Railroad Stock Outlook - December 2015

Weak Coal Spells Doom for Railroads: Turning Point in Sight?

Coal, a major revenue generating source for the railroad industry, has been experiencing soft demand for quite some time now. The downswing in domestic coal shipments has dealt a heavy blow to the railroad industry as is reflected by the 26.9% year-to-date decline in the Dow Jones U.S. Railroads Index.

As per the U.S. Energy Information Administration's (EIA), coal usage has reduced by 10% on an annualized basis, mainly due to a 10% year-over-year fall in electric power sector consumption. As cheaper natural gas continues to replace coal as a source of power production, the demand for coal is on the decline.

In the third quarter of 2015, major railroad operators like CSX Corporation ( CSX ), Norfolk Southern Corp. ( NSC ) and Union Pacific Corporation ( UNP ) faced the brunt of an annual decline in coal volumes of 18%, 16% and 15%, respectively.

As the problem is likely to persist, at least in the near term, the path ahead for railroad operators appears to be a bumpy one. Such apprehensions have been largely reflected by the disappointing outlooks issued by Kansas City Southern ( KSU ) and CSX Corp. Kansas City Southern expects overall revenues to decline in high-single digits in the fourth quarter of 2015 while CSX projects 2015 earnings per share growth at a mere 3% on a year-over-year basis.

Further, the proposed merger between Canadian Pacific Railway Ltd. ( CP ) and Norfolk Southern failed to materialize, owing to regulatory obstacles. The failed transaction seems to have dealt a major blow to the overall U.S. railroad industry as it hinders the construction of an extensive transcontinental network.

However, there are a few positive aspects that can offset the prevailing headwinds in the rail industry. The strength in the intermodal business also holds considerable opportunities which can help mitigate losses arising from the coal sector. Notably, nearly 50% of the U.S. rail intermodal volumes involve imports and exports. Moreover, an improvement in operating ratios and enhancement in infrastructural development will likely act as catalysts for the industry.

Moreover, increased spending on railroad to expand networks and improve tracks will boost productivity and also ensure safety. Accidents caused because of derailments or while transporting highly inflammable substances result in massive losses for rail operators.

In order to minimize the impact of such losses, the National Transportation Safety Board (NSTB) - an independent U.S. federal government agency - has laid out several guidelines. Further, the introduction of several applications to track rail operations is a major positive. Hence, the launch of new technologies and the framing of new guidelines are likely to create a better business environment for the railroad companies.

As per the U.S. Energy Information Administration's (EIA) latest Short-Term Energy Outlook, liquid fuel usage may go up by 1.5% to 19.4 million barrels per day (b/d) in 2015 from 19.11 million b/d in 2014. EIA also expects total consumption of liquid fuel to reach 19.56 million b/d in 2016. The increased fuel usage may result in a turnaround for rail operators. Moreover, EIA projects a 7.2% growth in U.S. crude oil production in 2015 to 9.33 million b/d which will drive crude by oil revenues for the country's railway industry.

It is also to be noted that railroads remain the most effective means of transportation compared to trucking and other modes, in spite of the ongoing development of pipelines across most oil fields, as it connects remote areas effectively and reduces losses arising from spilling.

Zacks Industry Rank

Within the Zacks Industry classification, railroads are broadly grouped within Transportation (one of the 16 Zacks sectors).

We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more, visit: About Zacks Industry Rank .

As a guideline, the outlook for industries with Zacks Industry Rank #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for the railroad industry is currently #99, implying a neutral outlook.

Earnings Trend

Railroads belong to the broader Transportation sector. With all the S&P 500 members in the transportation space having already reported their third-quarter 2015 earnings, the aggregate earnings beat ratio is 85.7%. Revenue beat ratio is much lower at 21.4%. Average earnings growth is 22.5% while year-over-year top-line growth has treaded into the negative territory and stands at -1.3%

(For a detailed look at the earnings outlook for this sector and others, please read our Earnings Trends report.)

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UNION PAC CORP (UNP): Free Stock Analysis Report

KANSAS CITY SOU (KSU): Free Stock Analysis Report

CSX CORP (CSX): Free Stock Analysis Report

CDN PAC RLWY (CP): Free Stock Analysis Report

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

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

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