How Much Will Weakness in Coal Affect Railway Stocks?

How Much Will Weakness in Coal Affect Railway Stocks?

Following a previous article on railway companies, new opportunities are appearing for this sector driven by the steady recovery in North America. As you might know already, some businesses are performing very well in the continent and will require more inexpensive and reliable transportation for their products and supplies. Crops are expected to reach record levels in Canada, and the boom of shale oil and gas is pushing demand for railway operators across the region. However, significant drops in coal prices and volume are affecting these companies. Let's see how three railway operators are performing, and their exposure to smaller coal shipments.

Record quarter
First we have Union Pacific, which operates the largest railroad in North America, connecting the Pacific and Gulf coasts with the Midwest and eastern U.S. gateways.

Union Pacific released some its best quarterly numbers ever in its third quarter report, with diluted earnings per share improving 13% and operating revenues totaling $5.6 billion, up 4% year over year. Operating ratio hit a record for the quarter, reaching 64.8%.

One advantage of the company is that it is relatively diversified, presenting lower single commodity risk compared to its peers. In fact, no single commodity group constitutes more than 20% of its business. This flexibility allows less exposure to single product downtrends, and the possibility to streamline its portfolio when opportunities arrive. In fact, the company dealt with disruptions caused by the Colorado flooding, lower grain and coal volumes, and still managed to perform well. Impeccable.

The growth in automotive and industrial segments is helping Union Pacific offset the weakness of its coal business, which accounted for 20.6% of total revenues this quarter. In the near term, growth in revenues should come from automotive, petrochemicals, housing, and grains.

Record quarterly earnings and the best operating ratio
Second, we have Canadian Pacific Railway , a transcontinental operator with direct links to eight major ports, including Vancouver and Montreal.

The third quarter was also very good for this operator, posting record quarterly earnings and its lowest operating ratio in history. Total revenues grew 6% to $1.5 billion and operating ratio improved 820 basis points to 65.9%.

Strategy-wise, Canadian Pacific remains focused on volume expansion, operational efficiency, pricing revision, and capability upgrade. These should drive higher revenues and earnings coming ahead. And let me tell you, profitability is on its way, considering that operating expenses decreased 6% and pricing is 3%-4% up year over year, above inflationary levels.

However, just like with Canadian Pacific, the company is suffering the weak outlook on its coal business, which accounted for 11.5% of total revenues in the quarter. Nonetheless, its industrial and automotive segments are promising and should counterbalance this bad performance. Plus, in order to benefit from the current boom in the energy markets, Canadian Pacific is building its network for shipping frac sand, pipe, and construction material. In fact, capital spending for 2013 was increased by $100 million to cover these investments.

Growing in oil despite coal
Finally, we have Norfolk Southern, which serves every major container port in the eastern United States.

This company's third quarter came with some good news. Operating revenues grew 5% to $2.8 billion, and income reached $849 million, up 16% year over year. The strong results were driven by growth in chemicals, metals/construction, intermodal, and automotive -- not bad.

The booming oil industry is contributing as well, with higher shipments of crude oil, frac sand, plastics and shale-related liquid petroleum gases. In addition, the South Carolina Inland Port project will very likely drive a major conversion of highway shipments from the port of Charleston to Greer, NC for BMW and other customers.

Something remarkable about this operator is its expense management focus, which improved its operating ratio to 69.9% in the quarter. Operating expenses are only 1% higher on a year basis, totaling $2 billion. If the company manages to continue increasing its businesses, while keeping costs contained, profitability could surpass its peers.

However, the lackluster performance of the company's coal segment, which dropped 9% year over year owing to lower average revenue per unit and a 2% decline in volumes, remains a factor of concern.

Final thoughts
Despite the company's diversification and flexibility, Union Pacific still presents high exposure to coal shipments. It will be important to monitor its segment performance in the near term.

Regarding Canadian Pacific, performance will continue to improve. Pay attention to the development of its venture as a transportation service provider for the growing oil industry.

Norfolk Southern is performing well and is on the path to increase its profitability. Decreasing coal shipments will continue to be an issue, but not one for investors to lose sleep over.

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