Railroad earnings and stocks are steaming ahead. The outlook from here is tied to the economy. By Fred W. Frailey, Editor October 24, 2006 The amazing renaissance of railroads continues. Consider this: Canadian National's third-quarter earnings rise 21%. Those of CSX more than double. Union Pacific profits for the quarter climb 14% and Burlington Northern Santa Fe's jump 22%. It's been like this for almost three years now, thanks to pricing power and rising volume -- a winning hand that railroads hadn't held for perhaps a century. Railroad stocks were great buys two years ago. They were good buys a year ago -- as of October 23, Union Pacific shares had risen 64%; BNSF, CN and CSX all about 35%; Kansas City Southern 29%; and Norfolk Southern 22% (versus 17% for Standard Poor's 500-stock index). They were even bargains as recently as August, after a big midyear selloff. The question is whether they are good investments to make now, and on this point expert opinion is divided. No railroad illustrates the railroad renaissance better than Burlington Northern Santa Fe (symbol BNI), which reported quarterly results on October 24. Since the start of 2004, this big western carrier has been on a tear, with blowout earnings gains that typically run 20% to 40%, quarter after quarter. The share price, at $30 three years ago, closed October 24 at $79.35, up $0.35 for the day. BNSF and its western competitor, Union Pacific, benefit from two megatrends. One is the shift of manufacturing from the U.S. to China. Rails traditionally carried raw materials to factories, and trucks the more-lucrative finished products, because the short distances between the shipping docks and store shelves played to the advantage of truckers. But with retailers now largely dependant upon goods arriving from the Far East at West Coast ports, such as Los Angeles and Long Beach, the game is different. Now railroads, with the ability to transport as many as 240 containers for 2,000 miles without having to break up a train, carry a distinct economic advantage. One recent study estimated that 42 such doublestack container trains leave West Coast ports each day for destinations as far away as New Jersey and the Carolinas. That represents almost 10,000 daily units of new business that didn't exist for railroads 20 years ago. The other huge plus is western coal, virtually all of it mined in a remote area of northern Wyoming known as the Powder River Basin. PRB coal is popular with electric utilities because of its low sulphur content, and it's profitable for railroads because of the economies of scale they've achieved -- some 100 coal trains averaging 17,000 tons each leave the Powder River Basin every day. BNSF in particular has been a winning way to play the rail revival. Think of its route map as being two lines converging on Chicago -- one from Seattle-Portland and the other from L.A.-Oakland. In between, and not interfering much with the container-and-trailer, or intermodal, train network, are the coal-distribution lines reaching from Wyoming to the Midwest, Southwest and now entirely new markets in the Northeast and Southeast. BNSF expertly managed the flood of new business and, unlike Union Pacific, managed to keep its transcontinental routes fluid. Chairman Matt Rose says that even with intermodal units up almost 8% this year, "our intermodal customers are getting a better ride than they did a year ago." Meanwhile, says John Lanagan, the railroad's chief marketing officer, BNSF is prepared to run test trains of Powder River coal to eastern utilities, which traditionally sourced their coal from eastern mines. The first new coal-using electric-generation plant is slated to come on line in 2007. Dozens more are in the works. The rub: What would happen to rail stocks if the economy were to slow or even dip into a recession? In the past, business activity fell, and so did railroad profits and stock prices. But that was when rails were cursed with overcapacity and a lack of pricing power -- then, their chief source of new business was that of rival railroads, but at lower and lower rates. Now that the rail network is full and some would-be customers are being turned away, it's not so certain what would happen were the economy to falter. BNSF's Lanagan, told during the post-earnings-release conference call that some trucking companies see their own business levels declining, was asked whether the truckers might take some of their business off his railroad's trains. Replied Lanagan: "Our 2,000-mile length of haul is a natural advantage for western railroads because truckers don't like drivers running that distance over that amount of time." Translated, Lanagan, a former executive at Schneider National, one of the nation's biggest truckers, is saying, "Wanna bet we'll lose much business?" He adds that there's no sign of a letup in rising demand for Powder River coal, and that economic forecaster Global Insight estimates that shipments to the U.S. from China will rise 8% to 9% next year. Still, most analysts are cautious about rail stocks, including that of BNSF. Citigroup's John Kartsonas recommends BNSF but has a 12-month price target of only $85. J.P. Morgan's Thomas Wadewitz believes the ability of BNSF to keep raising rates is waning. Scott Flower of Bank of America says it's too late in the economic cycle to be a buyer of any railroad's stock. Rick Paterson of UBS has a $92 price target on BNSF, but he has only a neutral rating on the stock. So it really comes down to a call on the economy. If you are confident that the current apparent slowdown is merely the pause that refreshes, then BNSF and the other rails are worth a close look. But should you expect a low-growth or no-growth environment, the stocks at best may be fairly valued.