The railroad industry has gained attention from analysts and investors over the last couple of years, even investing superstar Warren Buffett made a big move in this sector by purchasing Burlington Northern in 2010 for nearly $44 billion. In case you were wondering, it´s not too late to hop on the train.
1. Competitive Advantages
If there is one thing Buffett likes to see in a company is a strong and durable competitive advantage, and the railroad business is as good as it gets from that perspective. Nobody would build a new railroad near an existing one, costs would be enormous and there would probably not be enough demand for both companies to operate profitably.
Trains compete against trucks and airplanes, but they have a big advantage in fuel efficiency that make them the obvious choice when it comes to freight transport in areas like commodities. They have also made some remarkable improvements in efficiency since the industry was deregulated in the eighties.
The sector has streamlined operations, solved labor disputes, and implemented technological advancements; they now have sensors to detect mechanical issues before they cause delays or accidents. Work related injuries have been declining over the last years and punctuality, a critical factor, has been materially improved.
2. Macroeconomic Tailwinds
Railroads have been capitalizing on the US energy boom through different ways, even for oil transportation. Pipelines create connections between two fixed points, but trains can take the product where demand and prices are higher, so producers have been using railroads to take advantage of pricing spreads in different regions.
The US industrial is witnessing a big renaissance lately, caused not only by the local energy boom, but also by higher costs and other problems in countries like China. This has increased demand from industries like chemicals, automotive, and steel among others.
Some companies like Burlington Northern and Canadian National Railway (USA) (NYSE:CNI) are experimenting with natural gas as a cheaper alternative to diesel. Many of these companies consume nearly 1 billion gallons of diesel annually, and considering that the fuel is selling for $1 or $2 more per gallon than an equivalent amount of gas, the cost savings could be substantial.
The transition would be expensive, to make the switch to natural gas, a railroad would have to modify its diesel-electric locomotives, a process which costs somewhere around $600,000 and $1 million according statements by Normand Pellerin from Canadian National, which is running a test with a gas fueled train in Alberta.
But as long as natural has remains cheap enough, making the change sounds like a reasonable idea, it looks like the transition may be viable once all the tests and pacifications are finished. This would provide further efficiencies in such a critical aspect as fuel cost.
3. Strong Fundamentals
When analyzing financial statistics and valuation ratios for the major railroads like Canadian National Railway (USA) (NYSE:CNI), Canadian Pacific Railway Limited (USA) (NYSE:CP), CSX Corporation (NYSE:CSX), Norfolk Southern Corp. (NYSE:NSC) and Union Pacific Corporation (NYSE:UNP), the numbers look quite solid.
There are important differences among specific names, of course, and it´s important to notice that the numbers regarding Canadian Pacific are reflecting temporary issues like restructuring and asset-impairment charges. But the main take away is that the five companies are pretty profitable and trading at moderate valuation levels.
Operating margins in the area of 30% are more typical in industries like software than in the transportation business. And the same goes for return on equity – ROE – ratios showing that these companies are compounding shareholder´s wealth at a nice speed. Big profitability in a sector with amazing competitive advantages, no wonder Warren Buffett likes the railroad business.
And the valuations look quite reasonable too. With forward P/E ratios in the range of 12 to 17 we could hardly call the sector overvalued. If the sector continues capitalizing the opportunities created by favorable trends like the energy boom and the industrial recovery in the U.S., these stocks have room to run further.