Burlington, CSX Ride Rails of Rebound

BOSTON ( TheStreet) -- Few industries are as old school as railroads.

Fittingly, one of the most old-school investors, Warren Buffett, is heavily invested in the industry, with a 23% stake in Burlington Northern Santa Fe ( BNI) through his company, Berkshire Hathaway ( BRK.A). The Oracle of Omaha's investment has outperformed the S&P 500 Index over the past year by about 5 percentage points. Burlington's stock has fallen 11%, less than the 16% drop of the benchmark. Railroads may seem antiquated, but a mix of factors makes them an attractive, although cyclical, bet.

Michael Porter's five forces of competition applied to the railroad-shipping sector highlights some of the reasons this is an attractive investment as the economic recession ends.

Degree of Rivalry

Due to so-called trackage rights, competition isn't always direct. Major companies may not even own rail tracks in the same region, cutting competition between big-name players. Also, because of trackage rights, companies like Union Pacific ( UNP) and Burlington Northern, which own rail stretches in the western half of the U.S., need to remain amicable with companies including CSX ( CSX) and Norfolk Southern Rail ( NSC), which own railways in the eastern half to ensure that access to rail on cross-country treks stays relatively reasonably priced.

Regional concentration also adjusts the main products hauled by each company. Obviously, CSX, which has access to the Gulf of Mexico, will be competing for the hauling of fuels, while Union Pacific will be mainly focused on containers of goods coming from Asia through western ports.

Bargaining Power of the Customer

Volume holds the key to major success for rail companies. During the recession, the volume has dropped substantially as production and consumption has slowed to a crawl. That makes rail shippers cyclical, which can be seen in the double-digit decline in the stocks over the past year.

The inverse is also true. Since the beginning of 2009, CSX is up by almost 50%, while Union Pacific has surged 33%. When goods finally begin to flow to satisfy massive amounts of pent-up demand, rail shippers will reap the rewards.

While there are alternatives -- trucking -- that's usually inefficient for massive transport efforts. A single train can equal a fleet of trucks. Also, the use of intermodal shipping techniques used by CSX and Norfolk Southern help to increase efficiency for customers. Containers can be offloaded from ships directly on to rail cars and then directly to trucks for delivery to the final destination.

Bargaining Power of the Suppliers

Suppliers in the case of rail shippers are much the same as those for ground transportation. While many still associate rail cars with steam engines, most are powered by a diesel engine, much like a big rig. Rail cars are more efficient than trucks, though, because rails create less friction than asphalt.

Other competitors supplying rail tracks is another important consideration. Luckily, all rail companies will be in the same boat, needing to access rivals' rail ways, which keeps costs reasonable.

Threat of New Entrants

Shipping requires an engine and something to haul. A plethora of small operations, both on rails and roads, represent the most likely new sources of competition to the big names. Again, the issue of track rights comes into play and serves as a barrier to entry for new competitors. To gain access to lucrative ports, a new company would need to pay up. A classic case of "I win, you lose; you win, I win."

Threat of Substitutes

Substitutes are at a large disadvantage due to the massive carrying capacity and speed at which rail shipping can move goods. While planes may move things faster, and trucks may be more nimble, neither can beat rail for its shear ability to transport massive quantities of goods long distances relatively cheaply.

The American Association of Railroads reported on Sept. 10 that while total freight transportation is still declining year-over-year, the pace of that decline has slowed and the transportation of chemicals, used in most types of manufacturing, is up 14% from its low in March, indicating production is resuming and more goods should be shipping in the months ahead.

The economy's rebound is still in its infancy, but that's the perfect time to get into rail stocks like CSX, Burlington Northern, Norfolk Southern and Union Pacific. These should perform well in the rebound. But when the economy falters, cut your ties.

-- Reported by David MacDougall in Boston.

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Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.

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