Shares of U.S. railroad companies are poised to lag behind the broader market after more than a decade of outpacing it, as the boost to earnings from U.S. growth could start to wane.
The relative performance of the Standard & Poor’s Supercomposite Railroads Index -- which includes Union Pacific Corp. (UNP), Norfolk Southern (NSC) Corp. and CSX Corp. -- has stalled in the last 12 months, leading the S&P 500 Index by 2.9 percentage points after being ahead by almost 500 percentage points since 2000.
Such “extraordinary” gains in the past decade-plus made the railroad stocks a “great” large-cap group for investors to own, said John Larkin, managing director in Baltimore at Stifel Nicolaus & Co. That’s changing as the cyclical earnings power for these companies diminishes, especially amid a backdrop of a “mediocre economic environment,” he said.
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“These stocks have been sluggish as of late” because they’re overvalued, Larkin said, which is partly why he doesn’t have buy recommendations on any companies in the index. He downgraded Jacksonville, Florida-based CSX (CSX) and Norfolk Southern, in Norfolk, Virginia, to hold last month.
Railroads as a group are trading above their historic range, at a multiple of about 10.9 times enterprise value to earnings before interest, taxes, depreciation and amortization on a trailing 12-month basis, according to Larkin’s calculations. That compares with an average of 9.4 since 1993.
Earnings could suffer in part as the margin boost these companies enjoyed from re-pricing their legacy contracts has run its course, making it more difficult for rail operators to surprise investors, he said. Rail companies previously had been able to increase prices when the contracts came up for re-negotiation.
The benefit from legacy pricing is “fizzling,” while coal volumes have been weak, both of which have hurt profitability for railroads in “quite a permanent way,” Larkin said.
Early in the economic recovery that began in mid-2009, the strength of rail stocks relative to the broader market showed investors were betting on an acceleration in gross domestic product, said Robbert Van Batenburg, director of market strategy at broker Newedge Group SA in New York. Now, almost five years after the recession ended, being overweight this group for the same reason isn’t as viable, particularly with the Federal Reserve tapering its bond-buying program.
“With monetary stimulus being lifted, albeit gradually, this is a damper on U.S. growth,” Van Batenburg said. As a result, it’s hard for him to envision the economy expanding at a rate that causes the volume of cyclical shipments to rise much beyond the current level.
U.S. GDP will increase at an annual pace of 2.2 percent in the first quarter, according to the median forecast of economists surveyed by Bloomberg from Feb. 7 to Feb. 12. That follows an annualized gain of 3.2 percent in the three months ended Dec. 31, and 4.1 percent in the prior quarter, based on figures from the Commerce Department.
Car sales fell 3.1 percent last month, leaving dealerships with higher-than-normal stockpiles of unsold vehicles just as factories are cranking up production. The decline in purchases means slower earnings growth for railroads, which transport large volumes of these products, Van Batenburg said.
In addition, any sign American consumers are “tapped out,” would be bad news for other economically sensitive products transported by rail, he said.
Andrew Burkly, Oppenheimer & Co.’s head of institutional portfolio strategy in New York, says railroad stocks do offer a “domestic play” on the U.S. economy, though they aren’t universally attractive. Based on a model his team maintains, Union Pacific “looks very good” because analysts revised their earnings forecast for the Omaha, Nebraska-based company up in January by the most in five years, engendering more positive sentiment among investors. The stock closed at an all-time high of $180.14 a share on Feb. 14.
By contrast, CSX looks “very bad” using the same screening method, Burkly said. Analysts’ earnings expectations of $1.91 a share for fiscal year 2014 are down from as high as $1.97 before Jan. 15, when CSX reported a fourth-quarter profit for last year that trailed analysts’ estimates -- reflecting many of the problems hurting the industry, he said.
Even so, there still are good reasons to be positive about this group, particularly in the midst of what’s been an unusually harsh winter, according to Jeffrey Kleintop, chief market strategist in Boston at LPL Financial Holding Inc. After years of declining coal shipments, railroads could see a rebound in volumes this season as stockpiles are depleted and the price of natural gas rises amid colder-than-normal weather, he said, adding this could translate into higher earnings.
Van Batenburg cautions that any boost to stock performance from a pick-up in weather-related coal volumes will be temporary. Rather, these equities need better-than-forecast economic growth to resume their outperformance relative to the market on a longer-term basis, he said, adding that the slowing Chinese economy is a potentially “serious problem” because many commodity exports are transported by rail.
More impact could come if the Keystone XL pipeline -- designed to carry oil south from the oil sands of Alberta, Canada, to American refineries along the Gulf Coast of Texas and Louisiana -- is approved, further diminishing the volume of rail-shipped commodities and hindering the companies’ performance, according to Van Batenburg.
While the industry still has some “wind at its back,” investors who benefited from the huge gains of the prior decade may be looking elsewhere now, Larkin said, adding that these stocks have performed largely “in-line” relative to the market since 2012, which coincides with the decline in coal volumes.
“Rail stocks are less appealing now because the biggest gains are behind them,” Larkin said.
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