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The big news in the railroad industry is the potential for consolidation.
Canadian Pacific (NYSE: CP) has shown interest in buying competitor Norfolk Southern (NYSE: NSC). Norfolk has rebuffed Canadian Pacific’s advances, citing regulatory worries about the deal getting done. However, Canadian Pacific has now made three offers. It could get more aggressive with a hostile bid.
Now, we’ve talked about railroad consolidation and the good that it can bring. In particular, it could help hedge the fall in coal and oil prices from further pressuring rail operators. Teaming up, via consolidation, could help lower costs and increase efficiencies.
The railroad industry is interesting. As I’ve spoken about in the past, Warren Buffett is a big believer in the industry. The major railroaders also offer enticing dividends. Take Union Pacific (NYSE: UNP), the largest railroad operator. It pays a 3% dividend yield and has upped its payout for 35 years.
But there are a number of hurdles here. Railroad consolidation will be a tough sell for regulators.
Back in the 1990s, there were a number of mergers that ultimately led to a less efficient rail system. Rail companies shrank from close to 60 in the early 1990s to just seven by 2001. With that, there was a spike in derailments and lost cargo. That led to stricter rules when it came to mergers.
The Canadian Pacific-Norfolk deal would be the first to test these new laws. If that deal is going to get done, however, it would likely spur further deals. Warren Buffett’s BNSF Railway has said that it would be interested in making an acquisitions if the Canadian Pacific-Norfolk deal deal gets done. The natural target there would be Kansas City Southern (NYSE: KSU). Part of the reasoning is because its sub-$10 billion market cap makes it exempt from the new rules.
Still, investing in rails on the hope of big-time consolidation is a fool’s game. Seventy percent of shippers surveyed by Cowen & Co. said they would oppose a Canadian Pacific-Norfolk deal. But Canadian Pacific has Hunter Harrison at the helm, who has called out Norfolk for its poor operational performance. As well, Canadian Pacific has activist investor Bill Ackman as a major shareholder, and he supports the idea of railroad consolidation.
However, there’s a broader way to play the rails, without having to gamble on consolidation.
The Best Rail Play
The best railroad play right now could be rail product and servicing companies.
Instead of investing in railroad operators, investors can take some of the risk out of owning rails by investing in railroad servicers and product makers. These are the companies that service the major railroads and will benefit from an upcoming upgrade in rail equipment.
Trinity Industries (NYSE: TRN) is one of the top makers of railcars. It also has businesses in metal container making and construction products. The big driver for Trinity will be a cyclical recovery in the economy.
It has a strong backlog of work that should keep it busy. Its backlog is over $6.25 billion, which is 55,000 railcars, with orders expanding into 2020. Its operating margins are still strong despite the apparent weakness in demand for containers that ship oil.
One overhang for the company has been a lawsuit against its guardrail unit. Clarity and resolution on that issue in 2016 should help generate interest in the company and relieve uncertainty.
Trinity still has a double-digit return on invested capital and is one of the cheapest railroad servicers in the market. It trades at less than 6 times next year’s earnings. It’s also offers a solid 2% dividend yield and has paid a dividend for 28 years.
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