Marcial: Time to Hop Aboard Genesee & Wyoming?

Railroad stocks are starting to gather steam, mainly because of growing optimism that the economy is turning up. Part of the brighter outlook is due to Federal Reserve Chairman Ben Bernanke's assessment that the economy is coming out of its worst crisis in decades. So some pros say this is the time to jump on certain railroad stocks before they pull out of the station.

Bigger isn't necessarily better, however, in picking a potential winner. More important, says analyst George Pickral of investment firm Stephens, are two factors: how efficiently a company has handled the economic downturn and decline in freight volume and how well capitalized the company is.

Genesee & Wyoming (GWR), which operates short-line and regional freight railroads, is one such company, says Pickral. (Stephens has done banking for Genesee.) Generally, investors would go for the so-called Class 1 railroads, major large-cap outfits such as Burlington Northern Santa Fe (BNI), CSX (CSX), and Norfolk Southern (NSC), which dominate the industry.

But Genesee, the only small- to mid-cap investment play in railroads, has its own distinct attraction, operating in a niche market. Headquartered in Greenwich, Conn., it owns and operates 63 railroads in the U.S., Canada, Australia, the Netherlands, and Bolivia. Its railroads primarily transport commodities, such as pulp and paper, coal, minerals, and stone.

"less asset-intensive""It tends to do better as the economy recovers because it is leaner and operates more efficiently," says Pickral, who rates Genesee overweight. The stock, which hit a 52-week low of 16.42 on Mar. 9, has ramped up to 31 as of Aug. 24, although it still trades well below its 52-week high of 47 reached about a year ago.

"Genesee & Wyoming continues to offer investors the most attractive way" to play railroads, says analyst John Barnes of RBC Capital Markets. The company, first of all, "offers a model that is less asset-intensive and historically is more capital-efficient than its Class 1 peers." Railroads require "massive capital spending budgets to maintain the track and rolling stock," Barnes notes, so that every year a Class 1 operator will typically spend upwards of $9 billion for maintenance and expansion.

On the other hand, Genesee & Wyoming focuses on a strategy of "build to fit," says Barnes. It hasn't expanded beyond its means, analysts note, and past acquisitions have been well-managed. And like its bigger rivals it has cut costs and has continued to keep prices firm, says Barnes, who rates the stock outperform with a price target of 38.

Even with the first stirrings of an economic turnaround, the railroad industry is by no means out of the woods. Analysts still expect railroad companies to post weak earnings this year, mainly as a result of scaled-down freight traffic. Freight-car originations at major U.S. railroads have dropped steeply this year, according to independent investment research outfit Value Line (VALU). Even so, major rail companies whose cargoes are far less sensitive to economic cycles should continue to book decent profits.

Genesee's second-quarter results, reported in early August, fared better than many of its Class 1 peers and came in close to Street expectations, says Barnes. "We like the Genesee & Wyoming story in the near and long term, and we feel the valuation is at a very attractive level," he says. Barnes also expects more robust future sales growth, which should, he says, drive further expansion of the company's price-to-earnings multiple, given its ability to make and integrate acquisitions. He notes that Genesee has had a successful track record in acquiring assets, and he expects the company, which recently raised some $92 million from a secondary stock offering, to make another acquisition.

plenty of cashAs investors continue to look for early-cycle plays in railroads, "we should see significant investor interest" in Genesee, the analyst says. Despite the company's appeal, it still has a long way to go on the upside, says Barnes. The stock is down 3.9% year-to-date, he notes, vs. the gain of 11.2% in the Standard & Poor's 500-stock index, and it trails the performance of its Class 1 peers. Since the end of the first quarter, Genesee's stock is up 37%, vs. gains of 72.5% for CSX, 47.9% for Union Pacific (UNP), and 40.1% for Norfolk Southern. The relative underperformance surprises the analyst because results in the recent quarter have not been as bad as those reported by bigger rivals, reflecting Genesee's leaner cost structure and the benefits of acquisitions.

Genesee's financials are strong, says Art W. Hatfield, analyst at investment firm Morgan Keegan (it has done banking for the company), as the railroad operator continues to generate "solid free cash flow of $23 million thus far in 2009, and maintains a healthy balance sheet, with more than $62 million in cash." Hatfield rates Genesee outperform, based on his increased earnings estimate of $1.50 a share (up from an earlier $1.48) for 2009, $1.77 for 2010, and $2.16 for 2011.

Despite Genesee's small size, with a market cap of just $1.3 billion and revenues of $601 million (vs. No. 1 U.S. railroad Burlington's value of $28.5 billion and revenues of $18 billion), the company still has fans on Wall Street. Five of the 10 analysts covering the company recommend buying the stock, and the five others tag it a hold.

At least one institution remains on board. As of July 31, 2009, Baron Funds, which remains Genesee's top shareholder with 3.5 million shares, or a 10.5% stake, continued to add to its holdings. It bought 250,000 more shares in July.

With an economic rebound in the offing, and the stock attractively valued vs. the bigger players in the industry, shares of Genesee may chug along nicely in coming months.

Unless otherwise noted, neither the sources cited in Gene Marcial's Stock Picks nor their firms hold positions in the stocks under discussion. Similarly, they have no investment banking or other financial relationships with them.

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