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By Keith Schoonmaker, CFA | 03-10-2014 02:00 PM

Morningstar Minute: Rails Are Just the Ticket for Wide Moats

Class I railroads have cost advantages and scale efficiencies that give them a competitive edge over lesser players.

The Morningstar Minute is our quick take on investments, the market, economic indicators, and more. Join us every day for fresh insights from our analyst team.

Keith Schoonmaker: At Morningstar, we attribute wide moats to the Class I rails due to cost advantage and efficient scale. Let's look at some individual railroads.

First CSX. CSX is cheapest by our valuation methodology, we think because of the market concerns about its exposure to central Appalachian coal. We share this concern and have projected decreasing volumes in our valuation model.

CSX's neighbor in the east is Norfolk Southern. It has the same coal concerns but it bears a little bit higher dividend yield at about 2.2% relative to CSX's 2.1% at this time.

For overall quality of portfolio it's hard not to like Union Pacific. Union Pacific is the giant railroad in the West with high exposure to coal, but also to intermodal shipping coming from Los Angeles-Long Beach to Chicago. [The firm has] a big exposure to Mexico, as well, with about 10% of its revenue derived from traffic in and out of Mexico.

Kansas City Southern shares are a bit cheaper than they were earlier this year because of the market concerns about slowing growth due to some delays in bringing new automotive plants on line in Mexico. Also, a recent bill passed in the Mexican lower house, which brings some concerns about the longevity of the franchise in Mexico, through which Kansas City Southern earns about 46% of its revenue. In response to this, we increased our fair value uncertainty rating but feel that we lack sufficient information at this time to make discrete projections in our valuation model. So we're leaving our fair value estimate unchanged at this time.

It's hard to ignore the progress that CP has made recently, just in the past year and a half driving down its operating ratio tremendously. Morningstar in fact awarded the 2013 CEO of the Year award to the CP CEO, Hunter Harrison, for his efforts made here and just the tremendous improvement made in the operations at this northern railroad.

Railroads are really operating at their peak compared with probably all-time history. Valuation reflects this however, so we would encourage investors to take a look at railroads, especially when there is some pullback in the current share prices.

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