The diversified transportation sector, which includes airline companies, railroads, truckers and shippers, to name a few, recovered in the last quarter of 2017 after struggling for most of the year. An improving U.S. economy, substantial surge in manufactured and retail goods, and a sharp rebound in a number of end markets are expected to fuel growth of the transportation sector. Of the various means of the U.S. transport, freight railroad is an integral one.
Railroads Prosper Due to Multiple Tailwinds
The robust financial health of railroads bears testimony to the fact that the scenario has improved considerably for players in the sector, after being battered by coal-related headwinds for the last few years.
In fact, the primary reason behind the turnaround in fortunes of this key industry can be attributed to an improvement in the coal-related scenario. This is because coal is considered a key revenue-generating commodity for railroads.
Moreover, prospects of the coal industry have brightened because of President Donald Trump’s pro-coal stance, wherein he has promised to relax emissions rules. Higher price of natural gas and improvement of coal prices in global market have also given a boost to the demand for this key commodity. As the fortunes of most railroad operators depend on coal, any positive development related to this commodity augurs well for railroads.
Improvement in intermodal volumes is also a positive for railroads. In fact, according to the Intermodal Association of North America, intermodal volumes registered the highest growth rate in the third quarter of 2017. Moreover, efforts of railroads to drive bottom-line growth through cost-cutting measures raise optimism in stocks from this space.
Growth-Induced Polices
Trump’s proposed policy changes have made the overall economic outlook fairly bullish. The two pro-growth agendas of Trump, namely, significant cut in corporate tax and deregulation are major catalysts to the U.S. economy.
The proposal to reduce corporate taxes from the current 35% to 20% is likely to bring corporate tax rate at its historic low in 78 years. A large part of transporters book much of their revenues in the homeland. Therefore, a significant reduction in corporate tax rate faced by transporters would be immediately accretive to cash flow. Moreover, the tax proposal offers to provide incentives to companies to repatriate accumulated profits from overseas with an even lower tax rate.
Capital-Intensive Nature of Rail Transportation
Transportation stocks, mainly railroads, invest significantly in capital expenditure as the industry is capital-intensive in nature. In the current scenario, capital expenditures cannot be tax-deducted in the year they are incurred. Consequently, U.S. rail operators need to plan judiciously regarding their capital expenditure. However, companies will be able to deduct their capital expenditures from the taxable income immediately, per the U.S. tax overhaul. Naturally, this aspect hugely favors freight rail transports.
As and when the companies are able to reduce capital expenses in the year of their occurrence, their tax bills for the year would be lowered significantly due to higher deductions. This in fact will leave more cash in the hands of these companies to fund their capital expenditures, acquisitions and share repurchases among others.
Effect on Transportation Sector
A thriving and improving economy also supports the overall bullishness of the transport sector, as it implies that more goods are being transported across the United States. Improved global growth prospects and sustained business and consumer confidence have in turn helped the transport sector recover from the sluggishness in 2017 to quite an extent. Easily available credit also strengthens the situation.
Momentum to Continue
In fact, improvement in the prospects of key units like coal and intermodal has been benefiting railroads since the beginning of this year. The rise in natural gas prices will also boost demand for coal. Moreover, per the U.S. Energy Information Administration (EIA), coal production in the United States will increase in 2018. Apart from coal, the scenario pertaining to another key source of revenues for transporters is intermodal, which has improved by leaps and bounds this year. In fact, intermodal shipments are expected to grow 4.2% in 2018.
Stabilization of commodity prices has helped reignite investors faith in the transportation sector with the improvement in the economic conditions. Railroads should continue to witness an improvement pertaining to another key metric – operating ratio (operating expenses as a percentage of revenues) in 2018. The lesser the value of operating ratio, the better, as it implies that more cash is available to the company to reward shareholders through hike in dividends or share buybacks.
Rail Transport Industry Carries Strong Zacks Rank
The Rail Transportation industry is currently in a great position from the Zacks Industry Rank perspective. The industry is currently in the top 16% (41 out of 256) of the Zacks Categorized industries, suggesting that it is well-positioned. Historically, the top 50% of the Zacks Ranked Industries outperforms the bottom 50% by a factor of more than 2 to 1.
Our Choice
At this stage, we believe investors should choose stocks which carry a favourable Zacks Rank to cash in on future growth opportunities. Taking these factors into consideration, we present five stocks with a Zacks Rank #2 (Buy) for investors to consider. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
These stocks also promise strong long-term growth with solid dividend yield.
Union Pacific Corp. UNP provides rail transportation services across 23 states in the United States through its principal operating company, Union Pacific Railroad Company. As the largest railroad in North America, Union Pacific connects the Pacific and Gulf Coast ports with the Midwest and eastern United States gateways. The company also connects with Canada's rail systems and is the only railroad, serving all the six major gateways to Mexico. Union Pacific has a long-term (three-five years) EPS growth estimate of 10.67% and a dividend yield of 1.96%.
CSX Corp. CSX is a premier transportation company. The company provides rail, intermodal, and rail-to-truck transport services and solutions to customers across a wide array of markets, including energy, industrial, construction, agricultural and consumer products. CSX has a long-term (three-five years) EPS growth estimate of 13.33% and a dividend yield of 1.40%.
Norfolk Southern Corp. NSC controls a major freight railroad, Norfolk Southern Railway Company. The company is primarily engaged in rail transportation of raw material, intermediate products and finished goods, primarily in Southeast, East and Midwest United States and, via interchange with rail carriers to and from the rest of country. Norfolk Southern has a long-term (three-five years) EPS growth estimate of 12% and a dividend yield of 1.61%.
Kansas City Southern KSU is a transportation holding company that has railroad investments in the United States, Mexico and Panama. Its primary U.S. holding is Kansas City Southern Railway Company (KCSR), serving central and south central United States. Kansas City Southern has a long-term (three-five years) EPS growth estimate of 13% and a dividend yield of 1.27%.
Genesee & Wyoming Inc. GWR owns and operates short line and regional freight railroads and provides related rail services. The company operates in three business segments in two geographic areas: North America Railroad Operations, Australian Railroad Operations, and Industrial Switching. Genesee & Wyoming has a long-term (three-five years) EPS growth estimate of 8.93%.
Solid Charts
The chart below shows that all the above-mentioned stocks have performed well in the last three months.
Bottom Line
The U.S. economy is gathering steam. With the overall economy back on track, things are looking up for the transportation sector as well. We believe that this key sector (one of the 16 Zacks sectors) is likely to end 2018 on a triumphant note. At this stage, we believe that these five stocks, with a favourable Zacks Rank are poised to capitalize on the growing opportunities.
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