Railroads return as growth industry

August 12, 2007|By Andrew Leckey | Andrew Leckey,TRIBUNE MEDIA SERVICES

The revival of railroads as a growth industry has barreled ahead during the past year on a newfound ability to raise prices.

That has attracted the attention of many influential investors, including Warren E. Buffett, leading to a revival in several railroad stocks.

It also represents a round trip in American history. Railroads had ushered in the modern stock era, with nine railroad stocks on an 11-stock Dow Jones index launched in 1884.

The premier growth industry of that time, railroads were the only shares traded in large volume on the New York Stock Exchange. But railroads eventually were derailed as growth investments, victims of changing transportation trends and then deregulation.

"It used to be that the costs of invested capital for a railroad were higher than the returns generated," said Arthur W. Hatfield, analyst with Morgan Keegan & Co. in Memphis, Tenn. "You don't want to own stock in a company like that."

For their shareholders, the slow ride seemed to last forever.

"If you go back even to 2000, these were pretty sleepy stocks," said Rick Paterson, analyst with UBS Investment Research in New York. "They didn't generate much cash flow or earn their cost of capital."

In 2004, railroad stocks began to return as growth investments. That's because the U.S. industrial economy was running smack into a consolidated railroad industry that was running out of capacity.

In addition, there was an increase in imported goods to transport and the trucking industry was facing high fuel prices and driver shortages. Railroads were able to increase their prices.

Despite reduced freight volume stemming from the slowdown in housing and autos this year, some investors can't seem to get enough of railroads.

Buffet investments

Most notably, Buffett's Berkshire Hathaway revealed last week that it now owns more than an 11 percent stake in Burlington Northern Santa Fe Corp. It also has smaller pieces of Union Pacific Corp. and Norfolk Southern Corp. Icahn Management LP and several hedge funds also have made significant investments in railroad stocks.

"The fact that no one has been building new railroads led to higher pricing and that is not going to change anytime soon," said John Kartsonas, analyst with Citigroup in New York. "Eventually, more infrastructure and capacity will be built and bring the cycle down, but that won't be for many years."

Because circumstances are virtually the same for all railroads, there is more upside as investors recognize their profit potential, Hatfield said. Industry returns are starting to exceed costs.

A fourth of the nation's rail revenues are still under long-term contracts that have yet to be repriced at higher levels, and it will take another four years to do it, experts said. Paterson said pricing is now irreversibly changed and will remain better than in the past.

Volumes of freight and intermodal transportation (which uses ships, rail and trucks) were down in the latest quarter, but that doesn't mean earnings will be peaking anytime soon, he said.

Despite some pullbacks, railroad stock prices remain high when viewed from the perspective of history and earnings expectations.

Issues for investors

For today's investors, the issues are whether railroad stocks have overextended themselves and how this year's reduced freight volume will affect their profit structure.

Norfolk Southern, one of the two major rail carriers in the Eastern United States along with CSX Corp., is a stock recommended by Hatfield, Kartsonas and Paterson. It has more than 21,500 miles of track and its intermodal business benefits from a shift in ocean shipments to East Coast ports from crowded Western ports. Cash flow is outstanding.

Union Pacific, the largest North American railroad in route miles, is recommended by Hatfield and Paterson. It operates 33,000 miles of track across the western two-thirds of the U.S. and is a force in the intermodal market. It has 80 percent of rail traffic crossing the Mexican border.

Canadian National Railway Co., that country's largest railroad, is Paterson's top pick. Its acquisition of Wisconsin Central and Illinois Central railroads made it a major factor in the Midwest. It has 19,200 route miles and the only route structure stretching from the Pacific to Atlantic Oceans and down to the Gulf of Mexico. It has the industry's best balance sheet and a reputation for reliability, experts said.

Hatfield also suggests Burlington Northern Santa Fe, the second-largest North American railroad in route miles. The result of a 1995 merger, it operates 32,000 route miles of track in the western two-thirds of the country. It transports more grain than any other U.S. railroad.

Genesee & Wyoming Inc., operator of about 50 short-line and regional freight railroads in the United States and a railroad in Australia, is another Hatfield choice.

yourmoney@tribune.com

Andrew Leckey writes for Tribune Media Services.

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