Railroad Stocks, Hurt by Coal, to Make a Comeback

BOSTON (TheStreet) -- Some think the country's biggest railroads will become victims of the natural gas industry's success, as power plants replace coal as their fuel of choice, but they're still chugging along.

Coal has historically made up just over 20% of the biggest railroads' volume and as much as a third of their revenue. The reasoning is that railroads will get sidetracked by utilities' shift to the much cheaper natural gas, which is now selling for roughly half what it was a year ago.

That train, indeed, has left the station, as last week the Energy Information Administration reported that coal consumption by power generators fell 19% in the fourth quarter from the previous three months and 9.4% from a year earlier.

Certainly part of the decline is due to an unusually mild winter that contributed to a buildup of inventories of unburned coal to unprecedented levels, but utilities are relying on gas wherever they can and either building gas fired plants, converting their coal-burning ones to it, or at least thinking about it, which doesn't bode well for coal haulers.

In one example of the impact on rail volumes, CSX ( CSX) just reported that coal, which typically accounts for 20% of the shipping volume, fell 14% in the first quarter after slipping 8.1% in the fourth quarter.

Given those headwinds, industry earnings should be off the rails, but surprisingly, that's not happening.

"North American Class 1 railroads reported a healthy 28.5% growth in earnings per share in (the first quarter) compared to the same period last year," said BMO Capital Markets in a May 1 report. "All the railroads exceeded consensus estimates by a healthy margin largely due to greater-than-expected productivity gains, robust pricing and less-than-feared decline in coal revenues."

That's why CSX was able to report that its overall volume edged up 0.6% in the first quarter from the year-earlier period.

And the outlook is relatively robust for the major industry players. A review of Standard & Poor's collection of the latest analysts' ratings finds more "buy" ratings than any other recommendations and the sole "sell" was on Canadian National ( CNI), which comes, ironically, as that company works to improve one of its rail lines so it can haul oil and gas from the Canadian oil shale fields.

So what's going on here?

It turns out that rail volumes are benefiting from increased demand for auto transport as car sales are booming and intermodal traffic is healthy, thanks to the improving economy as there are significant savings for shipping by rail over truck, given high diesel prices.

Another factor is the rise in coal for export as the rest of the world's demand for high-grade coal is unabated, which is helping mitigate the expected big slump in coal volume.

Railroads should also benefit later this year from big shipments of agricultural products, as plantings of corn and wheat are high this spring, while S&P says growth will also come as the general economy recovers, "given (railroads') role in transporting many of the basic materials required in manufacturing and construction."

Railroads are also operating lean and mean after the recession forced a renewed focus on cost controls. S&P said that should result in better operatin margins during a period of rising volumes.

Also worth mentioning is that Warren Buffett's Berkshire Hathaway ( BRK.B) has a dog in this fight in its Burlington Northern Santa Fe Corp.

It's a leading West Coast railroad, and coal made up 24% of its shipping volume in 2011 and 27% of revenue.

Not one to get caught flat-footed, the Oracle of Omaha is fighting to get approval for BSNF to build a huge new rail yard facility in Long Beach, Calif., the busiest intermodal facility in the country.

Its ability to efficiently handle more containerized ship-to-rail freight traffic would help replace revenue lost from shipping coal.

Others in the industry have to be thinking about their alternatives for making up lost coal volumes as well, including long-term contract renegotiations with the utilities.

Here are summaries of North America's largest publicly traded railroad companies arranged in inverse order of their number of analysts' "buy" ratings:

5. Canadian National ( CNI)

Company profile: Canadian National, with a market value of $38 billion, spans Canada from coast to coast and extends through Chicago to the Gulf of Mexico over 20,000 miles of track.

Dividend Yield: 1.78%

Investor takeaway: Its shares are up 10.2% this year and have a three-year, average annual return of 29%. Analysts give its shares one "buy/hold" rating, 12 "holds," two "weak holds," and one "sell," according to a survey of analysts by S&P. Analysts estimate it will earn $5.41 per share this year and $5.93 next, which is 10% earnings growth.

Morningstar analysts are bullish on the company, saying: "Canadian National generates the highest margins of any railroad in North America, and we don't see this changing soon."

And on Monday, investor activist and hedge fund manager Bill Ackman, who is waging a proxy battle to install a new chief executive at the company, said in an interview on CNBC that the railway's stock should double over the next three years given changes in management he is seeking.

4. Kansas City Southern ( KSU)

Company profile: KSU, with a market value of $9 billion, is a holding company and owns over 6,000 miles of track and serves the central and south-central U.S., along with parts of Mexico and Panama.

Dividend Yield: 1%

Investor takeaway: Its shares are up 14% this year and have a three-year, average annual return of 71%. Analysts give its shares seven "buy" ratings, five "buy/holds," and eight "holds," according to a survey of analysts by S&P. Those same analysts estimate it will earn $3.47 per share this year and grow by 21% to $4.19 per share in 2013.

3. Norfolk Southern ( NSC)

Company profile: Norfolk Southern, with a market value of $24 billion, operates 21,000 miles of track in the eastern U.S. Its revenue sources are roughly 31% coal, 19% intermodal traffic, with the balance made up of automobile, agriculture, metal, chemical and forest products.

Dividend Yield: 2.55%

Investor takeaway: Its shares are up 2.5% this year and have a three-year, average annual return of 30%. Analysts give its shares nine "buy" ratings, eight "buy/holds," nine "holds," and one "weak hold," according to a survey of analysts by S&P. Analysts estimate it will earn $5.84 per share this year and grow by 12% in 2013, to $6.55 per share.

S&P has it rated "buy" with an $85, 12-month price target, a 16% premium to its current price. Sterne Agee has a "buy" rating and an $84 price target.

2. Union Pacific ( UNP)

Company profile: Union Pacific, with a market value of $55 billion, is the largest public railroad in North America, operating on 32,000 miles of track, primarily in the Western U.S.

Dividend Yield: 2.09%

Investor takeaway: Its shares are up 9.2% this year and have a three-year, average annual return of 34%. Analysts give its shares 12 "buy" ratings, 11 "buy/holds," and four "holds," according to a survey of analysts by S&P. Those same analysts estimate it will earn $8.10 per share this year, and that will rise by 14% to $9.25 per share in 2013.

1. CSX ( CSX)

Company profile: CSX, with a market value of $24 billion, operates primarily in the eastern U.S. Its traffic includes a heavy weighting to coal at 32% of revenue, followed by chemicals (14%) and intermodal traffic (12%). CSX is one of the nation's largest coast-to-coast intermodal transportation providers.

Dividend Yield: 2.13%

Investor takeaway: Its shares are up 7.6% this year and have a three-year, average annual return of 32%. Analysts give its shares 12 "buy" ratings, nine "buy/holds," five "holds," and one "weak hold," according to a survey of analysts by S&P. S&P has it "buy" rated with a $27 price target, a 20% premium to the current price.

Deutsche Bank has the company rated "buy," and says that while "utility coal tonnage was particularly weak" at down 28% year-over-year, it offset some of the decline with 17% growth in export coal tonnage and 33% growth in coke and iron ore tonnage as well as on pricing gains and tight cost controls. In the first quarter its earnings were up 14% despite lower coal shipments.

Disclosure: TheStreet's editorial policy prohibits staff editors and reporters from holding positions in any individual stocks.

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