Warren Buffet holds approximately 6.5% of his portfolio in Burlington Northern Santa Fe (BNSF), the U.S. biggest railway based on 2006 EBITDA. Bill Gates’ foundation owns a little under 6% of the common shares of Canadian National Railway (CNR). Before the private equity bubble burst, a syndicate of institutions, including Goldman Sachs, contemplated purchasing Canadian Pacific Railways (CPR). Why are all these really rich people and institutions buying up, or contemplating buying, railways? Aren’t railways a relic of a by-gone era?

Not necessarily. The world is a funny place and what goes around comes around and railways are back for several reasons and have become, for some sophisticated investors, a good place to invest. As usual, what is good for some may not be suitable for you so, as per usual, please do your own due diligence before you consider investing in a railway stock.

By railway stock, I am speaking of what the Association of American Railroads classify as U.S. Class I Railroads- these are rail companies with operating revenue equal to or greater than $346.8 million (2006 figures) and include two Canadian railways (CNR and CPR) who, even counting only their U.S. operations, would nevertheless classify as Class I Railroads in and of themselves. In other words, Class I Railroads are the major players in the industry. There are publicly traded stock of smaller railways but I am focusing on the big ones that the Buffet’s and the Gates’ invest in. The Class I Railroads are in order of 2006 EBITDA (expressed in millions):

1. BNSF (NYSE: BNI): $4,625
2. Union Pacific (NYSE: UP): $4,121
3. CNR (TSE: CNR): $3,680
4. Norfolk Southern (NYSE: NSC) $3,318
5. CSX Corp. (NYSE: CSX) $2,837
6. CPR (TSE: CPR) $1,564
7. Kansas City Southern (NYSE: KSU) $459 (KSU is so small, relative to its Class I Railroad counterparts, that it is often excluded when people speak of railway stock)

Why exactly are rich people buying the choo-choo train stocks?

• FEW COMPETITORS, HIGH BARRIERS OF ENTRY = PRICING POWER: Six major railways serve 300 million people in the United States (in practicality five since KSU is so small). Two major railways serve 30 million people in Canada with operations in the U.S. as well. These are not a lot of competitors serving a lot of people and the railways tend to have regional dominance rather than an all out free for all nationally. For example, Norfolk Southern is concentrated mostly in the north-east of the USA while BNSF serves mostly west of the Mississippi River. This means they have real market power on their home turf. It also costs a lot to become a major player in the industry- it is not easy to build track, labor costs are high, there are long established ship to train relationships etc. etc. This does not even count the regulatory barriers to enter the industry or buying a competitor. It is not exactly an industry where price wars occur a lot. This results in railways having pricing power which translates to healthy profit margins.
• ESSENTIAL SERVICE: Yes, railways are essential services. Last year, the perfect storm happened in central Canada: a refinery in Ontario was shut down because of a fire and a rail strike occurred which stopped the flow of oil to Ontario and Quebec from Western Canada. There were periodic gas shortages for approximately 2 weeks. We needed the trains to transport gas from the west to east. Most electricity plants run on coal (An often overlooked fact. We continue to burn a lot of coal- the “traditional” energy choices are still coal fueled electricity plants or nuclear). What was the leading commodity transported by railways? Coal. Railways keep economies going by transporting commodities and goods from one part of the continent to the other. Without this mode of transport, goods would be dramatically higher or we would have shortages. I will point out, however, just because it performs an essential services does not necessarily mean that stock prices will be stable as the market goes down.
• STABLE BUSINESS MODEL: A railway train for industrial use has not changed much in the last 20-25 years. Compare that to other modes of travel. There also isn’t a technological revolution that will fundamental change the industry unlike how hybrid vehicles are changing the production patterns of the automotive industry.
• PEAK OIL: Railways have become cheaper transportation options relative to other forms of transportation since the price of oil has increased so much. Rails do run on diesel but there are a certain economies of scale which railways have that trucks or jets do not.
• INTERNATIONAL TRADE: A lot of rail traffic occurs when the goods originating from abroad is picked up from a major port (such as L.A.) and transported into the interior. International trade has become such a large component of railway business that CNR built, with its own money, a port in Prince Rupert, British Columbia as a means to accommodate the flow of goods coming in from Asia and the transport of commodities out. The demand was that great that a railway got into the shipping business.

What are the risk?

• EXPANSION IS LIMITED: North America is densely populated in certain clusters. It is not easy to build more track without infringing on major urban centers. Track is also expensive to build since you have to assemble a lot of land, secure right of ways, buy a lot of material, ask the government for consent and hire a lot of mostly unionized labor to lay trade.
• UNIONS: CNR became a success story by basically breaking the union. Labor strife is always going to be an issue since the work-force is primarily blue collar, older and unionized. Unionized labor also increases costs which makes expense control harder to achieve.
• THEY ARE NOT EXACTLY GROWTH STOCKS: Stable does not equal exciting. If you disregard KSU, the price to earnings ratios of the Big 5 in the U.S. and Big 2 in Canada ranged between 13 on the low end and 20 on the high end for the end of 2006 (price to earnings is how much an investor is willing to pay for $1 worth of earnings/profit, the higher the p/e the more investors believes it is a growth stock) and the p/e estimates are in the 13-15 range for 2007/2008. These are comparative low compared to the S & P 500.
• DIVIDEND YIELDS ARE COMPARATIVE LOW: The average dividend yield for the industry is between 1.4%-2.2% excluding KSU which does not pay a dividend. Railways are capital intensive businesses which require a lot of cash (a railway’s capital spending budget can be 50% or more of its revenue). This results in less money being returned to shareholders in the form of dividend increases. Dividend payout ratios are in the mid-teen’s to low twenties.

The key industry specific financial ratio to focus on is operating ratio (which is determined by dividing operating expenses into operating revenue; the lower being the better since it means you are doing more with less). CNR currently has the lowest in the industry by about 10% (the range is in the low 60% to high 70%).  Given that railways are very cash intensive businesses, a even slight increase in the operating ratio can cost the business millions in profit. In case you haven’t notice from this post, CNR tends to be regarded as best in class leader in the industry (but, again, do your own due diligence).

Rail stock are also bellweather stocks. Slower rail business means a slowing economy so watch these stocks as indicator of where the economy is going. As an industry, they are not exactly going to light your portfolio on fire with appreciation or dividend payments but they have a steady-eddie, stabilizing quality to them (not to mention the business is easy to understand). They are not for everyone but the above may be some of the reasons why Buffet and Gates bought rail stocks. Despite my intellectual curiosity, I do not own any rail stocks.

I have had a hard time finding bloggers who have blogged about railway stocks in depth (which are not out of date). If you know of any, kindly share. Thanks.

…and, drum-roll please! The winner of our contest is Rick T. A copy of the book will be on a train to you. Thanks to everyone for entering.