Which Rail Stock Should You Board? Breaking Down Wells Fargo's Initiations In The Sector

Wells Fargo initiated coverage of rail stocks by issuing an Outperform rating for CSX Corporation CSX, Norfolk Southern Corp. NSC and Canadian Pacific Railway Limited (USA) CP.

The brokerage started Union Pacific Corporation UNP, Canadian National Railway (USA) CNI and Kansas City Southern KSU with a Market Perform rating.

Recovery In Coal Prices

The railroad sector, especially Eastern rails, is set to leverage the impact of a rebound in coal prices after eight-year slump. The higher natural gas prices should benefit utility coal stockpiles and seaborne coal markets.

“We believe the Eastern rails are better positioned to see coal stabilize in 2017 given export coal back in the money, the hit from environmental regulations now largely lapped, and stockpiles in better condition,” Matthew Troy wrote in a note.

In addition, the analyst sees potential upside in intermodal conversion given stabilizing fuel prices, improved service and resurgent consumer demand, albeit at modest levels.

CSX

Analyst Matthew Troy believes CSX should see among the highest leverage from coal price recovery given its unique exposure to export markets in addition to domestic utility coal.

The company should also benefit from a premium valuation after appointing Hunter Harrison as CEO. The valuation range stands at $54 to $56.

Norfolk Southern

Troy believes Norfolk Southern maintains among the greatest potential for operating ratio improvement among the rails over the next several years amid years of network rationalization and cost cutting initiatives by the Eastern rails.

The company’s merchandise businesses should benefit from reaccelerating secular momentum in intermodal and general economic firming. Troy has a valuation range of $135 to $140 on shares.

Canadian Pacific

Troy started coverage of Canadian Pacific with an Outperform rating and a valuation range of $165-$175, as it's now one of the best performing Class I railroads, mainly due to the efforts of Hunter Harrison.

Though the turnaround momentum for CP is set to slow, the company is now an industry leader in terms of margins, returns and FCF conversion.

“Put simply, we believe with recent valuation near 16-17x NTM consensus EPS, CP is not only one of the best run railroads, but it is also among the cheapest. In summary, we believe investors should hop aboard this train as margin momentum is set to continue,” Troy highlighted.

Canadian National

Despite having the best operating ratio in the sector, Troy said that future operational gains for CNI will be harder to come by relative to peers, leaving the company's ability to generate outsized EPS growth more revenue dependent on cyclical upswings in freight demand.

The analyst initiated coverage of Canadian National with a Market Perform rating and valuation range of $70-$74.

Union Pacific

Troy maintains a similar view on Union Pacific, which boasts of a solid return and operating ratio. The analyst rates the stock Market Perform, saying the valuation has become extended versus slowing pricing gains, while the future margin gains will be harder to come by relative to peers. Troy has a valuation range of $105-$115.

Kansas City Southern

Troy’s Market Perform rating on Kansas City Southern is based on the thesis that the company should reaccelerate top line growth above peers, show greater capex discipline and alleviate fears that shifting trade policy will impact its trans-border growth. The analyst has a valuation range of $89-$92.

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