The Railroad Week in Review:
Week Ending July 17, 1999

Recall WIR got its start five years ago as a forum for commentary on investing in railroads. To be sure one aspect was and is how to evaluate railroad industry stocks for inclusion in a private portfolio. A deeper more intense aim is to enable owners of small railroads to benchmark their own performance with the publicly traded companies.

If the past five years’ experience is any measure, the small railroad owners who have performed well as measured by the broader market are well regarded by their customers and their connecting class 1 lines. Doing the comparison is neither difficult nor time-consuming. Just go to www.rblanchard.com and click on “Industry Spotlight.”

The first duty of any railroad owner or stockholder is to understand the target company’s financial posture and prospects, with emphasis on the latter. Peter Lynch, in his classic One Up on Wall Street (1989, Penguin Books), says matter-of-factly “there are five basic ways a company can increase earnings: raise prices, reduce costs, expand into new markets, sell more of its product in old markets, or … dispose of a losing operation.” The goal of these actions is naturally to improve your company’s prospects.

One of the main tools for measuring prospects is the price/earnings (PE) ratio - the current share price divided by either trailing or estimated forward earnings per share (eps). The generally accepted rule is the higher the PE the more investors are willing to pay for future growth. How much one should pay for future growth is a matter for debate, but there are guidelines.

Dividing the forward PE by the growth rate provides an indicator of a current stock price compared to its potential for appreciation. One of my favorites, RailTex (Nasdaq: RTEX), trades at 10 times current earnings against a five-year forward growth estimate of 13%. If the PE matches the growth rate then the stock is said to be at “fair value,” so in this case RTEX has room to grow. Just how much room can be determined by the PEG ratio: the current PE divided by the forward growth rate. In this case the PEG ratio for RTEX is 0.76.

The rule is that a PEG of 0.50 or less is a strong buy, and anything between there and 1.00 merits further consideration. If the PEG falls between 1.00 and 1.50 it’s fully valued and bears watching lest the price get too dear, in which case it may be a clue to take the money and run. And if the PEG is above 1.50 - and you’re not already in the equity - it may be time to short the stock.

Now what about Norfolk’s announcement that earnings will fall short of estimates? The firm says it will earn 18-22 cents a share for the quarter just ending against the consensus estimate of 33 cents. NSC earned 48 cents in 2Q98, so a 20-cent middle-ground estimate puts earnings down 58%. The consensus is around 35 cents for 3Q99, off 11% from last year, and for the year Street estimates are for $1.42, off 18% from the 1998 figure.

NSC closed the week at $30 1/16 so the PE on 1999 estimates is 21.2. Since the growth rate for 1999 is a negative and Norfolk’s past performance would lead a rational reader to conclude this is an aberration, what about the eps growth rate for 2000? The consensus calls for $2.02, up 40% from the current FY estimate and the five-year estimate is for 11.3% growth. Do the math: the present PE of 21.2 divided by the forward growth rate of 11.3 yields a PEG ratio of 1.87, meaning the stock may be overpriced at $30.

Archrival CSX (NYSE: CSX) expects to earn 46 cents this quarter, off 46% from last year, and $2.45 for the year, up 22.6% from last year’s dismal performance driven largely by its SeaLand unit. For the week CSX closed at $48 15/16 for a 1999 estimate PE of 20.0. The FY 2000 eps estimate calls for $3.55, up 45% and the five-year growth rate is 14%. Do the same math and the five-year PEG is 1.43, right at the top of the “full value” range.

Readers who wish to delve more deeply into stock evaluation could be well served by visiting www.quicken.com. Just punch in a ticker symbol and get a thumbnail of the current valuation plus links to several useful tools down the left side of the screen. My favorite is the stock evaluator, now in beta test. Across the top are six measures with their own screens: Growth trends, financial health, management performance, market multiples, intrinsic value, and summary.

The Intrinsic Value screen is essentially another PEG measure, being “a hypothetical value that is based on the sum of a company's future earnings.” The most striking feature of this screen is the graphic comparison of the latest stock price with its intrinsic value. Of the major rails, only Burlington Northern Santa Fe (NYSE: BNI) comes up with a stock price less than intrinsic value. Running the PEG numbers on this week’s close ($32 3/8) we get 13.4/14.0 = 0.96, approaching full value.

In like manner running the small railroad holding companies through the same screens shows most to be trading at less than Quicken’s intrinsic value and having PEGs in the 0.50 to 1.00 range. Some would caution that trading volumes less than a $million a day mark shares that are too thinly traded to move much. However, looking at trading volume in terms of daily average volume traded as a percent of total capitalization yields a different story.

The four major US rails all have market caps in excess of $10 billion and have average daily trading volumes amounting to two or three tenths of a percent of total capitalization. Among four smaller rail companies the range is from 0.237% (RTEX) to 2.07% (Wisconsin Central, Nasdaq: WCLX). Of course, the liquidity question is also a function of sheer number of shares traded every day and the number of transactions involved. Where the class 1s are trading upwards of half a million shares a day it’s relatively easy to find buyers and sellers. But when you’re only talking 22,000 shares a day (again RTEX) it’s a different matter.

So, to sum up, a bad quarter does not necessarily kill a company but it does mean investors should be prepared to do some homework. And shortline managers would do well to determine the cash flow effects of class 1 railroad traffic changes on their own railroad’s prospects. The tools are there and the 15 minutes or so needed to run the numbers and reflect on Peter Lynch’s growth principles will be time well spent.

--Roy Blanchard

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