Here's What to Expect From Railroad Stocks in 2020

The investment thesis behind buying railroad stocks got a boost recently with the earnings report from the smallest Class 1 railroad, namely Kansas City Southern (KSU). Let's take a look at what happened, and why investors should be feeling a bit more positive after management's commentary.

The case for buying railroad stocks

There are three main parts to the argument for buying the U.S. listed class 1 railroads, CSX (CSX 0.56%), Union Pacific (UNP 1.04%), Kansas City Southern, and Norfolk Southern (NSC 0.55%). As follows:

• Railroad carloads and revenue are correlated to the industrial economy, so when economic growth returns you can safely assume the railroads will grow revenue, too.
• The major railroads are highly likely to retain their competitive positioning through the COVID-19 pandemic so, again, you can feel confident that investing in any one railroad will be rewarded by an eventual recovery.
• The Class 1 railroads continue to generate operational improvements through adoption of precision scheduled railroading, or PSR, management techniques -- something set to generate improvements in profitability over the long term.

Increasing train length is a key aim of precision scheduled railroading management techniques. Image source: Getty Images.

The first two points are reinforced when looking at Kansas City Southern's revenue by end markets in the first quarter. As you can see below, they pretty much correlate with what was happening in the economy in the first quarter. As an aside, note that the major impact from the measures taken to contain the COVID-19 pandemic started to hit the railroads after the end of the first quarter.

The weakness in automotive production (something subsequently increased by production shutdowns due to the pandemic) was borne out in Kansas City Southern's results. Similarly, the turmoil in energy markets (the slump in the price of oil has led to reductions in carloads for crude and sand for fracking in the U.S.) can also be seen in the results. Nevertheless, the 4% increase in carloads and 8% increase in year-over-year revenue suggests railroads were on a good growth track in the first quarter.

Data source: Kansas City Southern presentations. YOY=year over year. Chart by author.

Clearly, the railroads remain a key bellwether of the economy, and when growth bounces back from the COVID-19 slump they will surely be beneficiaries.

Operational improvements

The third point is what differentiates the railroads from many other stocks to play a recovery. In a nutshell, they are a play on a recovery and an ongoing improvement in underlying profitability from PSR.

PSR is a set of management techniques that emphasizes running trains between two points on a network on a fixed schedule, as opposed to the traditional hub-and-spoke approach. PSR practitioners tend to follow metric-like train velocity, the amount of time a carload spends idle at a terminal location, and train length.

Improving all of these metrics should allow railroads to generate the same amount of revenue by using fewer assets. In addition, railroad operating ratio, or OR, should improve. For reference, the OR is simply operating expenses divided by revenue, so a lower number is better.

After their fourth-quarter earnings reports, CSX, Union Pacific, Norfolk Southern, and Kansas City Southern all predicted OR improvement in 2020. The good news from Kansas City Southern's first quarter is that it reported improvements in all of its key PSR metrics.

The table below outlines the improvements across the board. Furthermore, Kansas City Southern's VP of PSR Sameh Fahmy outlined how the operational improvements were allowing the railroad to reduce the number of locomotives and cars in its fleet. Quoting Fahmy from the earnings call, "We have taken out about 20% of all locomotives. We have taken out about 10% of the cars" since the adoption of PSR until the end of February.

Data source: Kansas City Southern presentations.

Railroad stocks are a good way to play a recovery

To be clear, the railroad's first-quarter numbers are somewhat flattering and not reflective of the carnage that's going to come in the second quarter when the COVID-19 impact will hit the figures. It's definitely going to get worse before it gets better for the railroads. 

Nevertheless, the improvements in PSR metrics are a real and tangible of the underlying improvements the railroads continue to make in profitability. It suggests they can emerge from the COVID-19 pandemic in stronger shape than when they entered it. That's an added plus for anyone looking to invest in a recovery play, and a sector set to benefit from economic growth over the long term.