Railroad earnings appeared to veer off-track in the first quarter, with profits dropping from year-ago levels, but a deeper analysis shows that underlying trends are strong.

Over the last week and a half, the railroad sector announced first-quarter results that seemed weak, but nonetheless topped Wall Street estimates by a solid margin. Norfolk Southern's ( NSC) first-quarter net profit dropped $51 million, or 24%, year over year, while topping analyst expectations by a whopping 9 cents a share. Likewise, Union Pacific ( UNP) and CSX ( CSX) saw net profits drop, but easily beat expectations.

But net profit for many of the railroads were impacted by accounting changes and one-time items. A year ago, Norfolk Southern's net income was inflated by a $124 million charge, and without it profits would have been up 86% year over year, which is why shares jumped 5.4% when it released earnings on March 21.

Burlington Northern ( BNI ), the nation's second-largest railroad, may be the best indicator of where railroad stocks could be heading. When it released earnings Tuesday, Burlington Northern actually posted a slight gain in net income on 11% revenue growth. Even better, demand was so strong the company raised its average price by 2%.

"Burlington Northern's strong first-quarter results confirm that ... the company is taking advantage of robust demand within the intermodal and export grain markets and translating this into improved operating results," said James Valentine, analyst for Morgan Stanley, in reaction to the results. "The jump in Burlington Northern's quarterly earnings emerged approximately one quarter sooner than we anticipated."

Business Is Too Good

Indeed, the planets are aligning for railroads. Demand is so strong that many companies are seeing results falter because they cannot keep up. From coast to coast, retailers and manufacturers are turning to intermodal shipping, where truck trailers are hauled over long distances by trains, then unloaded onto trucks for local delivery.

Tracking the Railroads
Company Price-to-2005 Earnings Analyst Ratings YTD % Change*
Buy Hold Sell
Burlington Northern 11.84 8 4 2 +0.2%
CSX 12.11 3 8 1 -15.5
Kansas City Southern 18.51 2 1 2 -2.9
Norfolk Southern 12.44 8 6 0 +3.5
Union Pacific 11.45 7 7 1 -14.7
*Through April 28, 2004 Source: Bloomberg, Baseline, TSC Research

International growth is also driving railroad earnings. On the West Coast, where trains deliver goods to docks, the ongoing boom in Chinese trade, bad weather and high fuel prices have created massive snarls, slowing down the shipping process and forcing railroads to rush to hire thousands of employees.

Consider the case of Union Pacific, which saw first-quarter net income drop more than 60% from last year's quarter, despite a nearly 6% increase in revenue. While Union Pacific executives noted that demand and pricing are extremely strong, it had to turn business away because it is so short-staffed, and has announced a plan to hire 4,000 employees.

"Railroads are experiencing one of the best demand and pricing environments they've seen in over 15 years," said Fadi Chamoun, analyst at UBS. "The question is, who is going to be able to benefit from the environment and deliver on the operating leverage that these companies have?"

While companies like Union Pacific have had labor shortages, the industry is working hard to fill positions and offset a spate of retirements expected over the next decade after Congress lowered the industry's retirement age to 60 from 62 in 2002.

According to the Association of American Railroads, an industry trade group, 40% of the 220,000 people currently employed in the railroad industry will be eligible for retirement in 2014. In response, the AAR projects the industry will hire 140,000 employees to not only offset the attrition, but add new jobs to fuel growth, which is expected to continue.

"Demand is driven by two main factors," said Chamoun. "One is the continued improvement of the industrial economies of North America and the other is the continued strong international trade with China ... which is driven by the continued outsourcing of manufacturing because of low labor costs -- and that's expected to continue for the next 12 to 18 months."

There is a measure of execution risk, but analysts seem to believe that railroads won't be turning away business for much longer. According to Thomson First Call, Union Pacific's earnings are expected to jump from $4.41 a share in fiscal 2004 to $6.13 a share in fiscal 2006 -- an increase of 39%.

Don't Fight the Fed

But railroads face other risks, which could eat into profit growth even if they're able to overcome the execution risk -- notably rising interest rates and inflationary pressures.

Since 1988, according to research from Citigroup Smith Barney, the railroad sector has always underperformed the broader market in the year after the Federal Reserve hiked interest rates. The most recent gross domestic product data show not only 4.2% growth, which is good for railroad earnings, but also a rising risk of inflation, which is not.

"Overall, in the last 15 years, the rail stocks have typically underperformed the S&P 500 by 14.1% in the year following an initial rate increase," said Scott Flower, Citigroup's railroad analyst. "This is not unexpected given the highly asset-intensive nature of the railroads and their early cycle characteristics."

Indeed, as cyclical stocks, railroads are an early tell on a wide variety of economic signals, from recovery to Fed tightening. Rising rates would hurt the industry, boosting interest costs, but a fall in the price of oil would help results, making it hard to rely solely on one item to determine performance going forward. As Flower notes, over the last 10 years, railroads have outperformed the S&P 500 by 17% in the year after oil prices peak.

And this time around, analysts say that rising rates might not have such a major impact -- after all, interest rates are already near record lows.

"While we do not intent to fight history on this issue, we would suggest that the direct earnings impact to the rails this time is minimal, and we believe that we can see sustained double-digit EPS growth in 2005, even with milder 3% GSP assumption," said Valentine.

2005 Wears the Conductor's Cap

With a quarter of 2004 already in the books, this double-digit EPS growth in 2005 will begin driving stocks and making valuations look better than they already do. Historically speaking, railroad valuations range between 10 and 15 times future earnings. But while many in the industry, like Burlington Northern, trade near 13 times 2004 earnings, they're below 12 times 2005 earnings, which are expected to rise as companies hire more employees.

For investors with an eye on the long term, the specter of rising rates will haunt stocks, so analysts suggest picking those railroads that have fluid networks, like Burlington Northern and Norfolk Southern. Investors with a taste for risk might want to consider names like Union Pacific, which have underperformed the sector year to date.

"Our view is that there's still room for upside to 2005 EPS, even in a rising environment for rates," said Chamoun. "We see a range of 15% upside for stocks, to the extent the economy improves and railroads manage to come back from congestion issues."

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