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Genesee & Wyoming Inc (GWR), Providence & Worcester Railroad Company (PWX): This Takeover Target Could Jump 66%

While the markets seem to only be interested in rising rates and earnings, an entire sector has gone unnoticed and blown the doors off the market.

The Dow Jones U.S. Railroad Index is surging with a 24% gain this year and has quadrupled since its 2009 low. Besides the general rebound in the economy, crude production is at 20-year highs, far exceeding pipeline capacity and growth. That means a massive surge in demand for transportation by rail. An estimated 1.4 million barrels of crude and refined products were transported by rail every day in the first six months of 2013, an increase of almost 50% from the first half of 2012.

Genesee & Wyoming Inc (NYSE:GWR)

All signs pointed to another great year in 2013 and the sector again being a good investment. Then the unthinkable happened: Just after 1 a.m. on July 6, a freight carrier operated by Montreal, Maine & Atlantic Railway crashed in the Quebec town of Lac-Megantic, killing 47 people. Montreal, Maine & Atlantic filed for bankruptcy a month later.

The catastrophe in Canada will surely increase scrutiny on the industry. In addition, anecdotal evidence from Jeffrey Saut, chief investment strategist at Raymond James, points to an unbearable rise in insurance premiums for small short-line carriers:

“(Recently,) I met the CEO of a short-line railroad located in the Dakotas. He told me his insurance broker had just told him that because of the disaster … his insurance coverage is going to have to be increased by a factor of four with an attendant price increase — and his railroad doesn’t even transport crude oil! Such an increase in insurance cost will likely cause a massive consolidation for the industry.”

Lastly, possible regulatory changes by the U.S. Department of Transportation, which is said to be working on new policies for rail tank cars, could be the final catalyst for consolidation in the industry. These events have put the sector at risk — but with risk there is always return.

As Saut speculates, there could be a wave of consolidation as the smaller players get forced to sell to larger operators. These larger operators should be able to use their scale to negotiate smaller insurance increases and are better positioned to manage greater regulatory scrutiny.

Looking through the roughly 550 short-line railroad operators for good takeover targets is like finding the proverbial needle in a haystack — but I think I’ve found the needle and the seamstress.

Like the Pieces of a Puzzle, these Two Fit
After its acquisition of RailAmerica last year, Genesee & Wyoming Inc (NYSE:GWR) management has said that it is “comfortable continuing to actively look at investment opportunities … in multiple geographies.” Genesee & Wyoming Inc (NYSE:GWR) has very little exposure to the New England area with just one route from New London, Conn., straight up to Canada. At a recent global transportation conference, the company’s chief financial officer pointed to building regional rail systems through acquisitions as one of its key growth drivers.

Enter Providence & Worcester Railroad Company (NASDAQ:PWX), an $88 million short-line freight operator in Massachusetts, Rhode Island, Connecticut and New York. The company transported 31,727 carloads of freight for 140 customers in 2012 across a range of commodities.

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