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Railroad Stocks: All Aboard?

Railroad stocks have been zooming full speed ahead for the past six months, hitting 52-week highs in recent weeks and outperforming the Standard & Poor's 500-stock index by about 25% so far in 2001. If the economy continues to sag and the energy outlook doesn't improve dramatically, any of the four major U.S. railroad companies -- Burlington Northern Santa Fe (BNI), Union Pacific (UPI), CSX (CSX), and Norfolk Southern (NSC) -- should be a good defensive stock play in the near term.

But new merger regulations designed to ensure competition are scheduled to be released on June 11. At that point, the sector may be on its way to the next, and perhaps final, wave of consolidation. And in the railroad business, mergers could hurt rather than help share prices, so stocks in this industry aren't necessarily for the buy-and-hold crowd.

The low-margin, Old Economy business of moving freight by rail is suddenly in the spotlight, thanks largely to the robust demand for coal. Nowadays, utilities can't get the stuff fast enough as they scramble to deal with natural-gas shortages. Railroad companies have seen revenues for shipping coal from mines to electricity plants surge about 8% this year vs. 2000.

"POSITIVES." Coal transport, already one of the industry's biggest revenue sources, is expected to keep growing as the energy crisis moves beyond California. "Coal...increases the ability of railroads to raise rates meaningfully for the first time in more than three years," says Michael Lloyd, an analyst with Deutsche Banc Alex. Brown. "And now that they've fixed service problems, there are positives working for the industry that draw investors' attention."

Of the big four, Union Pacific and Burlington Northern stand to benefit most because they serve the Powder River Basin in Wyoming, the biggest source of clean-burning coal in North America. Omaha-based Union Pacific is the biggest by market cap, revenues, and earnings. Its shares trade for around $55, with a price-to-earnings ratio of 16. The other Western railroad, Fort Worth (Tex.)-based Burlington Northern Santa Fe, is regarded as the best-managed of the four major U.S. players. Its operating costs are only about 75% of revenue, vs. well over 80% for the others. Yet its stock, at around $30 a share, trades at a discount to the group, in part because it's growing more gradually.

The two Eastern railroads, Norfolk (Va.)-based Norfolk Southern and CSX in Richmond, Va., trade at $19 and $34 a share, respectively, and are the most expensive based on their p-e's of 26 and 41, respectively. But many analysts view these two as having the most potential to rise. That's because their earnings are finally showing signs of turning the corner 17 months after their troubled joint acquisition of Conrail. The two bought and divvied up the troubled rival railroad, but absorbing it has punished their profits ever since.

FUEL-ISH TRUCKS. For now, the slowing economic climate is helping railroads. Shipping customers, which include auto makers, grain producers,and chemicals makers, are opting to transport goods by rail instead of by trucks, which use four times as much fuel to haul the same amount of freight. Though many shippers think truck companies offer better service and reliability than railroads, the economic slowdown makes the higher cost harder to justify. "It's a great opportunity for railroads since they're a lower-cost provider," says Richard Stice, an analyst with Standard & Poor's.

But Stice figures that railroads may do well even if the economy rebounds. "Restructuring and layoffs at railroads will help to buoy the stocks. When the economy gets better, coal could still be strong, and companies could start to see pick up in demand in other areas," Stice says.

But is today's coal boom enough to justify investing in the lumbering railroad giants? The windfall may already be priced into their stocks, some analysts argue. "The best and sharpest relative move of these stocks has likely [occurred] year-to-date, and it is time to be less aggressive with the sector," writes Scott Flower, an analyst with Salomon Smith Barney in a recent note, in which he downgraded ratings on the four stocks.

SIDELINED DEAL. At the same time, the next round of railroad mergers is in the air. For the past 15 months, the Surface Transport Board, which regulates the industry, has put a halt to mergers. The moratorium was enacted last spring when the remaining railroad companies and shippers complained that the proposed mammoth merger between Burlington Northern and Canadian National (CNI) would be anticompetitive, since the industry is already down to six major North American players.

The combined entity would have had revenues of $12.5 billion and would have controlled over 30% of the market share of the six major railroads (which also include Canadian Pacific and Canadian National). The two companies ended up calling off their merger plans last March. Since then, Canadian National has made plans to acquire Wisconsin Central (WCLX).

How the consolidation trend plays out is an open question. Under the new government rules, merging railroads will have to outline what steps they'll take to alleviate anticompetitive issues. Still, "the new rules shouldn't stop any future mergers," says railroad consultant Lawrence Kaufman, echoing a widely held belief that these regs aren't that different than the previous rules. Pointing to aging CEOs at many of the companies and pressure from Wall Street to deliver earnings growth, Kaufman expects a next and last round of railroad mergers to begin in a matter of months. Adds Lloyd: "I believe that Burlington Northern would seriously pursue a merger with one of the Eastern railroads in the second half of this year."

"SIGH OF RELIEF." Meanwhile, CSX and Norfolk Southern are still waiting for the dust to settle on their troubled Conrail deal. Many analysts think they're likely to be the acquisition targets of Burlington Northern and Union Pacific -- or Canadian National. Once one company makes a move to buy either CSX or Norfolk Southern, analysts expect the remaining companies to jockey for position and make a retaliatory bid for the other one.

Just a whiff of this scenario could wreak havoc on these stocks because the difficulties of the Conrail merger and others are still fresh in invsestors' minds. "If the deadline comes and passes and nothing happens, there will be a sigh of relief," says ABN Amro analyst Jason Seidl, who notes that railroad mergers have been notoriously hard to pull off. The new regulations are expected to reinforce the requirement that companies show they have exhausted all possible ways to provide better service and rates before resorting to a merger.

However, many suspect that the alliances and partnerships formed during the moratorium will keep railroads from merging. But don't bet on it. Consolidation could begin with just one antsy railroad, setting the scene for a duopoly. "I think investors will have a negative reaction," Seidl says. "It's like fool me once. shame on you, fool me twice, shame on me."

The bottom line is that railroad stocks in the short term are attractive. But if merger fever sets in, some of them easily could derail later this year. By Amy Tsao in New York

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