Tuesday, November 6, 2012

Will The Rails Continue To Chug Along?

Yesterday I went to hear Ken Hoexter, transportation analyst at Merrill Lynch.

I have written about Ken on several occasions on this blog, and for good reason. He has been following the rails, truckers and shippers for years, and has made a number of good calls on the stocks.

In March 2009, for example, while the investment world was focused on the immediate economic problems, he upgraded the whole railroad sector, and the stocks subsequently doubled or tripled in value.

Ken has remained steadfastly bullish on the rails since 2009, and I was curious as to whether he was having any second thoughts at this juncture.

The short answer: No.

Ken remains a fan of rail stocks, but is being slightly more selective. He particularly likes Union Pacific and Kansas City Southern.  CSX has struggled due to its reliance on coal shipping (utilities continue to have large stockpiles of coal due to last year's warm winter weather) but Ken thinks the stock is cheap enough (trading at 10x P/E) to warrant investor attention.

The rail story is pretty straightforward.  Shipping by rail remains the most fuel-efficient way to move cargo, rail revenue has remained steady despite the uneven pace of economic growth.

More importantly, however, is the fact that all of the rails have become vastly more efficient when it comes to their operations. The internet allow the rails to optimize their use of their fleets, so that cars and engines are almost constantly in motion, and fuel use is optimized.  In addition, greater use of automation means less wage pressures.

Over the past 6 years, Ken noted, the rail industry has made over 800 basis point improvement in their operating ratios.  This trend is expected to continue.  As recently as 2008, for example, Union Pacific had an 77% operating ratio. In 2012, UNP's operating ratio will be 68%, and management told analysts a couple of weeks ago that they expect to be at 65% within the next couple of years.

From a shareholders vantage, this is obviously good news. As long as revenue trends remain reasonable, earning will continue to move higher.

I asked Ken:  What would make you change your bullish stance?

Ken replied that he would become concerned if competition among the rail companies pushed pricing to less profitable levels.  Most rails today quote their customers an annual rate increase around the rate of inflation, plus a little more.  If this pricing discipline goes away, Ken said, it would change the attractiveness of the group.

But for now:  Get on board!