It may be time to board the train again. Cargo: railroad stocks. Direction of travel: upward.
After several years of operational snafus and financial disappointments triggered by botched mergers, railroads are starting to put some of their worst problems behind them. Operations are starting to smooth out.
Meanwhile, the stocks remain cheap. The recent disclosure that financier Carl Icahn intends to acquire up to 15 percent of Eastern railroad CSX highlights what some portfolio managers see as a buying opportunity and puts pressure on railroad management to continue the turnaround.
“I think we have seen the worst of the rail-merger integration woes, and earnings should start to improve noticeably and with that investor interest should start to improve also,” says Gregory Sawers, director of research at Sanford C. Bernstein, which owns large positions in CSX and other major railroads. He adds: “There is a good turnaround about to unfold.”
Some investors were disappointed when the U.S. Court of Appeals ruled on July 14 that federal regulators were justified when they imposed a 15-month moratorium on rail mergers in March. It was hoped that lifting the embargo would lead to the acquisition of one or both of the major Eastern railroads at perhaps significant premiums to currently depressed stock prices.
Of course, the last time investors rode the train, they were in for an ugly derailment. Union Pacific, the nation’s largest railroad, stumbled badly after acquiring Southern Pacific Rail, and the freight congestion and service breakdowns that followed hobbled the railroad for nearly two years. Despite extensive preparations, CSX and Norfolk Southern also encountered major integration problems in breaking up Conrail last year.
For investors, the bottom line has been brutal. Since July 1997, the Standard & Poor’s Rail Index, which consists of the major U.S. railroads, fell 42 percent, while the S&P 500-stock index soared 52 percent. Railroad stocks have recovered some lost ground recently: Since late March, the S&P Rail Index is down 1 percent, compared with a 5 percent decline for the S&P 500.
“The rail industry in consolidating over the last five years has essentially done nothing but stub one toe after the other,” says Tony Maramarco, portfolio manager at David L. Babson, Cambridge, Mass., and manager of the Babson Value Fund. “And because it has taken so long to get the benefits of consolidation, investors have just given up on them.”
Investors still have plenty of excuses to stay on the platform. Surging fuel prices, a jump in labor costs and rising interest rates could keep a lid on the railroad stock prices.
Others still see logic in a case for a stronger rail industry in the future. Record on-time performance being posted by Burlington Northern Santa Fe and Canadian National Railway is attracting more customers and enhancing financial results. If the entire railroad industry could demonstrate sustained service reliability, the railroads would have a better chance of hauling more of the truck freight that goes on the highway. That would tap an opportunity that lies waiting due to a shortage of truck drivers and even worse fuel pressures for truckers.
For some investors, the most compelling case for the rail stocks is their price. How cheap are they? One way to look at the railroads is that their earnings growth rate easily matches or exceeds their current price/earnings ratios, which are at 10 times or less estimated 2001 per-share earnings, says Michael Lloyd, an analyst at Deutsche Banc Alex. Brown.
That ratio is less than half the market multiple for the S&P 500, which is about 22 times estimated 2001 earnings. In addition, stocks such as CSX and Norfolk Southern now offer annual yields of better than 5 percent, or quadruple that of the S&P 500, Lloyd says.
And for some, Icahn’s recent interest in CSX underscores the potential upside in rail stocks. “When people take a look at Icahn’s track record, who wouldn’t want to jump on the bandwagon?” says David L. Babson’s Maramarco.
Icahn’s record was established before his recent celebrated investment in Nabisco Group Holdings. On June 25, Nabisco agreed to be sold to R.J. Reynolds Tobacco Holdings for $30 a share, or $9.8 billion, valuing Icahn’s stake at $930 million and giving him a profit of $589 million.
In the 1980s, Icahn bought significant equity stakes in industrial companies and then put pressure on entrenched management to take action to boost shareholder value. His forays included stalking the likes of USX and Phillips Petroleum.
His signature deal came in the late 1980s, when he accumulated a large stake in Texaco after it started bankruptcy-law proceedings following a $10 billion judgment in favor of Pennzoil over Texaco’s acquisition of Getty Oil. Icahn put pressure on Texaco to settle the suit for $3 billion, and Texaco stock moved sharply higher, helped partly by higher oil prices. Icahn sold his 17.3 percent stake in 1989 for $2.07 billion, turning a pretax profit of about $600 million. Of course, Icahn has had his disasters, notably his stewardship of TWA, which eventually ended in a bankruptcy filing.
Icahn is tight-lipped about his intentions with CSX, saying he makes filings for government approval under the Hart-Scott-Rodino Act for lots of companies. “Just because we file, that doesn’t mean we’re going to be activists in that situation,” Icahn said in an interview. Until Icahn gets Hart-Scott-Rodino approval, his stake in CSX will be less than $15 million.
For its part, CSX amended its poison-pill anti-takeover plan to set a lower threshold at which a purchase beyond 10 percent becomes prohibitively expensive. Meanwhile, CSX plans to continue its strategy: improve operations, get through the fall shipping peak smoothly and then go after the costs the company has incurred to implement the Conrail merger.
Lloyd of Deutsche Banc Alex. Brown upgraded CSX to a “buy” because of improvement in weekly operations data, whereby CSX’s total car count — a measure of railroad congestion — is below 260,000 for the first time since Oct. 8, 1999. In addition, he expects CSX earnings to more than double during the next couple of years.
Stocks of most of the rail group are selling at 60 percent discounts to the S&P 500 price/earnings ratio, which is unprecedented, he says.
As service levels continue to improve, better-than-expected earnings growth could boost all of the stocks.
But others say that any turnaround is likely to develop over time and will require investor patience. Scott Flower, an analyst at Salomon Smith Barney, says he expects railroad stocks to produce annual returns of 15 percent to 20 percent over a multi-year period.
“Selectively, there is value to be had in these franchises,” Flower says. “But these are not dot-coms, and instant gratification is not the name of the game.”
