Time for Investors to Ride the Rails?

Jeremy Glaser: Is it time for investors to ride the rails? I'm Jeremy Glaser with Morningstar.com. I'm joined today by Senior Analyst, Keith Schoonmaker and Rick Tauber, to survey the railroad industry and see where the opportunities may lie. Gentlemen, thanks for joining me.

Rick Tauber: Thank you.

Keith Schoonmaker: Thanks for having us.

Glaser: So Keith, first off, can you catch us up on where the railroad industry is now after the huge downturn they had?

Schoonmaker: Sure and I'd be glad to. Jeremy, last year we saw that the headline news of Buffett's acquisition of BNSF really obscured a broader trend that was happening in the rails, that is, outstanding operating performance in the midst of really an unprecedented decline in volume and facing 15% to 16% declines in volume, the railroads still managed to turn in really impressive operating ratios. In fact, both CSX and Union Pacific turned in record margins last year.

Glaser: So that's something that maybe surprised a lot of people, what your outlook then for this year and for next year?

Schoonmaker: Well, certainly demand is recovering rapidly. In fact, year-to-date intermodal demand is up 13%, carloads are up 10%. That's year-to-date. And even last week, their numbers are much faster. Just came off the press now, intermodal run up 22%. Just today we learned intermodal was up 22% last week and carloads up 13% much faster than we've even seen year-to-date.

We're also expecting continued profitability, although that may temper as we get through the year a little bit. During the first quarter and maybe the fourth quarter of last year, the rails were able to basically add a couple more cars to each train and not have to increase the number of train starts or crew starts, thereby sort of adding more volume to the fixed side of the network and capturing some additional profitability that way.

Glaser: Certainly a lot of the railroads business there is tied pretty closely to the economic cycle, and as we've seen kind of growth in the United States slowed down a little bit and even the potential for slowing growth in Asia, what kind of impact could a less robust recovery have on your valuations and on your take on the industry?

Schoonmaker: Well, China's slowing would definitely affect commodities like imported containers from Asia into Vancouver or Long Beach, LA. We'd also see potentially the slower export of metallurgical coal for steel-making in China. Canadian Pacific carries a lot of metallurgical coal and Canadian Pacific, as well as Union Pacific and BNSF, all have substantial dealings in intermodal containers coming in from Asia. For example, the BNSF has 29% of its revenue from intermodal traffic; Union Pacific about 18%. So these are nontrivial amounts of revenue that are coming from imported transactions.

Glaser: So it's something we definitely want to keep our eyes on there. Rick, with profitability being strong, and with Keith projecting it to be strong with revenues trying to come back a little bit, where does that leave the credit picture for the railroads?

Tauber: Well, as part of our dynamic credit ratings process here at Morningstar, we review all of our credit ratings when there is any change to the equity models or valuations or assumptions. So that's what we did here, when Keith reviewed his assumptions on the sector and we'd actually rated four of the names back in November of '09 with initiations, and we basically went back and upgraded the whole sector.

So the original ratings were for Union Pacific, CSX and Norfolk Southern are BBB and Kansas City Southern at BB minus, and we went ahead and upgraded Union Pacific two notches to A minus, Norfolk Southern and CSX one notch to BBB plus and Kansas City Southern to BB. So basically, we're capturing that more constructive view in our credit ratings.

Glaser: Given those upgrades, did that then reveal some opportunities in the bonds that we're trading?

Tauber: Yeah, and I would also add, we initiated ratings on the two Canadian rails, Canadian National at A minus and Canadian Pacific at BBB. So those are the six names we rate, and basically the one name that kind of jumps out a little bit is Union Pacific, which I had mentioned. We updated two notches to A minus and we are now two notches ahead of the rating agencies there.

And basically if you look across the spectrum of bonds and there is a lot of bonds in the space, you'd note that Union Pacific, which we rate the same as Canadian National, actually gives you about 30 basis points of additional spread on their bonds. So like there is 6/8% bond due in 10 years, gives you a little bit over 4% yield and a spread of about 130 versus about 100 basis points on a similar Canadian National bond. So we see that as value in the space, and looking at the other direction we rate Union Pacific a notch higher than Norfolk Southern, but their bonds basically trade right about on top of each other. So we'd rather buy the Union Pacific bonds, which we feel is a better credit risk than the Norfolk Southern now.

Glaser: Keith, do any of the equities look attractively pressed?

Schoonmaker: Yeah, they do. We've got three rails at 4-star ratings right now, including the two rails which Rick mentioned both Norfolk Southern and Union Pacific. CSX joins the mix as a 4-star and the remainder of the Class-1 rails were all in the 3-star category right now. Long run, we're bullish on rails. We think it's a superior mode of transportation. It's got myriad advantage over trucking for all of society really as far as reduced emissions, reduced fuel consumption, cheaper prices for the consumer and less traffic on the highways. The advantages are not hard to see, but that doesn't mean the stocks are cheap.

Right now, our favorite pick is Norfolk Southern, because it's in the 4-star category. So it's trading at a discount to our discounted cash flow valuation and is also bearing a little over 2.5% dividend yield. So at the moment that's attractive but we also like Union Pacific and CSX.

Glaser: Keith, Rick, thanks so much for talking with me today.

Tauber: Appreciate it.

Schoonmaker: Thank you.

Glaser: For Morningstar.com, I am Jeremy Glaser.