Railroads' Q2 Powered by Volume Growth: 4 Solid Picks

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Stocks in the railroad space are being aided by the upturn in the U.S. economy. A robust domestic economy leads to more goods being transported across the country.

The market is expected to continue its winning streak banking on a rise in wages and more confident consumers. Moreover, the new tax law (Tax Cuts and Jobs Act) should boost profits further and drive stock prices of the participants of this key sector higher.

The robust financial health of railroads is reflective of the improved scenario as far as its players are concerned. The rebound has been aided by the much-improved scenario pertaining to the intermodal unit, a key revenue generating sector for railroads.

The sector has bounced back after a disappointing 2016. Intermodal revenues are likely to grow this year as well. In fact, intermodal shipments are expected to expand  4.2% in 2018 , strengthening the top line for railroads in turn. Improvement pertaining to another key metric - operating ratio (operating expenses as a percentage of revenues) - is another positive for railroads.

Railroads Flourish in Q2

Given this bullish backdrop, it is no wonder that railroads fared very well in the second quarter of 2018. Key sector players like Union Pacific Corporation UNP , CSX Corporation CSX , Norfolk Southern Corporation NSC , Canadian Pacific Railway Limited CP and Genesee & Wyoming Inc. GWR have not only outperformed, but also registered year-over-year growth in earnings per share and revenues.

Volume growth aided results. For instance, overall volume growth at Norfolk Southern and Kansas City Southern KSU were 6% and 1%, respectively. Strong growth in freight revenues, on the back of robust freight demand and favorable pricing are added tailwinds.  For instance, freight revenues increased 8% at Union Pacific.

Efforts of railroads to check costs boosted their bottom lines further. Improvement in operating ratio was another positive. For instance, Norfolk Southern's operating ratio in the second quarter of 2018 came in at 64.6% compared with 66.3% in the second quarter of 2017. The lesser the value of operating ratio the better, as it implies that more cash is available to the company to reward shareholders through dividends/buybacks.

Dividend Hikes Reflect Financial Prosperity

Financial prosperity of railroads is reflected by the fact that they indulge in shareholder-friendly (dividends/buybacks). Recently, railroad heavyweights Norfolk Southern and Union Pacific hiked their respective dividend payouts. Late last month, Norfolk Southern's board of directors approved a hike in its quarterly dividend by 11% to 80 cents a share (annualized $3.20). The first instalment of the new dividend will be paid on Sep 10, to its shareholders of record on Aug 6. This is the second dividend hike by the company this year. In the first quarter, the company had hiked its dividend by 18% to 72 cents a share. Combining the latest hike, the company has increased its dividend by 29% so far this year.

Union Pacific too announced a dividend hike late last month. The company's board cleared a 10% hike in its quarterly dividend payout to 80 cents per share (annualized $3.20 per share). The first instalment of the hiked dividend will be paid on Sep 28, 2018, to shareholders as of Aug 31. This is the third dividend hike announced by the company since November 2017.

A further increase in shareholder-friendly activities by railroads is likely in the wake of the massive savings prompted by the new tax law. Due to the significant reduction in their tax bills, more cash is expected to remain in the hands of these companies to fund their capital expenditures, acquisitions and share repurchases among others.

Good Run Should Continue

We expect railroads to perform well going forward too on the back of solid freight demand, volume growth, improving operating ratio and reduced taxes. For instance, Kansas City Southern expects volume growth to accelerate in the latter half of 2018 and full-year 2019, backed by a strong economy and network capacity investments.

Moreover, the fact that operating ratio will improve in future can be made out from Norfolk Southern's guidance on the metric. The company aims to achieve an operating ratio of below 65% by 2020 or even earlier.

Apart from the bullish scenario pertaining to the intermodal segment, a rebound in the coal-related scenario bodes well for railroads. It is a well-documented fact that the fortunes of railroads are tied to coal since the latter is an important revenue-generating commodity for the sector.

President Trump's pro-coal attitude is a huge positive for the sector. Prospects of the coal industry have brightened because of Donald Trump's pro-coal stance, whereby he has promised to relax emissions rules.

Zacks Industry Rank Supports Favorable Scenario

The Zacks Industry Rank of 20 (out of 250 plus groups) carried by the Zacks Rail industry further highlights the attractiveness of railroads. The favorable rank places the companies in the top 8% of the Zacks industries.

We put our entire 250-plus industries into two groups: the top half (i.e., industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the last 10 years, using a one week rebalance, the top half beat the bottom half by a factor of more than 2 to 1.

Click here to know more:  About Zacks Industry Rank

4 Railroad Picks

In view of the tailwinds mentioned above, we believe that it is prudent to add railroad stocks to one's portfolio now. However, with multiple companies present, the task of selecting the right ones for handsome returns is not an easy one. In fact, identifying a winning stock is akin to searching for a needle in a haystack for an investor, in the absence of proper guidance.

This is where the Zacks Rank, which justifies a company's strong fundamentals, can come in really handy. Markedly, the Zacks Rank is a reliable tool that helps investors to trade with confidence regardless of their trading style and risk tolerance. To learn more about how you can use this proven system for market-beating gains, visit   Zacks Rank Education .

Based on a favorable Zacks Rank (#1 or 2), we have zeroed in on four railroad stocks that should be present in one's portfolio for handsome returns.

Based in Omaha, NE,  Union Pacific Corporation  provides rail transportation services across 23 states in the United States. This Zacks Rank #2 (Buy) stock has gained 47% in a year's time. The Zacks Consensus Estimate for the current-year EPS has been revised 2% upward over the last 60 days.

Canadian National Railway Company  CNI is engaged in the rail and related transportation business. This Zacks Rank #2 stock has gained 12% in a year's time. The Zacks Consensus Estimate for the current-year EPS has been revised 2% upward over the last 60 days.

CSX Corporation  provides rail-based transportation services. This Zacks Rank #1 (Strong Buy) stock has gained 45.5% in a year's time. The Zacks Consensus Estimate for the current-year EPS has been revised 8.9% upward over the last 60 days. You can see  the complete list of today's Zacks #1 Rank stocks here.

Norfolk Southern , based in Norfolk, VA, is primarily engaged in the rail transportation of raw material, intermediate products and finished goods. This Zacks Rank #2 stock has gained 49.6% in a year's time. The Zacks Consensus Estimate for the current-year EPS has been revised 4.4% upward over the last 60 days.

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Kansas City Southern (KSU): Free Stock Analysis Report

CSX Corporation (CSX): Free Stock Analysis Report

Union Pacific Corporation (UNP): Free Stock Analysis Report

Canadian National Railway Company (CNI): Free Stock Analysis Report

Norfolk Southern Corporation (NSC): Free Stock Analysis Report

Canadian Pacific Railway Limited (CP): Free Stock Analysis Report

Genesee & Wyoming, Inc. (GWR): Free Stock Analysis Report

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Zacks Investment Research

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing , Business , Stocks
Referenced Symbols: KSU , CSX , UNP , CNI , NSC

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