U.S. Rail Stocks Seen Up 20% This Year Even as Cargo Stays Weak

  • Prices to rebound as efficiency climbs, according to analysts
  • Carloads tumbled 2.5% in 2015 for biggest drop in six years

U.S. railroad cargo in 2015 dropped the most in six years, and 2016 isn’t expected to be any better. Yet the carriers’ shares are poised for a rebound from their worst performance in at least 25 years.

Union Pacific Corp., CSX Corp. and Kansas City Southern each are expected to rise more than 20 percent this year, according to the average of analysts’ target prices compiled by Bloomberg. Norfolk Southern Corp. trails the field with an expected 11 percent return but that’s largely because its stock already was boosted by a takeover campaign from Canadian Pacific Railway Ltd. that began in November.

Cheap valuations coupled by railroads’ efforts to boost freight prices and improve efficiency will drive stock prices. Carloads fell 2.5 percent in 2015, the Association of American Railroads reported Wednesday. It was the biggest drop since 2009.

“The near-term setup is reasonably favorable for the stocks because sentiment is low,” said Benjamin Hartford, an analyst at Robert W. Baird & Co. “Volumes continue to be weak, but that’s embedded in investor expectations.” The Standard & Poor’s Railroads Index fell Wednesday after the release of the cargo data and amid a broad market retreat.

Railroads responded to last year’s freight decline by parking locomotives and cutting workers. Train speeds have steadily risen, partly because of less congestion, making the rails more efficient. Union Pacific, the largest publicly traded railroad, is expected to post a 7 percent gain in earnings per share this year, according to analysts’ estimates compiled by Bloomberg. Norfolk Southern is predicted to report a 9 percent increase.

The S&P railroads index plummeted 32 percent last year, only the fourth time in 15 years that the industry has trailed the broader market. The S&P 500 Index dropped 0.7 percent last year. That’s made railroads cheap.

The average price for the largest U.S. railroads fell to 14.5 times earnings in 2015 from 20.2 the previous year, while the S&P 500 Index’s price-earnings ratio stayed at 18.3. Last year was the first time since 2008 that the railroads’ ratio trailed the index’s.

Carloads of coal, crude oil and metals plummeted and don’t show signs of recovery this year. Auto shipments, one of the few bright spots, have little room to grow after record-breaking car sales last year.

“For those who expect last year was an aberration and there’s going to be a return to normalcy, they’re going to be disappointed,” said Larry Gross, a partner at FTR Transportation Intelligence.

The decline in rail freight this year puts pressure on the carriers to increase prices and improve efficiency, said John Larkin, an analyst at Stifel Nicolaus & Co.

“People would jump for joy if we could get to flat” carload growth, he said. “More realistically, you’re probably down 2 to 5 percent.” Sales are expected to increase 2 percent at Union Pacific this year and 1 percent at Norfolk Southern, according to analysts’ estimates compiled by Bloomberg.

Merger Strategy

While companies in other industries have acquired competitors to offset slow growth, U.S. regulators have made it difficult for railroads to merge after a flurry of combinations left only seven large carriers in the U.S. and Canada. Canadian Pacific wants to purchase Norfolk Southern in part because about 56 percent of the U.S. railroad’s traffic is intermodal, that is, hauling containers that are consumer-related, said Lee Klaskow, an analyst at Bloomberg Intelligence. Only 41 percent of the Canadian carrier’s freight is intermodal.

“CP is going after NS because CP is a commodity railroad,” he said. “Right now, its mix is at a disadvantage to someone that is more geared to the consumer.”

Norfolk Southern last month rebuffed a sweetened $27 billion cash-and-stock offer, and Canadian Pacific Chief Executive Officer Hunter Harrison has hinted that he may wage a proxy fight. Norfolk Southern called the proposal “grossly inadequate” and said regulators wouldn’t approve of the tie-up.

U.S. railroad shares could struggle to beat the S&P 500 Index if the strong dollar continues to weigh on industrial production and commodities, said Hartford, the Robert W. Baird analyst. Manufacturing last month contracted at the fastest pace in more than six years. Carloads of coal, which make up about a fifth of rail cargo, fell 12 percent last year.

“At some point in time, it becomes a game of matching very low sentiment with trends not getting any worse than expected,” he said. “That’s where we are with the rails.”

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