Susquehanna: railroads must grow volumes and FCF to maintain rich valuations

This week, Class 1 railroads will begin reporting their third quarter earnings, beginning with CSX’s (NASDAQ: CSX) call on Tuesday, October 16, after markets close. Ahead of those calls, Susquehanna Financial Group’s transport equities analyst Bascome Majors published an optimistic Q3 preview note anticipating beats across the industry.

A wave of cost-cutting has swept across the railroad sector, inspired by Hunter Harrison’s spectacular results at Canadian National (NYSE: CNI), Canadian Pacific (NYSE: CP), and CSX. Operating ratios have been driven down in every railroad, including Kansas City Southern (NYSE: KSU), which has resisted Precision Scheduled Railroading but still managed to lower its OR from 69.9% in 2012 to an estimated 64.4% by the end of this year. With that has come deteriorating service metrics, including train velocity and dwell time, for most railroads except CSX. KSU, in particular, has had trouble managing cross-border traffic at Laredo, and dwell times are up 20.6% year over year.

In Susquehanna’s view, railroads are approaching the limit to what can be accomplished through “‘Harrison-light’ operating principles,” and further growth in the value of railroads’ stock will be on the back on increased volumes and improved free cash flow (due to tax cuts and the winding down of the Positive Train Control investment cycle). 

“Looking beyond the quarter (and this week’s steep selloff in rails), we’re starting to see some parallels to the peak rail environment of 4Q14 where rail stocks reached a multi-year apex in price and valuation, though we don’t yet view today’s backdrop as extreme as late 2014’s,” Majors wrote. “Against this backdrop, we believe the rails need to continue to deliver solid volume and productivity growth to ‘work’ into 2019.”

The trouble is that the drive toward greater operating efficiencies has made railroad companies’ stock far more valuable, in terms of P/E ratio, than they have traded at historically. Majors wrote that one downside risk is that the end of 2018 resembles in some ways ‘peak rail’ in the fourth quarter of 2014, after which U.S. rail stocks entered a long slide, reaching the bottom of the trough in early 2016 at multiples of 12.5-14.5x. By contrast, Majors set aggressive new price targets for CSX, Norfolk Southern (NYSE: NSC), and Union Pacific (NYSE: UNP) at multiples of 18x, 19.5x, and 19.5x, respectively. Majors set CSX’s price target at $84, representing a 19.6% upside from where the stock closed last Friday, NSC at a price target of $203, representing a 19.27% upside from its previous close, and UNP at $179, representing a 17.26% upside from its close last Friday.

On Norfolk Southern, Majors wrote, “We believe this elevated P/E multiple is cyclically and structurally supported into 2018, given NSC’s region-leading volume growth vs. Eastern competitor CSX and sustainably improving free cash flow. To this point, our targeted FCF yield is a discount to NSC’s historical valuation vs. cash flow. Downside risk to our price target could be driven by slower than expected efficiency gains if volume growth slows network fluidity and hurts incremental margins as catch-up resources are added, or a deceleration in overall rail freight demand.”

Norfolk Southern’s appetite for increased intermodal volumes may have contributed to the higher multiple Susquehanna thinks the stock should trade at: after growing intermodal revenue by 10.6% from 2016 to 2017, NSC doubled-down and grew intermodal revenue by 18.3% from 2017 to 2018, according to Susquehanna’s estimates. Contrast that to CSX’s more modest intermodal revenue growth in the same period (4.2% and 7.4%), CEO Jim Foote’s stated reluctance to take on more intermodal freight, and CSX’s sub-80% on-time rate for intermodal delivery. In fact, last week CSX announced it will cut 230 more domestic intermodal pairs as of January 3, 2019. 

Still, CSX is Majors’ favorite rail stock, because he believes that the process of rationalizing railroad’s complicated, congested network—the result of consolidating nine separate railroads—is still in “middle innings.” Seaport Global’s Kevin Sterling, on the other hand, said he likes Canadian Pacific best in an October 5 note, because it’s the second-cheapest Class 1 stock after KSU, trading at 17.7x Seaport’s 2019 forecast versus Canadian National at 18.5x. Sterling thinks that CP isn’t finished optimizing and can pull its OR down to the high 50s by 2020. 

Investors have been impressed with what North American railroads have achieved in the 21st century in terms of efficiency and profitability; railroads went from moribund, bloated legacy businesses to achieving the best operating margins in the global transportation industry. We wonder, though, what the next steps will be. Will a return to ambitious volume growth come at the expense of OR? Will years of declining capex finally come home to roost in the form of increased accidents, infrastructure decay, and service levels dropping past what customers can tolerate? Finally, how will softening spot rates in the truckload sector—widely forecast for next year—affect railroads’ ability to grow volumes, especially if freight demand falls off? 

In the next year or two, we should start see how railroad executives, investors, regulators, and customers strike the balance, and we’ll begin to get a sense of what the first true post-Harrison strategy for adding value to railroads looks like.