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Railroads: A Value Pick and a Growth Pick for Keeps

Monday - 4/15/2013, 4:17pm  ET

For a long time, the future of railroad companies has been tied down to coal demand in the U.S. But, the shale gas boom in North America has presented natural gas as a cheap and eco-friendly alternative for coal. Although coal demand in the U.S is slumping, developing countries like India and China are rapidly moving towards coal gasification plants, and their coal requirement is increasing faster than ever. It is due to this reason that intermodal transportation is booming and railroad companies stand to benefit here.

A value pick

Norfolk Southern is one of the largest railroad companies in the U.S. with over 20,000 route miles of network spread in 22 different states. The company derives around 25% of its revenue from coal which is mainly supplied to electric utilities. In the recent quarter, its coal revenue slid 23%, yet, its overall revenue declined just 4%. This was because its intermodal segment, which accounts for over 20% of its overall revenue, rose 5% to a record $584 million. Its quarterly revenue from merchandise also rose 4%, further reducing losses due to weakening coal demand.

To bolster its growth, the company would be launching 30 new Crescent Corridors with around 1,400 miles of network this year. The corridors are expected to run 28 new trains, which would primarily be used for intermodal transportation. With slumping domestic coal demand, Crescent Corridors could play a vital role in reducing Norfolk Southern’s dependence on coal and boost its overall revenue. But until that happens, Norfolk Southern could remain under pressure.

A growth pick

Similar to Norfolk Southern, Canadian National Railway is also counting on intermodal growth. Its annual revenue from intermodal transportation stood at $2 billion in FY12, and has witnessed a CAGR of 12% since 2010. Management believes that with its current infrastructure, its intermodal revenue can increase another 10%. Its overall revenue aggregated to $9.9 billion, and intermodal revenue accounted to 20.2%.

But unlike Norfolk Southern, revenue of Canadian National Railway rose 10% while its operating earnings grew 12%. This was possible because the railroad company has relatively more exposure to automotive transportation, which grew about 5%. Overall, the company reported record earnings and volumes, with growth in almost all of its segments.

Adding to investors’ delight, Canadian National has a $1.4 billion share repurchase program underway. The company also boosted its quarterly cash dividend by 15%, and at the current price, its shares yield 1.7%.

A stock to miss

Canadian Pacific Railway has also had a profitable ride, and its shares have appreciated 64% over the last year. But at the current prices, its shares appear to be greatly over valued with a trailing P/E of 44x, as compared to 16x and 14x of Canadian National and Norfolk Southern, respectively.

That said, the company reported a 5% increase in annual revenue with a 3% increase in annual volume. Its coal revenue was down 1% even though coal volume was up 1%. Strangely, Canadian Pacific would be expanding its coal capacity in Vancouver and its management wants to meet the rising coal demand.

Unlike its peers, Canadian Pacific reported relatively weaker intermodal revenue, and expects the weakness to continue into Q1. The company derived most of its growth from merchandise and automotive transportation, but the lack of optimistic guidance about intermodal transportation should discourage investors from picking Canadian Pacific at lofty valuations.

A quick wrap up

According to analyst consensus, the annual EPS of Norfolk Southern, Canadian National, and Canadian Pacific should grow 10.8%, 11.42%, and 14.9%, respectively. But since there aren’t many growth triggers for Canadian Pacific, investors should wait for a dip before getting in. In my opinion, Norfolk Southern is a value play since its Crescent Corridors could boost intermodal revenue, while Canadian National Railway is a growth pick due to its solid earnings and Q1 guidance.

This article was originally published as Railroads: A Value Pick and a Growth Pick for Keepson

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