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The U.S. railroads have fallen on hard times. In the past two years, the steep decline in commodity prices and the strengthening U.S. dollar have weighed on volumes and earnings across the industry. In addition, the collapse in the coal market has been an additional headwind.
This has caused two railroad industry stocks, Norfolk Southern (NYSE: NSC) and CSX Corp. (NYSE: CSX), to decline 30% and 25%, respectively, over the past year.
In times like these, when growth slows down across an entire industry, consolidation typically follows. The railroads are no different – in November, Canadian Pacific Railway (NYSE: CP) made a $28 billion takeover attempt of Norfolk Southern. More recently, Canadian Pacific CEO Hunter Harrison said CSX would be a good fit as well.
If the industry majors are interested in buying, should investors be interested?
For Whom the Bellwether Tolls
America’s railroads are often seen as bellwethers for the broader economy. This reputation is well-deserved, because the railroads are in charge of transporting various industrial and consumer goods all across the country. In a way, railroads are at the heart of economic activity in the U.S.
Coal is arguably the biggest problem facing the railroad stocks. Many railroads depend heavily on coal for shipment volumes, which is a problem in a world that is increasingly turning to natural gas as a source of power.
Coal is among CSX’s biggest individual product by revenue. Its coal sales declined 38% last year. The good news is that CSX managed to significantly cut costs, which helped earnings grow 4% for the year. CSX has meaningfully reduced its exposure to coal, which now makes up 16% of total revenue.
Norfolk Southern struggled last year as well. Earnings per share declined 20% in 2015, due primarily to a 23% decline in coal revenue. Coal still makes up 17% of Norfolk Southern’s total railway revenue.
Canadian Pacific submitted a shareholder proposal for Norfolk Southern’s annual general meeting, which would call for further discussion between the two companies regarding a merger. A date for the meeting has not been announced, but if Canadian Pacific is once again unsuccessful in bringing Norfolk Southern to the bargaining table, it will likely move on, perhaps to CSX.
But investors need to keep in mind that just because Canadian Pacific has launched bids does not mean a railroad merger is a certainty. Any potential merger between Canadian Pacific and one of its U.S. competitors would instantly result in heightened regulatory risk. It is likely that U.S. regulators would look harshly at a takeover by a Canadian rival. This creates a high hurdle for M&A, which adds another layer of uncertainty.
The Best Bet in Railroads
Given the industry downturn, it’s difficult to see any reason for optimism toward the railroads. But the buy case for the railroads is based on not just potential merger activity, but also their turnaround prospects and attractive valuations.
Railroad stocks are fairly cheap. Norfolk Southern and CSX both trade for 12 times next year’s earnings estimates. Those are discounted valuations compared to the S&P 500.
And railroad stocks offer decent dividend yields. Norfolk Southern yields 3%, while CSX pays a 2.8% yield.
Merger activity is a promising catalyst, but investors should focus on fundamentals. Both Norfolk Southern and CSX are significantly exposed to coal, and their fundamentals are deteriorating as a result. With no clear recovery in sight for coal, neither stock looks like a compelling buy. Consolidation might happen, but it’s far from a certainty given the regulatory risks.
Norfolk Southern has a better chance of being taken over than CSX, since Canadian Pacific has already launched a takeover bid. It also has a higher dividend yield than CSX. As a result, if an investor has to buy a railroad, Norfolk Southern looks to be the best stock pick in the industry.
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