Kansas City Southern (KSU): This Sector Is Booming and Nobody Seems to Have Noticed

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There’s a sector that’s been booming in recent months, and almost nobody seems to have noticed. That sector is—surprise—railroads. The bluest of blue chips have seen surging share prices, revenue, and earnings per share lately. The boom seems to be across the board, not just in a few big players.

A little railroad that could

The surge in share prices for rail operators has been phenomenal. Take Kansas City Southern (NYSE:KSU), which, despite its name, operates mostly in Mexico and Texas. This smaller railroad saw its share value rise from $63 on June 1, 2012, to $111 on May 22 of this year. The growth has carried over into other areas, including earnings per share; on March 31, Kansas City Southern reported a diluted EPS quarterly growth rate of 38% over the same period in 2012.

Kansas City Southern (NYSE:KSU) also reported that revenue has nearly doubled since 2009. For the fiscal year 2009, the company reported revenue of $1.4 billion, which increased to $2.3 billion for the 12 months ending March 31, 2013. The company is also expected to report revenue of $2.7 billion next year.

Kansas City Southern (NYSE:KSU) is the smallest of the class-one railroads; it only has 6,000 miles of track compared to the 20,000 miles of track operated by the Norfolk Southern Corp. (NYSE:NSC) and the 31,000 operated by Union Pacific Corporation (NYSE:UNP).

Transcontinental freight booming

Kansas City Southern (NYSE:KSU)’s key to success is that it is one of only three U.S. railroads that operates lines clear to the Pacific Coast. The others are the Union Pacific Corporation (NYSE:UNP) and Burlington Northern Santa Fe, now part of Warren Buffett’s Berkshire Hathaway empire. Kansas City Southern’s lines run all the way to the deep-water container port at Lazaro Cardenas in Mexico, which enables it to compete with the big boys.

The reason why having Pacific ports is profitable is obvious: China. When stuff comes in from China, it arrives on containers that are loaded on trains and shipped to their destinations. When commodities like grain from the Midwest or coal from Wyoming go out to China, they go by train. Rail is still the way most finished goods and commodities get shipped to ports.

Big revenue increases on the transcontinental rails

The biggest of the transcontinental railroads, Union Pacific Corporation (NYSE:UNP), is also surging ahead. Union Pacific’s share price rose from $108 on June 5, 2012 to $158 on May 22 of this year. Union Pacific’s revenue is rolling to success as well; for the 12 months ending March 31, 2013,  Union Pacific reported revenue of $21.1 billion compared to $13.4 billion in the fiscal year 2009.

Yet Union Pacific Corporation (NYSE:UNP) and Kansas City Southern (NYSE:KSU) definitely are not flukes. The Canadian National Railway (USA) (NYSE:CNI), which operates lines between Ontario and British Columbia on the West Coast, reported revenue of $9.9 billion for the fiscal year 2012, compared to revenue of $6.6 billion for the fiscal year 2009. Canadian Pacific Railway Limited (USA) (NYSE:CP), which also operates lines between Ontario and British Columbia, reported revenue of $5.8 billion for the 12 months ending March 31, 2013 compared to $4.3 billion in the fiscal year 2009.

Are railroad stocks too high

All of the railroads that touch the Pacific are sharing in the boom. It’s no fluke; revenue on the rails is up. The question we have to ask is, does revenue and the other performance figures justify the current railroad share prices?

It looks like some railroad stocks, especially Canadian Pacific, Union Pacific Corporation (NYSE:UNP), and Kansas City Southern (NYSE:KSU), have entered overvalued country. These once under-appreciated shares seem to be becoming too popular. That might be happening because more conservative players, such as retirement investors and anti-gold-bugs, are reentering the stock market.

It might also be happening because of all the publicity Uncle Warren got when he bought Burlington Northern Santa Fe. Buffett’s action showed investors that there was a lot of value to be had on the rails. Whatever the reason, it is pushing rail stocks up to unrealistic prices.

Some rail stocks should be sold

There are some rail stocks that should be sold off right now because they’re about to take a plunge. Union Pacific Corporation (NYSE:UNP), Kansas City Southern (NYSE:KSU), and Canadian Pacific are all overvalued right now. Kansas City Southern, and Canadian Pacific are trading at P/E ratios in the high 30s as compared to the industry average of ~18.

That being said, the Canadian National might be a buy because it hasn’t been inflated to the level that the others have. It has higher revenue than both Canadian Pacific and Kansas City Southern (NYSE:KSU), yet it is selling for less based on the P/E ratio of 17.3.

Some buys in railroads

Canadian National shows that there are still undervalued rail stocks out there. Another is Norfolk Southern Corp. (NYSE:NSC), which is trading at around $78 a share.

Norfolk Southern Corp. (NYSE:NSC) was also the only major US railroad that reported a drop in revenue in the first quarter. Revenue was approximately $11 billion for the 12 months ending March 31, 2013, compared to $11.2 billion in the year-ago period. Yet the Norfolk Southern did report some positive figures and it also increased its dividend by 18% in the last year.

Most notably, Norfolk Southern Corp. (NYSE:NSC)’s intermodal revenue climbed 9% to $575 million as volumes increased by ~10% compared with first-quarter 2012. The company also repurchased 0.5 million shares in the first quarter and has plans to buyback up to an additional 50 million shares in the next four years.

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