Railroad Stocks Build Up Steam

Though shares in rail carriers have outperformed the broader market, S&P has a neutral outlook on the industry. The only buy-rated name in the group: CSX

The Standard & Poor's 1500 Railroads subindustry index is the newest member of the high momentum list (see the full list at the end of this column), indicating that its trailing 12-month price performance is now in the top 10% of all subindustry indexes in the S&P 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes). Year-to-date through Feb. 8, the S&P Railroads index rose 4.9%, vs. a 9.1% decline for the S&P 1500. During 2007, this subindustry index gained 19.5%, vs. the broader market's climb of 3.2%.

Take a look at the accompanying chart. Remember, the jagged blue line represents the subindustry index's rolling 52-week price performance as compared with the 52-week performance for the S&P 1500. Any point above 100 indicates market outperformance over the prior year, while points below 100 indicate market underperformance. The red line is a rolling 39-week moving average, while the two green bands indicate one standard deviation above and below the index's 17-year mean relative strength.

There are five large- and small-cap companies in the S&P 1500 Railroads subindustry index covered by S&P equity analysts. The market-cap weighted S&P STARS ranking for the group is 3.2, vs. 3.8 for the S&P 1500. Only one company has a favorable STARS ranking: CSX (CSX), which carries a 4 STARS (buy) recommendation. The other four companies—Burlington Northern Santa Fe (BNI), Kansas City Southern (KSU), Norfolk Southern (NSC), and Union Pacific (UNP)—carry 3 STARS (hold) recommendations.

At or Above Historical Averages

Kevin Kirkeby, CFA, who follows the group for S&P Equity Research, has a neutral fundamental outlook for the Railroads group. He believes freight rates will rise in the mid-single digits in the coming year as railroads use the generally tight network capacity to revise contract terms upon renewal—and get rid of low-profit shipments. Volume weakness in market segments such as lumber, construction materials, and intermodal is expected to remain through 2008, but should be offset by gains in coal and grain. Fourth-quarter earnings at several major railroads—and the companies' outlook for the industry—generally support this view, says Kirkeby.

Nevertheless, S&P sees neutral valuation indications for the group. Most railroad stocks trade at or above their historical average valuations, and regulatory risk is rising. Kirkeby also points out that an increasing proportion of earnings growth has been the result of aggressive share buyback programs.

Rail revenues rose an estimated 4% in 2007, while operating earnings were up just under 6%. Traffic in ton miles (weight times distance) decreased about 1.0% in the U.S. in 2007, but increased 1.0% year-to-date through Jan. 12, according to estimates from the Association of American Railroads. Total carloadings declined 2.5% in 2007, but were up 0.2% year-to-date through Jan. 12.

After reaching record levels in 2006, intermodal volumes declined 2.1% in 2007, to 12.0 million trailers or containers. In the first two weeks of 2008, intermodal units were down 5.7%.

S&P's longer-term outlook for railroads is favorable, with the industry's core traffic base (coal, grain, and chemicals) increasing volumes in line with the economy. Kirkeby sees railroads' greater fuel efficiency relative to other transportation modes, along with highway congestion and driver availability, as factors that could drive more industrial and intermodal shipments to the rails over the longer term. However, he notes that the rail carriers face considerable infrastructure expenditures before they can accommodate these additional volumes. Over the past five years, capital expenditures by the leading railroads exceeded 14% of annual revenues.

So there you have it. Despite the group's strong relative strength, it appears as though the overall fundamental outlook does not support this optimism.

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), along with a stock that has the highest S&P STARS (tie goes to the issue with the largest market value).

Subindustry Company Ticker S&P STARS Rank Price (2/8/08)
Agricultural Products Archer Daniels Midland ADM 2 $41
Coal & Consumable Fuels Peabody Energy BTU 3 $54
Commodity Chemicals Georgia Gulf GGC 3 $7
Construction & Engineering Fluor FLR 4 $112
Diversified Metals & Mining Freeport-McMoRan Copper FCX 4 $91
Education Services Career Education CECO 5 $19
Fertilizers & Agr. Chem. Monsanto MON 3 $110
Health Care Services LabCorp LH 5 $79
Industrial Gases Air Products APD 3 $89
Internet Retail Amazon.com AMZN 3 $74
Oil & Gas Drilling Noble Corp. NE 5 $45
Oil & Gas Equip. & Svcs. Baker Hughes BHI 5 $65
Oil & Gas E&P Swift Energy SFY 5 $42
Railroads CSX CSX 4 $48

Source: Standard & Poor's Equity Research

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