The transportation sector of the United States economy is comprised of nine industrial groups. One particular group moves more volume of tonnage based on ton miles than any other form of transportation – Railroads. In accordance with the Federal Department of Transportation, railroads move 39.5% of all freight in the US (based on ton miles which is the length freight travels). It’s a $60 Billion industry with over 140,000 miles of track. It is dominated by seven major carriers (referred to as Class I Railways). They are:
- Union Pacific
- BNSF (100% owned by Berkshire Hathaway)
- CSX Transportation
- Norfolk Southern
- Canadian National
- Kansas City Southern
- Soo Line Railroad
There is a close eighth, but it is classified as a Class II railroad. It is a holding company called Genesee and Wyoming Inc. which holds over 100 short line railroads in its portfolio.
Of the seven Class I Railways, six are currently publicly traded. BNSF is a wholly owned subsidiary of Berkshire Hathaway (I think Warren Buffett knows something here).
Another interesting aspect of this article deals with Genesee. As of today’s date, 10/08/19, Genesee & Wyoming have an offer from Brookfield Infrastructure Partners awaiting federal approval. Brookfield’s offer is $112 per share and today’s trading price is $110 per share and has held steady since the offer was made in early July. Prior to the offer, the stock was trading at $97 per share. For the purposes of this article, I will compare six of the Class I Railways and Genesee since it has many of the attributes of the six above and prior to the offer, Genesee had a market capitalization of nearly $6 Billion.
This article is designed to educate the reader in understanding the core business ratios used by this industry and to identify a standard bearer, a particular stock (railroad company) that can act as the standard to measure others against.
My Public Notice of Non Investment
The purpose of this article is two-fold, one to create a standard and second to create a buy/sell decision model and update the results quarterly over the next year to evaluate whether business ratios and other input criteria that is publicly available can increase wealth under the value investment concept. As identified in my book, Value Investing with Business Ratios, I want to illustrate how to apply the knowledge to a unique set of parameters. In this case, freight transportation companies, specifically Class I Railways. In order to prove my theory, I must first demonstrate that I created a model, built a decision tree, updated my analysis and made buy/sell examples based on my analysis. Thus, there will be a history recorded to this site to vouch my system. This way no can challenge that I did this after the fact. Once posted, I will not change this post even for grammar/spelling issues, thus the system will track the date to the posting date.
In addition, since I am only discussing highly traded stocks, it is unlikely that my analytical input will sway the market values of the particular investments. Thus, even if I did own the investment (neither I nor any family member – well it is possible my older brother owns some railroad stock in his retirement portfolio, a managed portfolio by the way – have money invested in these stocks), it is unlikely I would gain economically from this analytical write-up.
In effect, I gain nothing from this article or series other than the advertising revenue generated from you reading this article on this website, approximately .2 cents per view.
I chose railway companies for several reasons:
- Highly stable industry,
- Limited participants for comparison purposes,
- Each company limits its revenue stream to transportation (there are some alternative sources of revenue but they are less than 5% of their entire total revenue),
- Easy to apply the ratio formulas to their respective data,
- All of the companies are profitable and have positive cash flow.
As explained in my book, the primary value for comparison purposes is the Price to Book ratio. Why is this particular ratio so important? Simply put, this ratio represents the downside risk for the investor. The closer the book value of a stock investment is to the market value of the stock, the less likely the investor will lose money. After all, worse case scenario is the company closes up shop and the investor gets back the book value of his investment. This single ratio sets the floor for the investment. The greater the difference between the market price and the floor price, the more the investor can lose with the investment. Thus, the primary measurement is the Price to Book ratio. Given this, let’s start out with identifying the book values of each of the above six Class I Railways and Genesee.
Book value is simply the entire stockholder’s equity divided by the number of shares. The equity comes from the current balance sheet, which for most of these investments is the 2nd quarter of 2019. Here are the results:
. Name Record Date Shareholder’s Equity # of Shares Book Value
Union Pacific 06/30/19 $18.17B 725 Million $25.06/Share
CSX Transportation 06/30/19 $12.28B 798 Million $15.39/Share
Norfolk Southern 06/30/19 $15.31B 263 Million $58.21/Share
Canadian National 06/30/19 $17.98B 725 Million $24.80/Share
Kansas City Southern 06/30/19 $4.83B 101 Million $47.82/Share
Soo Line (Canadian Pacific) 06/30/19 $7.16B 140 Million $51.14/Share
Genesee & Wyoming 06/30/19 $3.49B 57 Million $61.23/Share
This is going to change come next week when the third quarter reports and presented to the public (3rd Quarter Reports Ending Sept. 30, 2019). But that will merely update the book values per share for most if not all of the railway companies. I expect the deviation from the current value to be insignificant (< 3% change).
Price to Book Ratio
This step is easy, you simply divide the share price in the market by the book value for a ratio or number of times the book value can be divided into the current market price. The lower the value, the better for the investor as it means that a greater percentage of the market price is covered by the book value. In effect, the lower the downside risk for the investment. More importantly, if the particular railroad company has good business ratios or leads in a few of them, the greater the upside potential as buyers of stock are interested in performance. More on this later. For now, let’s look at the price to book ratio and see which company has the lowest downside risk or floor related to price an investor will pay for the stock.
. Name Record Date Share Price Book Value Price/Book Book as a % of Price
Union Pacific 10/09/19 3 PM EST $153.59 $25.06/Share 6.13 16.32%
CSX Transportation 06/30/19 3 PM EST $66.35 $15.39/Share 4.31 23.20%
Norfolk Southern 06/30/19 3 PM EST $169.29 $58.21/Share 2.91 34.38%
Canadian National 06/30/19 3 PM EST $84.80 $24.80/Share 3.41 29.25%
Kansas City Southern 06/30/19 3 PM EST $128.93 $47.82/Share 2.67 37.09%
Soo Line (Canadian Pacific) 06/30/19 3 PM EST $210.90 $51.14/Share 4.12 24.25%
Genesee & Wyoming 06/30/19 3 PM EST $110.46 $61.23/Share 1.80 55.43%
Take note that Genesee & Wyoming sets the standard for this value within this group. How so? Let’s think this through. Above I mentioned that Brookfield Infrastructure Partners offered $112 per share, cash, to take the company private. This means that Brookfield sees a lot of positives with Genesee to own them. Prior to the offer, Genesee was trading at around $97 per share, which means the Price/Book was 1.58 or as a percentage of price, 63.12%. Thus, for the purpose of the price to book ratio, any time the ratio goes below 2.0 or is tending towards 2.0, the company looks enticing to buy. Thus, within the six publicly traded Class I Railways, Norfolk Southern and Kansas City Southern look impressive. The downside risk is low for these two investments.
As the price to book gets closer to 1:1, the more likely the stock is a good buy. This is predicated on the five assumptions above not changing, i.e. the company remains profitable, good cash flow and no pending lawsuits that will change the value of the stock by more than 3%. Think of PG&E’s reserve of $11 Billion for the fire they started in California in late 2018.
But with a buy/sell investment decision, it takes more than just the price to book ratio to determine what is an ideal investment. Of course the buyer must set buy and sell points in order to acquire true value from the investment over the long term. To determine good potential investments, the value investor must first find the standard bearer and good standards to gauge the other investments against. Therefore, we need to evaluate the companies based on more than just one or two ratios. In my book I explain that no investor should use less than 12 ratios in their decision model. But you must select the best 12 or more ratios of the 21 ratios out there. To do this, let’s talk about the basic financial principles that exist for railroad companies.
One aspect of all railroad companies is normal, there is a large investment in the underlying physical assets for a company to operate. Everything from rail lines, rights to tracks, locomotives and cars are essential in transporting freight. As the assets age, they must be maintained or replaced. Thus, the net fixed assets should increase from one period to the next over the long run. Therefore, ratios that tell us about fixed assets are important. The two best are the fixed assets turnover rate (activity ratio) and return on assets (performance ratio). Let’s illustrate this by looking at a simplistic balance sheet for Union Pacific and analyze the information. This is Union’s simplified version of their balance sheet on 06/30/19:
. Current $4.086 Billion
. Fixed 55.191 Billion
. Other (Includes Investments) 2.431 Billion
. Total Assets $61.708 Billion
. Current $5.665 Billion
. Long-Term Debt/Liabilities 37.872 Billion
. Sub-Total Liabilities 43.537 Billion
Equity 18.171 Billion
Total Liabilities and Equity $61.708 Billion
For legal purposes, this link takes you to their actual 10-K filing with the Securities and Exchange Commission.
First, notice the strong fixed asset position for this railway company. Its 89.44% of all assets. In general, this is very high as a percentage, very few types of industries have higher fixed asset percentages. Many real estate companies carry between 85 and 95 percent fixed assets as a percentage of total assets. Therefore, 89% is very strong.
The fixed assets turnover rate basically tells the reader how often the company earns a dollar for every dollar of fixed asset investment. The higher the ratio, the more the company uses the assets to generate sales. For Union Pacific, year-to-date sales as of 06/30/19 from freight hauling is $10.246 Billion. The last half of 2018, sales from freight were $10.945 Billion for a total of $21.191 Billion over the last year from freight hauling. Thus the fixed assets turnover rate for Union Pacific equals:
Fixed Assets Turnover = Sales from Freight = $21.191 Billion = .384
. Fixed Assets $55.191 Billion
The return on assets is similar, except it utilizes all assets and all sales in its formula. For Union Pacific, total sales for the prior 12 months ending 06/30/19 was approximately $22.168 Billion. Therefore, the total assets turnover rate equals .359.
Utilization of fixed assets and all assets to sales ties indirectly to the ability to generate a gross profit from sales.
Another ratio that carries a lot of weight in the overall formula is the gross profit percentage of revenue. Basically, you want to know how well the company can control direct costs of production of revenue. The higher the gross profit percentage, the better the performance. Let’s take a look at all seven and their respective results:
. Name Record Date Gross Profit Percentage
Union Pacific 12/31/18 41.78%
CSX Transportation 12/31/18 38.70%
Norfolk Southern 12/31/18 34.55%
Canadian National 12/31/18 44.89%
Kansas City Southern 12/31/18 35.19%
Soo Line (Canadian Pacific) 12/31/18 39.99%
Genesee & Wyoming 12/31/18 23.25%
The best within this group is Canadian National at 44.89%. The worse is the one that is getting purchased outright by Brookfield at 23.25%. With this dispersion, it makes you wonder how it is possible to have such a wide array of costs. The answer is simple, everyone assumes that every company within their respective industry defines costs the same way. In reality, they may not. A good example is your management within production. Some companies classify them as costs while others will classify them as administration. Although this is good ratio to utilize, it should be absorb in context with the operational profit margin (Pre-Tax Margin). Now, let’s take a closer look if we include the operational profit margin (gross profit less general/administrative costs, commonly referred to as overhead).
. Name Record Date Gross Profit Percentage Operational Profit Percentage
Union Pacific 12/31/18 41.78% 33.90%
CSX Transportation 12/31/18 38.70% 35.13%
Norfolk Southern 12/31/18 34.55% 30.28%
Canadian National 12/31/18 44.89% 39.68%
Kansas City Southern 12/31/18 35.19% 32.23%
Soo Line (Canadian Pacific) 12/31/18 39.99% 35.37%
Genesee & Wyoming 12/31/18 23.25% 13.58%
Notice how the operational profit margin brings the companies closer together in terms of performance (with the exception of Genesee)? Naturally, Canadian National is very good and is the standard for both gross profit percentage and operational profit percentage.
All of you should be asking, ‘Why is Genesee performing so poorly?’ Unlike the other railway companies, Genesee is a holding company. It owns over 100 short-line railroad companies, thus if you look at their balance sheet, you will find over $2 Billion in intangible assets (goodwill, purchase rights etc.). I would need to get into the details, but my gut feeling is that the amortization of these intangibles is included in the cost of goods sold thus driving down the profit percentage and the overall operational profit percentage. Amortization in 2018 was $57,000,000 and if excluded from costs, the gross profit margin as a percentage of revenue would have increased to 25.7%. For now, we’ll just note that Genesee is under performing related to controlling costs of operations.
Compiling Data/Setting Limits
As an accountant I have learned to give the greatest credence of value to the gross profit percentage than the other profit points over any other measurement. Without profit, all other aspects of the financial information have little to no value because a company not making a profit will go out of business soon (insolvency first, then bankruptcy). Secondly, after profit points, cash flow is important. Of the cash flow ratios, the operational cash flow per share is essential to ensuring success. Cash from investments and financing can mislead the reader into believing there is positive cash flow when in reality the company could just be borrowing money.
The balance sheet ratios focus on fixed and total assets turnover rates along with understanding the debt ratio. The other ratios are not as essential in the decision model and are weighted very low for value.
Below is a table of the respective ratios and their corresponding results. I also provide a PDF of this with the following link.
If the ratio is highlighted in yellow, it means that particular company is performing well related to that respective ratio.
The following summation for each company explains the results and how to understand them in the aggregate.
Union Pacific – Considered the ‘Granddaddy’ of all the railway companies, Union Pacific’s revenues are almost a third of the entire industry’s revenue (Class I Railways). Naturally, there is safety in numbers and Union is a safe investment. Thus, the high price to book ratio. If you look at the ratios, Union either leads or is in the top 3 with all the value points except for the debt ratio. This merely means they are using more debt (leverage) to finance assets. Given their size, Union is an excellent comparative for any investor to use when making decisions.
CSX – The company has one serious flaw, look at the cash flow per share. I dug into the details, CSX repurchased $4.6 Billion worth of shares in 2018. In effect they bought back about 9% of all the stock. They did this by borrowing $3 Billion thus the high debt ratio reported. Cash flow from operations was $4.6 billion, about $5.92 per share, still not impressive, but stable. No single value point stands out, thus CSX is not a standard in my opinion. It is still a safe bet if one wants to just buy and hold the investment for many years. But my goal is to find a couple of railways that can provide some trigger points to buy and then to sell to make gains, i.e. safe value triggers.
Norfolk Southern – With an attractive price to book, Norfolk Southern looks enticing, however, the low net profit percentage raises a red flag. Thus one needs to dig into why the cash flow per share is so high. Upon reviewing the cash flows statement, I discover that in 2018, Norfolk Southern did buy back $2.7 Billion of stock. However, cash flow per share from operations remains lucrative at $13.29 per share. The company spent almost $2 Billion for capital improvements and had depreciation of $1.1 Billion, so the company is investing for the future. This investment looks like there could be opportunities in the future and I believe the trigger points will occur with more frequency with this particular company.
Canadian National – If there is a standard to compare against, this is the company. Note how all three profit points are the best within the entire table. It then begs the question, why is cash flow so low per share. I looked at the cash flow statement and the company generated over $5.9 Billion from operations. The company spent $3.5 Billion on new fixed assets and they too repurchased stock by spending $1.9 Billion. Notice the price to cash flow ratio is the best within all the companies at $10.57. This makes this stock very attractive from a buyer’s perspective. Given all this, I’m surprised the price to book isn’t closer to four or higher. I suspect this particular stock will have few if any long-term or significant reduction in market price over the next year.
Kansas City Southern – This company is attractive due to the price to book at such a low value. The reader can see why though, with a net profit margin of only 22.8%, Kansas City Southern seems to not be able to compete with the other Class I Railways. As I dig into the details, I will focus on why they lack control over their costs or if there is a cost driver that they solely bear in comparison to the other companies. I would think that the stock price has greater volatility given the profit points involved. Thus, this particular investment is the one to pay attention to related to stock price.
Canadian Pacific – I love the cash flow per share, but the market price per share dampens the price to cash flow ratio. This particular company looks lackluster as an investment opportunity. However, I’m sure I’ll learn more about how companies make their money as I dig into the details and it will assist me understanding how the other railway companies leverage their respective assets.
Based on the results, Canadian National is my standard and I’ll ignore Union Pacific as an investment opportunity unless it hits its trigger. I doubt it will because of Union’s stability. In my schedule, I’m going to start out with trigger points to buy at 90% of the current market price and then sell at 96% of this current market price. I believe over time that I will raise the trigger points to take advantage of opportunities. For now, I’ve set some very low points for each company. I have to be patient during the upcoming year to buy and then sell the stock based on my trigger points. As I dig into the details about the respective entities, I’ll update my trigger points so that I can get more opportunities to buy and sell.
Remember, this is all based on my thinking of how value investing should work. With each successive article, I’ll update my analysis and continue to develop trigger points. This article is the first in a series as I develop a deep knowledge about the railway industry and acquire a deep understanding of value for this respective industry. Act on Knowledge.
1st in a Series, Written Oct 9 – 11, 2019; posted on 10/11/19
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