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The railroad industry was one of the worst-hit corners of the stock market throughout 2015. Railroads stocks have suffered from a number of stiff headwinds all year, including weak commodity prices and the strong U.S. dollar.
What made it worse was that railroads cater heavily to the coal industry. Coal has been brought to the brink this year and is dragging down railroads along with it.
Two of the major railroad stocks, Norfolk Southern Corp. (NYSE: NSC) and CSX Corp. (NYSE: CSX), are down 18% and 30%, respectively, this year. There may be reasons for investors to consider the railroad stocks, for those investors who don’t mind bottom-fishing in a troubled industry. But in order to do so, investors need to be able to stomach some risk.
Consolidation on the Way?
When cyclical industries enter downturns, it is not uncommon to see a wave of consolidation. Bigger corporations try to buy smaller competitors to scoop up market share, with the added benefit of bargain-bin prices.
This was the rationale for Canadian Pacific Railway (NYSE: CP) making a play for Norfolk Southern. Canadian Pacific has come through with two separate bids, and both have been rejected by Norfolk Southern. The latest offer is for $32.86 in cash and 0.451 shares in the combined company that would own both railroads.
The new offer gives less cash than the initial offer of $46.72 per share, but more stock than last month’s offer of 0.348 shares in the combined company. Norfolk Southern shareholders would own 47% of the new company under the latest offer, up from 41% initially.
But Norfolk Southern insists the new offer is still too low, and that the decreased amount of cash in the updated offer actually makes the takeover riskier.
Reasons to Be Optimistic
Other than the potential for mergers and acquisitions, investors should determine whether they are bullish on the long-term potential of railroads in North America. That is the most important fundamental factor that will fuel the future for railroads like Norfolk Southern and CSX.
To be sure, railroad stocks are fairly cheap. Norfolk Southern and CSX trade for 15 times and 12 times next year’s earnings estimates, respectively. Those are discounted valuations as compared to the S&P 500.
And railroad stocks offer decent dividend yields. Norfolk Southern yields 2.75%, while CSX pays a 2.9% yield.
Of course, investors should keep in mind that cheap stocks are often cheap for a reason. Both Norfolk Southern and CSX are struggling with weak volumes and falling earnings, due in large part to the downturn in the coal industry.
Coal revenue accounts for 18% of Norfolk Southern’s quarterly revenue. Its coal railway revenue fell 23% last quarter for Norfolk Southern.
CSX is even more heavily exposed to coal than Norfolk Southern, and its fundamentals have suffered more as a result. Coal is actually CSX’s biggest individual product by revenue. Coal sales declined 19% last quarter, year-over-year.
With no clear recovery in sight for coal, these problems may linger well into 2016. As a result, consolidation might be the best play for investors next year.
Norfolk Southern’s fundamentals have held up relatively well in comparison to its peer group. And it could receive an even more generous takeout offer from Canadian Pacific. That means Norfolk Southern looks to be the best pick in the group.
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