Last updated: July 30. 2013 10:07AM - 1332 Views

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An improvement in several economic indicators over the past two months suggests that the US economy is back on track. The improvement in almost all economic indicators in the previous month spurred my interest in the transportation sector, a segment heavily dependent on economic activity.

Among the various modes of transportation available, I would focus on the cheapest mode available to the consumers: railroad transportation. The recent warning signs to the largest air freight companies in the US, UPS and FedEx, suggest that despite the economic growth witnessed in the country, manufactures are still opting for the cost efficient means of transportation. For this reason, I have chosen the railroad segment, and within the segment, I have chosen the three largest railroad companies operating in the US.

Union Pacific (NYSE: UNP), CSX (NYSE: CSX) and Norfolk Southern (NYSE: NSC) all experienced a decline in their volumes in the first quarter, primarily driven by lower domestic coal shipments. This reduction in volume resulted in the companies achieving lower than expected bottom line results. All the companies in the rail road business are heavily dependent on the demand for coal both domestically and for export purposes. Revenues attributable to coal transportation for the three companies range between 20%-25% of their total operating revenues. Thus, the future of these companies is highly dependent on the demand and supply of coal in the domestic as well as the international market.

Out of the three peers selected Union Pacific has the largest railroad network, has been able to generate revenues close $21 billion in 2012. The company achieved an annual growth rate in revenues of around 5.15%. The company has also improved its margin drastically over the same period increasing from 11.39% in 2007 to 18.84% in 2012. Union Pacific also had the lowest debt-to-equity ratio among the peers.

CSX and Norfolk Southern each experienced similar growth rates in revenue at around 3.2% over the last 5 years. Out of these two companies, CSX was able to generate greater revenues, at around $11.75 billion in 2012 while Norfolk Southern was able to generate revenues slightly greater than $11 billion.

CSX was able to improve its net margins by around 250 basis points reaching 15.81% in 2012. Norfolk on the other hand has a somewhat stable margins increasing slightly by only 32 basis points in 5 years. However, out of the two companies, Norfolk is operating at a lower debt level, at a debt-to-equity ratio of 0.86 as compared to the 1.01 of CSX.

The use of coal for power generation has increased since 2012, as it replaced natural gas as a source of power generation. Power generation utilizing coal or gas inflicts similar costs. However, a large increase is expected in the price of natural gas as compared to coal. This has resulted in power producers in the US reverting back to generating power from coal. Thus, the demand for coal is expected to remain strong in the future.

CSX’s second quarter earnings report has shown an increase in the number of coal shipments as compared to the previous quarter. As average prices of gas continues to rise, the demand for coal will rise as well. The current coal stock pile report indicates that the current stock levels in the US are below the historic average, in terms of days of burn. Hence, I expect the demand for coal to remain strong for the remaining part of the year, especially in the hotter regions of the country.

The export demand for coal is also expected to remain strong in the coming periods. Coal exports in March set a monthly record, and the EIA expects 2013 to be the third consecutive year to achieve more than 100 MMts of coal exports. China is the largest single export destination for the country’s coal, and the recent slowdown in the Chinese economic growth has impacted the demand for coal. However, the expected turnaround in the Chinese economic growth will certainly ramp up the demand for coal once again. Europe, the second largest region for the country’s coal exports, is also expected to maintain the current level of demand in the long term.

Improving economic indicators, including retail sales, consumer confidence and industrial production, suggest that the reported figures for various railroad transporters are going improve substantially in the coming periods. The recovery of the US economy coupled with a slight growth in US exports means that the outlook for the transportation and logistics industry is highly positive, especially the cheap railroad transportation. The reviving demand for automotive, agricultural and industrial production will certainly improve the company’s revenues and margins, resulting in greater profitability for the investors.

The most recent transportation traffic data released by the Association of American Railroads and Cass Freight Index shows quite an improvement in the last two to three months. This trend is also confirmed by the recent results reported by CSX. The company reported increased revenues along with improved margins and beat the analysts’ estimates. This trend was experienced by all the railroad operators and is expected to continue in the foreseeable future.

As per the analysis of the industry fundamentals, I expect the demand for railroad services to remain strong in the coming years. The demand of coal for domestic power generation and export purposes will drive the industry revenues and earnings higher in the long run.

Among the three peers selected, I expect Union Pacific to outperform its competitors primarily due to its stronger network and a higher demand expected for coal in the western region of the country. The potential for high revenue growth and improving margins along with an attractive dividend yield makes Union Pacific an attractive buy for any investor.

(Editor’s note: Hussain is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.)

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