Railroad Stocks Power On Amid Oil Spike

Crude oil and railroads mix well together.

Four times more fuel efficient than trucking, railroads tend to prosper when oil prices are rising.

The carbon story fits well too. Moving goods by rail rather than truck reduces greenhouse omissions, especially as the industry embraces lighter, high-tech materials and parts.

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Other factors—like a growing economy and rising demand for commodities —have provided an extra push.

CSX is up 57.4 percent in the last 12 months, leading the rail group, with Norfolk Southern picking up the rear with a 28.3-percent gain.

In comparison, the Dow Jones Transportation Average, which includes trucking, airline and marine companies as well as railroads, has climbed 22.9 percent during the same period.

“Railroads have lots of momentum at their backs,” says Anthony Hatch, a New York City-based railroad analyst. “They’re on the rise. Sophisticated shippers are trying to increase their use of rail,” concludes Hatch. “It saves them money and they’re sure of capacity.”

Part of that momentum has to do with squeezing costs. Rail companies have doubled their efficiency since 1981. The reason: they invest 40 cents of each revenue dollar back into their network—more than twice other industries. That gives them pricing power.

“Trucking productivity has already peaked,” says Hatch.

No wonder then that railroad growth is coming at the expense of trucking.

“Railroads have become more reliable," says Keith Schoonmaker, a senior equity analyst at Morningstar. "And they’re better inventory managers.”

Warren Buffett, among others, saw that train coming. In late 2009, Buffett'sBerkshire Hathaway culminated its move into railroad stocks by acquiring Burlington Northern-Santa Fe Railway for $34 billion. What he saw were strong fundamentals: lush cash flow, high barriers to entry and predictable growth.

Railroad revenue growth should exceed that of U.S. GDP for the next three to six years, says Arthur Hatfield, a transportation analyst at Morgan Keegan. “We like the industry as a whole,” he says. “All management teams are doing a good job.”

Particularly when the industry's biggest business—transporting coal for power-plant consumption—has been under pressure for years, thanks to falling natural gas prices and environmental concerns.

Catching The Train

Only half a dozen big publicly-traded rail companies remain, and all of them have already enjoyed strong runs. But Hatfield thinks there’s still room for growth. Priced at 12 times 2012 earnings, rails are underpriced, he says. Historically, the range is 12 to 15.

“These stocks could outperform the broader market,” says Hatfield. The reason, he adds, is that their volume growth—in the high single digits—exceeds economic growth.

Dividend growth is also good. Railroads raise their dividends every year, says Schoonmaker. Union Pacific, for instance, raised its quarterly dividend from 27 cents a share to 38 cents in 2010—a 41 percent increase. “And they’re not alone,” adds Schoonmaker.

The country’s largest rail company covering 23 states, Union Pacific exemplifies the railroad story, say analysts. It’s highly efficient, thanks to capital spending, which totaled $2.5 billion last year. Schoonmaker expects UP to churn out 13-plus-percent revenue growth in 2011.

Canadian National looks even better on paper to Hatch.

“It’s one of the best run rails in the world,” he says, citing an operating margin of 63.6 percent and 13-percent revenue growth in 2010.

Hatch also likes CSX ,which serves many big cities, has kept reining in cost. “Its rate of improvement is second to none,” says Hatch. “They under promise and over deliver.”

CSX will generate 10-percent revenue growth annually for the next few years, adds Hatfield.

Norfolk Southern has the biggest dividend yield of the group—2.4 percent, well above the S&P 500's 1.72 percent.

Guidance from the group has been upbeat after posting strong fourth-quarter earnings. Kansas City Southern , for instance, forecast revenue growth in the low double digits this year, following a better-than-expected January.