While the markets seem to only be interested in rising rates
andearnings , an entire sector has gone unnoticed and blown the
doors off themarket .
The Dow Jones U.S. RailroadIndex is surging with a 24%gain
thisyear and has quadrupled since its 2009 low. Besides the
general rebound in theeconomy , crude production is at 20-year
highs, far exceeding pipeline capacity and growth. That means a
massive surge in demand for transportation by rail. An estimated
1.4 million barrels of crude and refined products were
transported by rail every day in the first six months of 2013, an
increase of almost 50% from the first half of 2012.
All signs pointed to another great year in 2013 and the sector
again being a goodinvestment . Then the unthinkable happened:
Just after 1 a.m. on July 6, a freight carrier operated by
Montreal, Maine & Atlantic Railway crashed in the Quebec town
of Lac-Megantic, killing 47 people. Montreal, Maine &
Atlantic filed forbankruptcy a month later.
The catastrophe in Canadawill surely increase scrutiny on the
industry. In addition, anecdotal evidence from Jeffrey Saut,
chief investment strategist at Raymond James, points to an
unbearable rise in insurance premiums for small short-line
"(Recently,) I met theCEO of a short-line railroad located in
the Dakotas. He told me his insurancebroker had just told him
that because of the disaster ... his insurance coverage is going
to have to be increased by afactor of four with an attendant
price increase -- and his railroad doesn't even transport crude
oil! Such an increase in insurance cost will likely cause a
massiveconsolidation for the industry."
Lastly, possible regulatory changes by the U.S. Department of
Transportation, which is said to be working on new policies for
rail tank cars, could be the finalcatalyst for consolidation in
the industry. These events haveput the sector at risk -- but with
risk there is always return.
As Saut speculates, there could be awave of consolidation as
the smaller players get forced to sell to larger operators. These
larger operators should be able to use their scale to negotiate
smaller insurance increases and are better positioned to manage
greater regulatory scrutiny.
Looking through the roughly 550 short-line railroad operators
for good takeover targets is like finding the proverbial needle
in a haystack -- but I think I've found the needle and the
Like the Pieces of a Puzzle, these Two Fit
After itsacquisition of RailAmerica last year,
Genesee & Wyoming (
management has said that it is "comfortable continuing to
actively look at investment opportunities ... inmultiple
geographies." GWR has very little exposure to the New England
area with just one route from New London, Conn., straight up to
Canada. At a recent global transportation conference, the
company's chief financial officer pointed to building regional
rail systems through acquisitions as one of its key growth
Providence & Worcester Railroad Co. (Nasdaq:
, an $88 million short-line freight operator in Massachusetts,
Rhode Island, Connecticut and New York. The company transported
31,727 carloads of freight for 140 customers in 2012 across a
range of commodities.
For prospective buyers, the company canoffer important routes
and connection points from Queens, N.Y., through New England and
up to Canada. Comparing the company's route map with that of GWR
shows a good fit, with PWX providing a coastal transportation
system to complement the Connecticut-to-Canada route.
||Will Genesee & Wyoming make a bid to take over
Providence & Worcester Railroad?
PWX'srevenue was down 7% in 2012 to $29.4 million, with
hauling of chemicals and plasticsaccounting for almost 40% of the
total. Despite the drop in revenue, the company was able to turn
anoperating profit by decreasing itsoperating expenses by
The company has a fairly strongbalance sheet with nolong-term
debt and $98 million in property, equipment and land held for
development. These assets are booked at cost, not replacement
value, and could be a significant prize for a buyer. Best yet,
the company paid off all its $4.9 million in long-term debt last
year, possibly making itself a more attractive target.
Atakeover of PWX by Genesee & Wyoming is far from certain,
but PWX would make an attractive target to other rail operators
as well. An acquisition would add 516 miles of track in a region
with a high density of business. As operatorsconsolidate ,
efficiencies of scale in administration and marketing can be
realized. Theshares trade just abovebook value at 1.2 times, a
steep discount to the peer average of 3 times.
PWX still has room for growth if it isn't acquired. High
operating costs, 92% ofsales relative to an industry average of
75%, have held back profitability. These are mostly due to salary
costs of union contracts and could become more favorable with the
next round ofnegotiations . The massivelayoffs resulting from the
Canadian Pacific strike have set a precedent in the industry, and
the union may be more amenable to negotiate. If the company can
lower its operating expenses down to 82% of sales, still well
above the industry average, it can add another $2.9 million to
thebottom line and boost earnings per share by 82%, to $1.33 per
An uncertain future for an industry with strong
The bankruptcy of Montreal, Maine & Atlantic Railway after
the July crashputs in question service throughout the New England
area with opportunities for mergers to create a strong rail
network. Larger players like GWR could combine assets from
Montreal, Maine & Atlantic with those from PWX to create a
Aside from abuyout or interest from anactivist investor , the
Providence & Worcester Railroad Co. has a strong balance
sheet and the potential to add significant shareholder value
through cost management.
Risks to Consider:
PWX has had a problem with profitability and higher
regulatory or insurance costs could hit the bottom line. While
the company is a goodtakeover target , investors may need to wait
on the shares for a while.
Action to Take -->
Changes in the business costs for short-line railroads, combined
with a strong book of a company assets, makes the Providence
& Worcester Railroad Co. one of the best speculative targets.
Even if an offer was made for twice book value, below the
industry average, investors could realize a 66% return on the
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