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The news that Canadian Pacific Railway (NYSE: CP) might be looking to take over Norfolk Southern Corp. (NYSE: NSC) has made the usually unsexy railroad industry enticing again.
The buyout of Norfolk would give Canadian Pacific exposure to the East Coast. It would also allow Canadian Pacific to connect its routes around the oil-rich shale and oil sands regions with refiners along Norfolk Southern’s routes.
But despite various rail congestion complaints, the U.S. Surface Transportation Board will likely still push back against this merger. When the UST rejected the Canadian National Railway (NYSE: CNI) and Burlington Northern Santa Fe deal in 2000, it said that a merger would need to improve rail service and not just preserve it.
So there’s still a lot of uncertainty with the rail industry in the near term – namely regulatory hurdles when it comes to consolidating this oligopolistic industry. Hence, Canadian Pacific dropped its buyout pursuit of CSX Corp. (NYSE: CSX) last year.
I’ve talked about railroads in the past, specifically because Warren Buffett has a special appreciation for them. Compared to trucking, rail shipping is less expensive over longer distances.
And it’s no secret that Warren Buffett loves dividend stocks. (Some of the very best can be found right here.)
So let’s forget the merger speculation for a minute. You can still get exposure to these economic bellwethers while collecting some income. And in truth, if you’re going to invest in railroads, there are really only two worth owning:
No. 1 Railroad Income Stock to Own: Union Pacific Corp. (NYSE: UNP)
Union Pacific is the market leader. This company really doesn’t need a merger to keep rewarding shareholders. It’s paying an industry tops 2.6% dividend yield.
Union Pacific has paid a dividend for 35 years and grew its dividend by an annualized 25% for the last three years.
It also has industry-leading returns on invested capital, while also maintaining one of the best balance sheets. Although shares are down 28% year-to-date, the fear might be overblown.
The company does have exposure to declining coal consumption; however, it hauls one of the cheapest-priced coals from the Appalachian region. While cheap natural gas is driving down coal demand, those buying coal will be looking for the cheapest prices, which is a positive for Union Pacific.
Intermodal freight transport, which is an impressive growth angle for rails going forward, makes up 20% of Union Pacific revenues. This segment will benefit from a rising demand for goods in the U.S. Last year, intermodal was the single largest revenue generator for the entire U.S. rail industry.
No. 2 Railroad Income Stock to Own: CSX Corp. (NYSE: CSX)
CSX operates in the same geographical market as Norfolk Southern and has a similar market cap. The two also have similar dividend yields around 3%. However, CSX has paid a dividend for 34 years, versus Norfolk’s 18-year streak.
CSX has grown its dividend by an annualized 9% over the last three years – more than 50% higher than Norfolk’s growth rate.
With the recent selloff, CSX shares are down 25% year-to-date. It’s now trading at 13 times next year’s earnings, which is the cheapest multiple among the major railroad operators.
One of the biggest issues is that CSX generates a lot of revenue from coal. However, the company has been transitioning away from coal. In 2011, it generated close to 32% of its revenue from coal. Today, that number is down to 20%.
CSX also has some geographic advantages over Norfolk, as its routes go a bit further north into New England and south to Florida.
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