Keith Schoonmaker: Railroad profitability continues to improve, but volume growth is hard to come by, so we think every freight commodity deserves careful consideration, including coal.
Coal is particularly meaningful to the large U.S. rails and constituted 32% of revenue at CSX as recently as 2011. However, we believe coal remains a decreasing annuity for U.S. railroads.
Coal volume has declined for much of the past decade and since 2008 has basically cut in half at most big rails. But for much of 2017, coal carloads were up double-digit percentages year over year and ended the year 8% improved from 2016.
Coal killers are cheap natural gas and the growth of renewable energy sources. The recovery of coal last year came from slightly more expensive natural gas but still pales compared to all but the prior year. Even in Texas, the greatest coal burning state, we believe wind will produce more energy than coal within a few years. Using projections from our utilities team, we believe utility coal will resume its secular decline at a 3% CAGR into the future, and that export coal for eastern rails will return to more normal demand levels by the end of 2018.
We identify Canadian Pacific as our favorite pick among the rails. While rated 3 stars, as are most rails, it is cheapest in terms of price/fair value estimate, forward PE, and forward EV/EBITDA. In terms of its coal franchise, CP's coal book is 90% export coal that we believe will be stable going forward, unlike the high steam coal exposure and higher cost export coal of U.S. rails.