Meet the Best U.S. Railroad Stock

U.S. railroads are oligopolies -- a handful of companies in control of an entire industry that's tough for new rivals to crack. This strength helps oligopolies crank out steady, solid returns for their investors. But while all four main U.S. railroads enjoy this general advantage, one in particular seems to stand taller than the rest.

Railroads 101
CSX (NYSE: CSX), Norfolk Southern (NYSE: NSC) and Union Pacific (NYSE: UNP) represent the railroad industry's publicly traded players, while their rival Burlington Northern is part of Warren Buffett's Berkshire Hathaway.

All these railroads require a sound balance sheet, strong cash flows, good margins, and heavy capital expenditures.

Versus peers, Union Pacific combines categorically better balance sheet returns and margins on less debt. Cash flow is outstanding.

Let's review a handful of fundamental metrics that help better understand this rail carrier's strength:

Debt-to-Equity Ratio: Building and repairing tracks, engines, and railcars doesn't come cheap, so railroads require a lot of debt to finance heavy capital expenditures. Union Pacific has a far lower debt-to-equity ratio than its peers.

Return-on-Equity and Return-on-Assets: Given railroads' limited competition, investors want to know which companies most efficiently generate income relative to owner's equity and total assets. Union Pacific management provides investors with superior RoE and RoA.

Return-on-Capital Employed: Rail carriers invest enormous amounts of capital into new and existing business: track, engines, cars and land. UP offers shareholders better RoCE versus peers.

Margins: Operating and Net Margins compare how effectively each company's management controls its operating and overall expenses. Unions Pacific leads the pack.

Free Cash Flow / Share: Cash is king. Railroad investors focus upon free cash flow to evaluate how much actual cash is left over after expenses and capital expenditures. Union Pacific generates outstanding FCF.

UP has an added advantage of being the primary rail operator for the western two-thirds of the United States. This provides unique access to transport oil and oil equipment to-and-from the most prolific energy-producing regions of the country. It also gives Union Pacific unrivaled access as a U.S.-to-Mexico freight carrier. The company controls six interchange points along the Mexican border; it participates substantially in cross-border rail traffic.

When compared with peers CSX Corporation and Norfolk Southern Corp, Union Pacific Corp offers differentiated strength. UP rail lines are geographically situated to take particular advantage of growing freight volumes of cross-border automobiles, mid-west agriculture, and mid-continent oil and industrial goods.

The table below summarizes the discussion:

Valuation metrics
Union Pacific certainly appears to be a sound railroad enterprise when compared to its peers. But it is a good investment? Let's review several basic valuation metrics in order to make an informed judgement.

UP has a trailing-12-month price-to-earnings ratio of 16.8, which is nearly spot-on its 10-year normalized multiple. Railroad peers have a higher five-year average P/E ratio of 18.5. Union Pacific's price-to-cash flow ratio is 11.9, versus the peer group average of 12.4.

On both counts, UP trades at lower multiples of earnings and cash flow than its rivals. The shares appear fairly valued.

Railroad stock investors also seek strong and consistent earnings trends. Union Pacific's operating earnings have grown 16% a year over the past 10 years. Looking forward, Wall Street analysts forecast Union Pacific will grow operating EPS at an average 15% rate for the next three years. Now that's consistent earnings growth!

Union Pacific senior management has a history of creating shareholder value. Stockholders have been rewarded with steady cash dividend growth and stock repurchase plans. UP leadership has a long record of building equity and growing dividends, as the following 10-year graph shows:

Target price
Last week, Union Pacific reported better-than-expected third quarter operating earnings of $2.48. Fiscal 2013 EPS is now projected to come in about $9.40. Using that base, let's back down Street consensus earning growth to 15% in 2014, and only 13% in 2015. Then let's assume a price-to-earnings multiple of 16.5 -- the 10-year normalized average.

Placing that P/E ratio on projected 2014 and 2015 EPS of $10.81 and $12.22, we obtain a 12- to 24-month fair value target price of $178 to $202 per share.

Compared to the recent trading price of $152, that indicates a potential share uplift of 17% to 33%. When the approximate 2% dividend is added, investors may find these shares worthy of consideration.

In conclusion...
To me, Union Pacific looks like the best U.S. railroad stock. UP will have a continued edge as long as the mid-continent oil/chemical transportation business keeps growing, and cross-border durable goods shipments keep rising. Continued company leadership in returns, margins and cash flows should will also signal clear track ahead. Barring a general North American recession, there are few obstacles that could derail this carrier.

The article Meet the Best U.S. Railroad Stock originally appeared on

Raymond Merola is long UNP shares. Please do your own careful due diligence before making any investment. The Motley Fool owns shares of CSX. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.