In a way, railroads are the backbone of the U.S. economy. A huge amount of goods—across a wide range of industries—are transported through the railways. This is why railroads are seen as an economic “bellwether”.
Railroad stocks have widely underperformed the market so far in 2018. For example, Kansas City Southern (KSU) stock has increased just 1% year-to-date, compared with a 7% gain for the S&P 500 Index this year.
Fears of an economic slowdown and trade jitters have held down the railroad stocks over the course of 2018. But KSU is a strong business, with long-term growth potential. And, the stock appears to be undervalued.
Investors looking to add a railroad stock to their portfolios should consider buying KSU, the top railroad stock today.
Business Overview & Current Events
Kansas City Southern traces its roots back to 1887, when Arthur E. Stilwell and Edward L. Martin incorporated the Kansas City Suburban Belt Railway. Today, KSU has railroad investments in the U.S., Mexico, and Panama. The company has a market capitalization of $11 billion.
Although KSU stock has generated weak returns for shareholders so far this year, the company itself continues to perform well. Business conditions are holding up fairly well, even though escalating trade tensions threaten global economic growth. In the 2018 second quarter, KSU grew revenue by 4% from the same quarter last year. Earnings-per-share grew 16% year-over-year, as the company got a significant boost from tax reform.
KSU’s fundamental strength remains intact. Overall carload volumes increased 1% in the second quarter. Revenue increased in five of its core operating segments, led by a 17% increase in the automotive group and a 14% increase in the company’s Chemicals & Petroleum segment. Coal continues to be a weakness, which resulted in a 20% decline for KSU’s Energy group. However, the Intermodal & Industrial and Consumer segments both grew by 3% for the quarter, while Agriculture & Minerals grew by 1%.
KSU grew earnings-per-share by 12% per year from 2008 through 2017. The company has clearly benefited from global economic growth since the Great Recession ended. Growth has slowed in recent periods, which has dragged down KSU’s revenue growth. However, there is still potential for continued earnings growth in the years ahead. The global economy remains on track, particularly in North America.
For 2018, KSU expects mid-single digit volume growth. The Intermodal and Automotive segments are expected to be the primary drivers of growth. Three major automakers—BMW, Toyota, and Mercedes—are opening new manufacturing plants in Mexico. KSU will play a big role in the transportation of produced vehicles, since its vast network stretches across the North & South as well as along the U.S. and Mexico border.
Investor sentiment has become more negative toward the railroad stocks so far in 2018. Heightened geopolitical risk and fears of slowing economic growth due to potential trade wars have held back the railroad stocks. Despite these fears, KSU continues to generate strong earnings.
KSU is expected to generate earnings-per-share of $6.15 in 2018. This would represent nearly 20% growth for this year. Based on the earnings forecast, the stock is currently trading for a price-to-earnings ratio of 17.2, which is a significant discount from its historical average. In the past 10 years, the stock held an average price-to-earnings ratio of 21. Fair value for the stock could be a price-to-earnings ratio of 19-20, which is more in-line with the company’s earnings growth rate and industry peers.
If KSU shares trade for a price-to-earnings ratio of 19.5, valuation expansion would add 2.5% to shareholder returns over the next five years. In addition, KSU stock pays a 1.3% dividend yield which will also boost returns.
Lastly, the company is expected to grow its earnings by 8%-9% per year over the next five years. This growth rate is attainable, provided the global economy stays out of a deep recession, because KSU has durable competitive advantages. The railroad industry has only a few major operators, without much overlap between their networks.
Railroad stocks have hit the brakes this year, after a prolonged rally in the past several years. This has caused their stock valuations to decline across the industry. However, investors could view the current environment as a buying opportunity, as high-quality railroad operators like KSU still have long-term growth potential.
The combination of valuation changes, dividends, and earnings growth results in total expected returns of over 12% per year. This is a strong expected rate of return for a large-cap stock, which makes KSU the top railroad stock to buy today.
Ben Reynolds is CEO of Sure Dividend. Sure Dividend helps individual investors build high quality dividend growth stock portfolios for the long run.
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