# Railroad Stocks – Analysis 02/15/2020

Every one of the six railroad stocks are at or above their all-time highs. As of today, February 15, 2020, the various stock prices are as follows:

Union Pacific                    \$184.65
Norfolk Southern              \$206.85
Kansas City Southern       \$173.64
CSX                                    \$79.59

In addition, the price to book ratios are also higher than last quarter. The key question for me related to this fund is figuring out if there is value in any of the stocks. To do this, I must fill out a table of various preferred ratios and then explain them in a write-up. This way the reader will understand my reasoning as I write about it further below.

Here is the table.

## Gross Profit Margin

I highlighted in yellow those particular ratios that are the best indicating outstanding performance for the respective row. I place emphasis on two particular ratios.

The first is the value. This is how well a company performs from actual services. Notice that Canadian National has the highest gross profit margin. This means their costs to operate their fleet of trains is 56.23% which is efficient. This is important because the 43.77% margin covers administrative overhead, interest on debt and income taxes. The balance is the net profit. Notice how Canadian National has a high net profit at 28 cents on the dollar. This bodes well for any owner of stock.

Now take a look at the operational profit for Canadian Pacific, notice how their’s is much higher than all the other railroads. Management is stating to readers of financial statements that their administrative overhead is a mere 1.76% on every dollar of revenue. For me, this is difficult to believe. You rarely see administrative costs less than 3% of sales. Therefore, I looked at their income statement and discovered the following. Their SG&A expense is \$137 Million on \$7.8 Billion in revenue. Whereas Canadian National had \$936 Million on \$14.9 Billion (double the sales of Canadian Pacific) in revenue. How can this be? Companies this size should not have 3 times as many administrative personnel or extravagent marketing budgets. How can this be the case? The answer: cost shifting.

Cost shifting means that the particular entity defines certain costs into different pools. It is conceivable that Canadian Pacific defines certain admin costs as costs of production thus having a lower gross profit margin over Canadian National.

The key though is the operational profit margin for the particular investment, what did they earn before taxes, not necessarily gross profit margin. Thus, an investor needs to be careful and monitor margins and make sure they understand how the particular entify defines the respected terms used.

I would imagine many of you are saying, why not just use net profit margin as the best financial ratio. The answer is simple, tax rates for the respective entities are different and lack consistency from year to year. Both Canadian National and Canadian Pacific pay both Canadian and US taxes whereas the other four mostly just pay US taxes. Furthermore, the tax rates change from year to year. As evidence, look at Canaidan Pacific again, it looks like they pay around 8.78% on the dollar of revenue for taxes.

Canadian National paid or deferred \$1.2 Billion on \$14.9 Billion of revenue or 8.05% of sales. Canadian Pacific paid \$706 Million on \$7.8 Billion in revenue or about 9.05%. Thus, taxes do impact the final outcome; not overwhelmly, but enough to make a difference.

## Operational Cash Flow Per Share

The second most important ratio to me is the ability of a company to generate cash from its operations. To compute this, an investor first acquires the operational cash flow per share and compares this to other similar investments. The table above shows a vast discrepancy between the railroad operations. Canadian Pacific generates \$21 per share whereas CSX only generates \$6 per share. How do you compare them? The answer is with the price to cash flow ratio. This compares the share price between the two entities against their respective ability to generate cash per share. The lower the value, the better the ability for the railroad company to generate cash per \$1 of market price per share. Ideal values are below 10 when referring to any of the S&P 500 stocks.  Ten to fifteen are the most common values for the S&P 500. The table reveals that Canadian National with an 11.47 is the best value among the group. Since Union Pacific is often considered the standard bearer for the railroad industry (Union Pacific has a long history of profitability and stable revenues, costs etc.; also it generates the most sales among the railroad investments at just over \$21 Billion), it has a high 15:1 price to cash flow ratio. Yes, I do see that Kansas City has a 15.83 price to cash flow ratio but Kansas City reported an unusual event during 2019 affecting their financial results and of course the corresponding ratios. Thus I defer to Union Pacific for comparison purposes.

Continuing with Union as a comparative, McDonald’s sales are also just over \$21 Billion per year; but because McDonalds has a market capitalization of \$50 Billion more than Union, McDonalds is one of the DOW Jones 30 investments and Union is not.  What is interesting is McDonald’s price to cash flow ratio is just over 18:1. This informs an investor that all of the railroad companies above are good investments even at their current high prices.

But this is about value investing. That model requires us to buy when there is a drop in value, usually anytime there is more than a 9% decrease from a peak price. Buy the stock and simply wait for it to return to the peak price as the history of the railroad investments have shown continuous market value increases over time due to their stability and the respective industry’s position in the transportation sector.

## Results

At this point it is best to evaluate each company in isolation. The next set of articles will explore each one individually and reset the buy and sell points and then we just wait. ACT ON KNOWLEDGE.