Railroads on Bullish Track

While most of an increasing part of our lives, from social to shopping, are taking place online there is still the need to move things around in the physical. Railroads not only play a vital role in the supply chain, but and they also provide an accurate barometer of economic health. Until recently things were looking pretty sickly, but thanks to recovering energy prices, surging agriculture prices and a general pickup in industrial activity, shares of railroad companies appear poised to track higher.

Railroads are considered a wide moat industry, as it entails immense capital requirements and new entrants in the industry are almost unheard of. Railroads are the pulse of the economy. Whether transporting crude, lumber, merchandise, agricultural or industrial products, railroads are what keeps the economy moving. Railroads are often closely observed by economists and analysts to get a sense of how the overall economy is doing.

So it comes as no surprise shares of railroads stocks have mostly meandered sideways over the past few years, as even 7 years after the financial crisis economic recovery remains muted. What’s made matters tougher for railroads is that shipments of their most important cargo, namely coal and energy, have dropped precipitously with the former in a secular decline, unlikely to regain former levels.

The chart below shows the overall rail traffic in the US in which carloads for the five major U.S. carriers fell 6.5 percent in the first quarter and so far have dropped 10.4 percent this quarter, according to the Association of American Railroads, a trade group that reports weekly shipments. But grains have been a bright spot over the past few months and shipping of oil is starting to resume, but could ultimately be threatened if more pipelines get built.

Railroad carload image 6.14.16

While it was a tough quarter for coal (carloads down 34%) and oil (down 3%), other parts of the business are starting to look better.

Farmers, who have stored grain to wait for higher prices, may begin to ship more as prices for corn, soybeans and other crops begin to climb, said Frank Lonegro, chief financial officer of CSX said during a presentation at a Deutsche Bank AG conference in Wednesday. Since April, prices have risen 22 percent for corn and 29 percent for soybeans.

Intermodal loads, which include consumer goods, is a key revenue generator for many of rails as they command higher rates, saw an 9% increase in the first quarter and now contributes about 20% of industry wide revenue.

The Institute for Supply Management Purchasing Managers Index indicates conditions are likely to improve going forward citing the bottoming of energy prices, rising grain prices, strong auto shipments and positive signs for chemicals which should more than offset the decline in coal.

Choo Choo Choose Union Pacific

While I think the whole industry could enjoy a cyclical recovery my top pick is Union Pacific Corp (UNP), which is the largest publicly traded railroad company in North America. The company commands an impressive 32,000 miles of rail network in western US. It offers freight transportation covering the full gamut of goods ranging from agricultural products, food and beverage products, automotive products, such as finished vehicles and automotive parts, as well as chemicals, plastics, fertilizers, petroleum, coal and lumber. The following system map image demonstrates the scale and reach of Union Pacific.

UNP track map 6.15.16

UNP has continued to increase the revenue year after year except in 2009 (due to the recession) and 2015 due to the challenges mentioned above (crude and coal shipment issues). The earnings have followed the revenue.

Looking forward, revenue is expected to fall another 8% this year compared to 2015, but things are looking up going forward. For 2017, revenue is expected to grow by 5%. Earnings are also expected to fall a bit going forward.

One item that has investors concerned is that Union Pacific has not raised its dividend since the first quarter of 2015. This comes after it having raised its dividend for 9 consecutive years. The current dividend stands at 2.48%, a historically high yield. If the company intends to keep its dividend grower status, UNP needs to raise its dividends before the end of this year. Considering that the company has a current payout ratio of 41% and analysts expect earnings to grow at approximately 7% over the next five years, and expect it will announce a raise before the end of the year.

Lastly, the technical picture looks constructive as the shares broke through resistance near the $85 level and are now forming a bullish cup and handle.

UNP Chart 6.15.16

I think shares could cross above $100 by the end of the year. To profit from such a move I’m targeting the purchase of LEAP call options. Specifically, the January 2017 calls with a $90 strike price for $5.00 per contract. This limits your risk to just 5.5% of the current stock price but gives you potential 100% return should shares increase by 13% above $100 by the end of the year.

— Steve Smith

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About the Author: Steve Smith