The iShares Transportation ETF (IYT) has traded with a poor tone in recent sessions, and the price action is catching attention. IYT extended over its May high on July 18th, but the rally has not been sustained. Many in the trade see the transport sector as an indicator of not only the economy’s health, but the condition of the overall equity market.
The potential breakdown in the transport sector prompted an examination of the rail sector, as Union Pacific (UNP), Kansas City Southern (KSU), and Norfolk Southern (NSC) are three of the six largest holdings of the IYT ETF with an approximate weighting of 27.5%. The table following displays a sampling of rail names with a focus on Q2 results relative to expectations and the movement in earnings per share estimates over the past 7 days.
Q2 earnings results varied:
The results for the industry were mixed in Q2. CSX (CSX) posted the strongest positive EPS surprise, while Canadian Pacific (CP) recorded the largest negative earnings surprise. Genesee and Wyoming (GWR) reports earnings on August 1st. Three companies beat forecast, while two fell short not providing great bullish momentum for the sector.
Analyst reactions to the results and economic trends have been uneven, and this may have taken some wind out of the transport sector. As the table displays, three 2103 EPS estimates have been raised for CSX over the past seven days, but 2014 EPS estimate revisions have been mixed with one up and one down. UNP saw six estimate revisions upward and five estimate revisions downward for 2013, but a stronger seven up to one down ratio for 2014. KSU has posited positive looking agreement with five estimates up and two estimates down for 2013 and four estimates up and two estimates down for 2014. It is difficult to read much form CP, GWR, and NSC where estimate changes have been limited.
Valuation close to average:
The valuation of the sector is unexciting with the forward PE ratio of CSX and NSC trading at a slight discount to the 10 year median, but UNP, KSU, and CP trading at a premium to their 10 year median.
The PEG Ratio, the PE ratio relative to earnings per share growth, shows CP as the most attractive. It is trading at a discount to growth and low relative to its history. CSX and KSU are trading at a discount, while GWR and UNP are at a premium to the longer term median range.
Looking at cash flow, it is more difficult to draw a conclusion. The table indicates that CSX, UNP, and NSC have strong enough and consistent enough free cash flow to generate a price to free cash flow ratio. This may be a sign of financial stability, but expansion and future growth opportunities may distort the usefulness of the metric.
Sales growth varies by operator:
The sector faces modest sales growth into 2014 with KSU, GWR, and UNP projected to have the strongest growth rates. NSC and CSX have the highest dividend yields and a payout which is competitive with the 10 year treasury. The companies are expected to produce earnings per share growth which is strong compared to sales growth in most cases. The market is probably more focused on earnings than sales for the sector.
Fundamental trends lack a major bullish catalyst – at this juncture:
The backdrop for the industry is constructive, but lacks great excitement. There are some themes running through the industry:
1) Weak grain shipments have been a drag on the industry, but KSU expected improvement in Q4 2013 due larger crops and harvest. On a more positive note for KSU, there is a build out of capacity to handle the shipment of oil from the Bakken and Canada to facilities in Texas.
2) In its press release, UNP’s CEO made the following statement: "As we move into the second half of the year, the economic outlook remains uncertain, but we're hopeful that we'll see some economic improvement in the months ahead… ”. The comments suggest economic conditions are a headwind to vibrant profit growth.
3) UNP noted weak international Intermodal volumes in Q2, but was positive on autos, chemicals, shale production, and housing in the second half. Housing seems less constructive given recent price action in home building stocks. International intermodal was expected to improve, but the peak season was expected to be muted. UNP expected continued success in converting highway business for Domestic Intermodal.
4) On coal, NSC saw continued sluggish demand in Europe for export met, metallurgical, coal demand and slowing shipments into Asia. Shipments to Asia were also hurt by a weaker Australian dollar and lower benchmark met coal price settlements. The thermal coal export market was being adversely impacted by the weak API 2 index in Northern Europe. NSC saw headwinds to export volumes through the rest of the year with softer third and fourth quarters than the first half of 2013.
5) CSX indicated that the outlook for Q3 was favorable for 72% of its volume with support from the oil and gas markets, light vehicle production, Ag and fertilizer traffic, and waste and equipment markets. 17% of volume was expected to be negative with coal, both domestic and export, contracting.
6) In the week ending July 20th, the U.S. rail traffic was down 0.3% y/y with total carloads off 3.0% and intermodal up 2.8%. Petroleum and products were the main driver of growth rising 28.0% y/y. Motor vehicle and coal were down 7.6% y/y and 8.2% y/y respectively providing drag.
7) CP maintained its outlook for 40% earnings per share growth and projected revenues up in the high single digits. It also seems focused on cost reduction.
Conclusions:
All the names examined are Zacks Rank #3 (Hold). Sifting through the stocks, CSX may be attractive for value focused investors given its PEG ratio, price to cash flow, and dividend yield. Its slow relative sales growth for 2013 explains the discounted valuation. Those looking for stronger sales growth and the chance to exploit the shipment of oil by rail may like KSU. Although the PEG ratio is at a discount to its median, the forward PE ratio is pricing a healthy growth outlook and the PEG ratio is above 1.0. CP may be the surprise given its low PEG ratio and expectations for solid earnings growth in 2013 and 2014.
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