Maybe it seems quaint that an industry associated with the taming of the West and the robber barons of the Gilded Age even survives today, but railroads remain a significant part of the North American economic infrastructure.

As a major component of the transportation sector, railroad companies and their stocks are worth the time and trouble to investigate further. Their cyclical nature suggests that there will always be future opportunities to buy (or sell) these stocks.

What the Railroads Do

Railroad companies operate a pretty straightforward business. They charge companies for carrying cargo over their network of rails and railcars. In practice, it's a bit more complicated.

Major railroads in North America basically operate as duopolies. Union Pacific (NYSE:UNP) and Berkshire Hathaway's (NYSE:BRK.A) Burlington Northern Santa Fe jointly run routes throughout the Western U.S. Norfolk Southern (NYSE:NSC) and CSX (NYSE:CSX) control the East.     To the north, Canadian Pacific (NYSE:CP) and Canadian National (NYSE:CNI) operate throughout Canada. 

Once again, the details are a little more complicated.

Within the rail industry, railroads are frequently defined by category – Class I, Class II, and Class III railroads. The distinctions are a product of their respective revenues, Class I being the largest and Class III the smallest.

In practice, these categories have questionable value. Kansas City Southern (NYSE:KSU) is technically a Class 1 railroad, but it is much smaller than the smallest of the Big Six listed above.  

Key Takeaways

  • Rail companies are responsible for 43% of all intercity freight transportation in the U.S.
  • The use of standardized containers has added to the efficiency of the business in moving goods from ship to rail to truck.
  • Rail is a cyclical business and is subject to any downturn in the economy.

Nevertheless, it is worth noting that there is profit opportunity not only in the large continental networks but also in the smaller short-line railroads that connect industries to supply sources, like a power plant and a coal mine, or that connect companies and small towns to larger railroad lines.

The Modern Intermodal Network

Intermodal operations are an increasingly significant part of railroad company operations.

Intermodal transport relies on the use of standardized containers that can be transferred from ship to rail to truck with no reloading or unloading of the freight itself.

At one time, trucks were required to transport freight from cargo ships to rail yards. Now, railroads can run lines straight to the ports. That offers their customers faster, safer, and cheaper service than before.

Why Rails Matter

To this day, 43% of all intercity freight transportation is handled by rail.

While that number is impressive in its own right, it only tells part of the story. More than two-thirds of the nation's coal is transported by rail, and railroads carry a sizable percentage of the bulk shipments of chemicals, grains, and cars in the U.S. 

Rail also offers compelling safety and efficiency advantages. Accident rates are far lower for trains than for trucks, and a train can move a ton of freight over 430 miles on a gallon of fuel. 

Granted, these comparisons are not apples-to-apples. There are many more trucks than train cars out there, and the emissions standards are different for the two industries. 

Nevertheless, railroads are still a relevant mode of transportation today and are likely to remain so for the foreseeable future.

The Carload Indicator

Rail traffic is a valuable proxy for economic activity. Carload traffic correlates pretty well with economic activity, as do the number of railcars deployed or held in storage. 

The big railroads are duopoly businesses with just six players dominating the U.S. and Canada.

In addition, intermodal traffic can offer important information about the state of international trade. The mix of traffic offers signals on what areas of the economy are notably strong or weak. For example, lumber and building material shipments grew strongly into the housing bubble of 2008-2009, and then tumbled sharply as it reached its bursting point.

How to Evaluate Rail Operators

To a certain extent, railroad companies should be evaluated like any other company. Investors should look for revenue growth, strong profit margins, efficient capital deployment, and so on.

That said, there are particular facets to the rail industry that require additional scrutiny.

The operating ratio is a major measure of profitability in the railroad industry. This is the company's operating expenses as a percentage of revenue. (In fact, it's the opposite of operating margin, which uses operating income divided by revenues.)

An operating ratio of 80 or lower has generally been seen as good but having a target as low as the mid-70s is even better.

Top-Line Growth

Investors should also keep an eye on the composition of a railroad's top-line growth. Volume growth is fairly straightforward, but pricing can tell investors something about a management's strategic approach.

Some railroads have turned to long-term contracts as a strategy for surviving downturns more easily, but those contracts can come back to haunt the company during recoveries by leaving them locked into lower prices.

Ongoing capital expenditure needs also are a major consideration with railroads. It takes a lot of money to maintain thousands of miles of rail, as well as the freight-handling infrastructure and locomotives. As a result, railroads do not often stack up well in terms of their conversion of revenue into free cash flow.

The Duopoly Advantage

That said, investors should remember that these companies enjoy virtual duopolies in their markets and have lower effective costs of capital than many investors realize.

In other words, railroads must continue to spend large amounts of money on infrastructure, but a dollar spent on railroad infrastructure has historically offered a more certain (and lower-risk) return than a dollar spent on infrastructure in other industries.

Issues and Hazards for the Rail Investor

Here are some of the issues that a rail investor should be aware of:

  • Fuel Costs. Fuel can make up 20% of a railroad's operating expenses. While the fuel efficiency of rails gives them an edge versus trucks, in periods of rising prices, companies are not always able to fully hedge their costs or offset the risks with surcharges.
  • Labor Costs. Compensation and benefits comprise more than a third of operating costs for some railroads. The industry is heavily unionized.
  • Capital Demands. Railroads have very high capital requirements and access to cost-effective capital is essential to their operations.
  • The Business Food Chain. As service providers, railroads do not create economic activity, but thrive or wither on the basis of it. If economic activity is sluggish, there is little or nothing that a railroad can do to stimulate demand or capture market share.
  • Cyclicality. Demand for rail services is a byproduct of economic activity, making railroads a cyclical business. While that means investors can always look forward to an eventual second chance to buy quality railroad operators, it limits their viability as long-term buy-and-hold positions.
  • Harder to Value. Due to their high ongoing capital expenditure requirements, railroads seldom look appealing by conventional discounted cash flow models. Investors can work around this by using lower discount rates to acknowledge the duopoly position of rail operators. Or, they can use or less rigorous methods like price/book, EV/EBITDA, and price-to-earnings.

Why Railroads Matter

No widget, computer, grain, or automobile is worth a dime if it cannot be moved from the warehouse to the customer.

As the preeminent provider of freight transport in North America, railroads are an essential part of the economic infrastructure and very much an investable industry. Though there are quirks and drawbacks to these stocks, well-timed purchases can be worthwhile.