Agreed..Barron's Bearish on Railroaders- $TRANS Slide
Railroad Stocks Are Just Blowing Smoke
By DIMITRA DEFOTIS
SHARES OF AMERICA'S LEADING railroad companies should be barreling down the track as the U.S. economy improves, but some of their stocks remain derailed by congestion.
Rail industry shipments are up about 4% so far this year to record levels for some railroads. But there have been freight bottlenecks because the four big U.S. railroads were late in adding enough new equipment or workers to keep traffic moving.
Most railroads are increasing hiring as demand improves, but labor costs could remain an issue into 2005 as older workers retire.
Another big issue: skyrocketing diesel fuel prices, the result of record high crude oil prices.
And if the economic recovery begins to peter out, the railroads could suffer. In recent weeks, the government has revised downward its data on consumer spending and gross domestic product growth. Meanwhile, short-term interest rates are on the rise, and historically railroad stocks slide thereafter.
At A Glance
Burlington Northern Santa Fe
Stock Price: $35.58
52-Wk High: $35.72
52-Wk Low: $26.58
Market Cap: $13.2 billion
Earnings Est. 2004: $2.54 per share
Forward P/E: 14x
Projected Long-Term EPS growth rate: 11%
Projected EPS growth ('05/'04): 13%
Sales (2003): $9.4 billion
Div Yield: 1.92%
CEO: Matthew Rose
Headquarters: Fort Worth, TX
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At A Glance
Norfolk Southern
Stock Price: $27.06
52-Wk High: $27.13
52-Wk Low: $18.00
Market Cap: $10.6 billion
Earnings Est. 2004: $1.97 per share
Forward P/E: 13.7x
Projected Long-Term EPS growth rate: 11%
Projected EPS growth ('05/'04): 12%
Sales (2003): $6.4 billion
Div Yield: 1.50%
CEO: David Goode
Headquarters: Norfolk, VA
Sources: Thomson First Call, S&P; Data by Commodity Systems Inc., Reuters.com and Thomson Financial Network provided through Yahoo! Finance.
"Any type of softness in the economy would really ripple through their results quickly," says Jonathan Schrader, an analyst at Morningstar.
In the past year, shares in the biggest U.S. rail company, Union Pacific, which is concentrated in the Western states, are down 8%, while shares in CSX, a big player in the East, have been flat. Their stocks reflect the worst congestion issues.
Competitors Burlington Northern Santa Fe in the West (up roughly 30% in the past 12 months) and Norfolk Southern in the East (up around 40%) have fared better.
But higher costs and weaker economic growth may limit these stocks' gains in the next year.
"The railroads have difficulty following through on making their service more reliable," Schrader says. "It makes it difficult for [long-term] investors to have a lot of confidence in the stocks."
Manufacturing has been expanding for a year, resulting in a freight boom railroads haven't seen since 2000. Yet some rails, including Union Pacific, couldn't staff the added engines needed to haul goods.
That's why Norfolk Southern's biggest increase in operating expenses in the second quarter was in compensation and benefits, including bonuses for locomotive engineers.
In a July conference call, David Goode, Norfolk Southern's chief executive officer, acknowledged "the difficulty of continuing to provide high service levels."
Last month Burlington raised its 2004 hiring projections by 27%, although CEO Matthew Rose recently told analysts, "We are not thinking that 11% [shipment] growth is going to be forever."
Another rising cost: Fuel, which is about 10% of a railroad's costs.
Yet Norfolk Southern, which has been hedging about 77% of its diesel fuel requirements, said in July it is cutting back on its hedging because fuel prices are near historic highs, and it says it can pass on surcharges to customers. Only 38% of Norfolk Southern's 2005 fuel costs are hedged, so it's less protected from future hikes in fuel prices.
Burlington is hedging 60% of its 2004 and 55% of its 2005 fuel costs.
Also, timing is not on railroads' side. Generally, transportation stocks rebound early in an economic cycle as investors anticipate a recovery, says Sam Stovall, S&P's chief investment strategist. (Indeed, railroad stocks are up 65% from their 2000 lows, according to Thomson Financial Baseline.)
But since 1970, Stovall says, rail stocks have declined 14% on average in the 12 months following an initial hike in short-term interest rates.
Andrew West, an analyst at S&P, expects Norfolk Southern to grow its earnings by 67% in 2004 but only by 6% in 2005.
"There is not a whole lot of improvement left for 2005. [Norfolk Southern] would have to reveal some new way of surpassing themselves, combined with an economy even stronger than we are projecting," West says.
Though Norfolk Southern has the highest operating margin of the four largest U.S. rails, it looks fairly valued near its current price, West says.
Using 2004 earnings, the stock is trading just below its five-year median 14.2x projected earnings, according to Baseline (see At A Glance).
Burlington Northern's return on invested capital has largely declined in the past several years, one reason Donald Broughton, an analyst at A.G. Edwards & Sons, has a Hold rating on the stock.
Burlington Northern's shares are trading near a peak multiple of 14x forward earnings, above their five-year median P/E of 12.4x forward earnings, according to Baseline.
Of course, demand could remain healthy, especially because the weak dollar has improved the outlook for the U.S. exports railroads haul. Burlington executives also expect strong growth over the next decade in shipments from China to the U.S. And "intermodal" loads, those often-imported containers that move from ship to rail to truck, are a significant source of growth, too.
But high fuel costs could bite hard, especially if consumers tighten their purse strings and economic growth slows.
So, investors looking to jump on the profit train may have missed the "all aboard" call for some railroad stocks, and this one already may have left the station.
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