Filed Under: ,
Tickers in this Article: NSC, PW, UNP, PWX, CSX
The railroad industry is facing several issues that will have a mixed effect on earnings for the third quarter, as this economically cyclical industry faces the effects of the credit crunch and the economic slowdown. Traffic Down, Fuel Down Too
Rail traffic is beginning to fall according to industry reports. U.S freight rail traffic was down 4.6% from September 2007, with 16 of 19 categories showing a drop. While some of this decline is due to the effects of Hurricane Ike, it is clear that traffic is softening.

Offsetting the weakening traffic is the fall in the price of locomotive diesel fuel used by the industry. A fuel price index created by the Association of American Railroads peaked at close to 800 in July 2008, almost double the level in July 2007. The index is now at approximately 675.

Locomotive fuel is a major expense for railroads. Fuel was 25% of total operating expenses for CSX (NYSE:CSX) in the six months ending June 30, 2008. CSX's actual fuel expense is higher because its non-locomotive fuel cost is contained in the materials, supply and other expense line on the income statement. Railroads have two options to deal with this cost: either hedging through the financial markets, or passing along the higher costs to customer as fuel surcharges. (For more on this critical document for investors, read Understanding The Income Statement.)

Pricing power for railroads is a matter of dispute, with some analysts, such as Thomas Wadewitz form JPMorgan, predicting strong pricing power will get some of the industry through hard economic times, while others, like Art Hatfield from Morgan Keegan, fear that this power will dissipate as volumes remain flat in a slowing economy.

A Unique Railroad
Larger players like Providence & Worcester Railroad (AMEX:PWX) and Union Pacific (NYSE:UNP) may have a bumpy ride, but one railroad that doesn't have to deal with any of these issues is Pittsburgh & West Virginia Railroad (AMEX:PW). Pittsburgh & West Virginia Railroad is a "captive" owner of 132 miles of railroad located in Ohio, Pennsylvania and West Virginia.
Investing here is almost like buying a stock that was actually a bond.

What do I mean by "captive" company? Pittsburgh & West Virginia Railroad is locked into a 99-year, perpetually renewable lease with Norfolk Southern (NYSE:NSC). Norfolk Southern pays the railroad $912,000 per year, under a lease that is essentially perpetual, with no escalator clause. Norfolk Southern is responsible for all maintenance of the track during the lease. The lease dates from 1964, but in 1990, Norfolk Southern sold the track to a private railroad called Wheeling & Lake Erie Railway Co., who is now responsible for paying the rent.

Pittsburgh & West Virginia Railroad is also a real estate investment trust for tax purposes and must pay out at least 90% of its income to shareholders. This gives the company a steady dividend of 52 cents annually and a yield of 5.7%. (For more information about REITs, check out Basic Valuation Of A Real Estate Investment Trust.)

Inflation Risk
The obvious problem with the contractual arrangement between the two companies is inflation risk or loss of purchasing power; the lease payment will be worth less and less as the years goes by, until, in theory, it wouldn't be enough to cover the office rent for the company.

There are some good things about the company's business model. There is no business risk, since the payment is fixed and long term, and Norfolk Southern must pay it whether or not it uses the track.

A Bond By Any Other Name
So, if you add this together: a fixed annual payment passed through as a dividend to shareholders, combined with purchasing power or inflation risk, what you have in essence is a bond, not a stock. This situation is not that different than the 100-year bonds that some companies issued several years ago.

It may even be safer than a bond since the relationship between Pittsburgh & West Virginia and Norfolk Southern is not bondholder to issuer, but a simple contractual one that wouldn't necessarily be discharged in a bankruptcy. Also, if Norfolk Southern defaults on a payment, Pittsburgh & West Virginia reclaims the track.

So what is the value of this perpetuity? The formula used is cash flow divided by the discount rate. So, the value would depend on what discount rate an investor uses for the calculation: (To learn more, read How Some Companies Abuse Cash Flow.)

$ 0.52
Discount rate
Value of Perpetuity
PW Market Price
$ 9.23

Bottom Line
With rail traffic falling and fuel prices falling too, investors may have to wait to see how the industry fares. Earnings season will illuminate some of the issues facing the railroad industry, but for investors who want more stability, they can check out Pittsburgh & West Virginia Railroad and its stock that acts like a bond.

comments powered by Disqus

Trading Center