hope that the boom in the crude oil production could provide some upside to the freight stocks. This got me thinking what will be the future of the railroad stocks, will it be positive because of the rise in crude production, or whether the weakness in the coal segment will drag it down.

Below are three players of the U.S. railroad transportation industry analyzed. Continue reading to see how these are expected to perform in the future:

Union Pacific 

In the quarter’s results, it was evident that the biggest drag on the operations and profitability of the company was because of the coal segment. Going forward, I see a mixed performance from the segment, which could create headwinds for shares of Union Pacific.

The Coal segment is one of the most important segments for the company, as it contributes about 20% of the total revenue. In the last quarter, the volume of the coal segment fell 14%, because of the increased usage of cheaper natural gas by utility companies in place of coal for generating electricity. This trend is expected to continue in 2013 as well, because according to the U.S. Energy Information Administration (EIA), the coal accumulation at electric power plants in January 2013 was above the levels recorded last year.

If the price of natural gas rises and utilities again prefer to use coal instead of natural gas, they will still have significant coal reserves to avoid additional purchases in the short-term. In addition, the weakness in the coal segment should continue in 2013 because of the decline in domestic production. Last year, domestic coal production dipped about 9% due to low demand in the market, and some weakness is expected in the coming year also, which could result in low freight volume.

On the positive side, another report of the EIA states that strikes in Columbia have initiated the suspension clause in several coal shipments to the U.S. Since these contracts fulfill about 95% of the utility companies’ coal requirement, the strike should provide some short-term boost to the domestic coal market, and hence the coal transportation segment.

Other than this, strong crude oil volumes, increased highway to rail conversions, higher construction activity, and shale gas growth should provide some more tailwinds to the stock.

Canadian Pacific Railway 

I see the grain and crude segments as Canadian Pacific's growth drivers. With the end of the Canadian Wheat Board’s exclusive rights to market Canadian grain to global markets, the company is positioning its grain transportation network to leverage its connection to 60% of the high-capacity grain elevators in Canada.

Its shift to an on-demand business model is helping customers improve their supply-chain velocity. This shift has allowed it to move more grain carloads in the last quarter than it had in four years at a higher revenue rate, and it is expected to do so in the future as well.

The company moved 70,000 carloads/year of crude, and currently runs at a 1,530 average length of haul, more than twice the average of its industrial and consumer products. This highlights the profit potential from the increased moves.

In addition, Gibson Energy's plans for expansion of its crude terminal in Hardisty, Alberta, appears to have been well-received by its customers. Canadian Pacific serves the route, and the new capacity that would commence in late 2013 or early 2014 should double the current crude carload of the company.

The company's cost cutting plan to reduce the operating ratio to about 70% by the end of 2013 seems to be on track. The company has already laid-off about 3,000 employees, and plans to reduce additional 1,500 employees by 2016 in order to achieve an operating ratio of as low as 60%. Recently, the company indicated that depending on volume growth, layoffs could be near 6,000.

Canadian National Railway 

The company can face some near-term volatility due to bad weather conditions. The temperature in the corridor between Edmonton and Winnipeg for January and early-to-mid February was about 14 degrees less than the historical average. This means that the company should have downsized the average train size in the region at least by 10,000 feet.

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