2011 In Review - Railroads

By Stephen D. Simpson, CFA | December 27, 2011 AAA

Maybe any sector gets interesting after a while if investors follow it closely enough. It was definitely interesting to watch the trends in railcar traffic and Wall Street perception for railroads this year. All in all, this was quite a solid year for the industry and the "average" railroad not only beat the market, but beat it by a healthy margin. Although the linkage between railroads and ducks is not exactly obvious on first blush, 2011 showed that they have at least one thing in common; things may look consistent on the surface, but there can be a lot of turbulence below the waterline.

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Rail traffic went on a noticeable skid from the early spring and into the summer, feeding a lot of fears that industrial growth had stagnated in the U.S. and the economy was at risk of slipping back into recession. So far, though, it looks like this slide was just part of the seasonal pattern in traffic that has held true for many years now. Not only has rail traffic rebounded nicely, but intermodal activity continues to accelerate and pricing has been solid. (For related reading, see A Primer On The Railroad Sector.)

The Very Good
At least three railroads stand out on the top of the heap for 2011 performance. Kansas City Southern (NYSE:KSU) has delivered returns of nearly 40% this year, as this predominantly north-south railroad has posted solidly above-average carload growth. With its operating area extending down to Mexico City and the Mexican coasts, Kansas City Southern has been a good play on the growth of Mexican manufacturing and outsourcing south of the border.

Norfolk Southern (NYSE:NSC) has delivered nearly 15% returns this year. Although coal demand from U.S. utilities has been sluggish this year, Norfolk Southern has seen very strong coal exports through its terminals and good intermodal traffic, as well. With a strong operating ratio, Norfolk Southern is making the best of this better traffic and rate environment. (To learn more, read Operating Performance Ratios.)

Last, and not at all least, Canadian National (NYSE:CNI) has delivered almost the similar returns as Norfolk Southern. Canadian National has seen strong intermodal performance, largely on Chinese demand for commodities, and still boasts some of the best performance numbers in the industry.

The Pretty Good
Although there are tremendous differences between international short-line operator Genesee & Wyoming (NYSE:GWR) and Western Class 1 railroad Union Pacific (NYSE:UNP), they have delivered similar year-to-date market returns around 10%. Acquisitions have definitely boosted Genesee and the Australian operations are looking good, while many of its American short-line customers still seem to be in demand of more freight capacity.

For Union Pacific, it's been a more challenging year. Competition is increasing in hauling Powder River Basin coal and UP's intermodal performance has not been very strong. UP has also seen below-average carload growth, but improving pricing is helping to offset that.

RailAmerica (NYSE:RA) is also a short-line operator, but one focused on the U.S. Volumes have been weaker for this railroad, largely due to the fact that some major customers have reduced their coal shipments.

The Also-Rans
Two major railroads look primed to lag the market for 2011 and may well end the year with negative returns. Eastern operator CSX (NYSE:CSX) has somewhat more reliance on weaker categories like coal and chemicals and doesn't have quite the intermodal operations of Norfolk Southern. For Canadian Pacific (NYSE:CP), 2011 has been a very tough year, as Mother Nature did a number on its tracks earlier in the year. CP also lags its rival Canadian National in many significant operating statistics and has a larger exposure to met coal and Chinese steel activity.

The Bottom Line
While the recovery in rail activity is heading into its third year, investors can take comfort in several facts. First, intermodal business is chipping in higher-margin/higher-return business and still has a lot of room to grow. Second, the rail traffic recovery is only about halfway between the bottom and the former peak. Third, while some U.S. industrial companies have trimmed estimates, most signs of industrial activity and commodity consumption continue to point up and suggest ongoing rail demand growth in 2012. (For related reading, see The Industry Handbook.)

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At the time of writing, Stephen Simpson did not own shares in any of the companies mentioned in this article.

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