North American Rails: On Track for Growth

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1 North American Rails: On Track for Growth INDUSTRIALS SECTOR REPORT 4 October 2017 ANALYST(S) Dan J. Sherman, CFA Rail companies Edward Jones follows that are mentioned in this report: Canadian National (CNI - $81.73) - Hold Canadian Pacific (CP - $166.87) - Buy CSX Corp. (CSX - $52.12) - Buy Norfolk Southern (NSC - $131.57) - Buy Union Pacific (UNP - $114.89) - Buy Prices are as of market close on 10/2/17 and are subject to change. Source: Reuters. Edward Jones clients can access the full research report with full disclosures on any of the companies Edward Jones follows through the Account Access link on the Edward Jones Web site ( Clients and others can also contact a local Edward Jones financial advisor, who can provide more information including a complete company opinion, or write to the Research Department, Edward Jones,12555 Manchester Road; St. Louis, MO Information about research distribution is available through the Investments & Services link on Investment Overview Higher Canadian and U.S. economic growth has been creating more freight for rail operators, and better earnings growth. From late 2014 to late 2016, North American railroads had encountered a freight recession, forcing them to constantly become more efficient to maintain their earnings growth. Those reduced cost structures combined with growing freight volumes should lead to good future earnings growth. We have Buy ratings on Canadian Pacific, CSX, Norfolk Southern and Union Pacific in anticipation of better growth ahead. Volume on the Upturn - Better economic growth in both the U.S. and Canada has led to rising freight volume for the rail stocks, boosting earnings growth and stock prices, and we think more is on the way. The ability of the rail stocks to harness economic growth makes them attractive long-term investment vehicles. Lower corporate tax rates would also benefit U.S. rail stocks by increasing both rail stock prices and the cash available to rail companies to reinvest in growth. Solid Business Positions Lead to Pricing Power - North American rails should continue to have the ability to price their services above the rate of inflation in rail costs. Rails have pricing power due to inherent competitive advantages such as rights of way and thousands of miles of track, and due to regulatory regimes that allow pricing at or above inflation. When combined with continued cost control, this pricing power should allow the North American rails to continue to grow their earnings. Industry Focused on Efficiency - Since the mid-2000s, one of the main drivers of earnings growth for the North American rails has been an increased focus on controlling costs and increased efficiency across the railroad network. The push for efficiency has resulted in a more streamlined rail network and much better service. We expect the North American rails to continue to focus on efficiency going forward. Please see important disclosures and certification on pages 4-6 of the report. Page 1 of 6

2 Volume on the Upturn Economic Growth Better economic growth in both the U.S. and Canada has led to rising freight volume for the rail stocks, boosting earnings growth and stock prices. The economic growth and the corresponding willingness of consumers to spend is important to the rail stocks because new houses mean more rail cars full of gravel, cement, lumber, dry-wall and furniture. More cars sold means more steel, more tires, more car parts and more new cars shipped. All these connections illustrate why better economic growth leads to more rail shipments and higher earnings for the rail companies. This ability of the rail stocks to harness economic growth makes them attractive long-term investment vehicles. In the medium term, economic growth may also benefit from changes to U.S. policies, including tax cuts and infrastructure investment. The outcome of the ongoing tax discussion is difficult to predict. However, the proposed structural changes to the tax code look likely to increase business investment and the willingness of U.S. businesses to hire workers and raise wages. Higher wages would mean additional consumer spending, and higher spending by both businesses and consumers means more goods shipped by rail. In addition, lower corporate tax rates should benefit U.S. rail stocks directly by increasing both rail stock prices and the cash available to rail companies to reinvest in growth. Added infrastructure spending has been proposed in both the U.S. and Canada. Canada is well along the path to vetting projects and beginning work. In the U.S. details have yet to be worked out, but the idea seems to be to attract private investment to build infrastructure in the U.S. with an infrastructure bank much like the one proposed in Canada. With only US$100 million to US$200 million in U.S. federalgovernment funding, bringing in private capital may potentially create infrastructure worth the talkedabout one trillion U.S. dollars. Coal Since early 2017, coal volumes have stabilized because export demand has increased over that seen in 2016 and because natural gas prices have risen. From early 2015 to early 2017, coal shipments in the U.S. had been negatively affected by low natural gas prices, which allowed natural gas to be substituted for coal to produce power; by low export demand; and by changing regulations for the burning of coal in power plants. Facing the more stringent regulations on carbon emissions embodied in the Clean Power Plan, utilities are converting coal-fired power plants to natural gas or replacing the capacity with renewables. The current U.S. administration has signed an executive order that requires the EPA to review and rewrite the Clean Power Plan that regulates carbon dioxide emissions from power plants. As originally written by the previous administration, the regulations embodied in the Clean Power Plan would have slowly phased coal burning power plants out of the electricity-generation network of the United States. The U.S. Energy Information Administration (EIA) estimated that under the original Clean Power Plan, coal would have accounted for only 18% of electricity production in the U.S. by 2040, down from an estimated 30% in Solid Business Positions Lead to Pricing Power North American rails should continue to have the ability to price their services above the rate of inflation in rail costs. While that does not sound like much, when combined with cost control, it should allow the North American rails to grow their earnings. Rails have pricing power due to both inherent competitive advantages and regulatory regimes that allow pricing at or above inflation. The huge base of installed track and thousands of freight cars and locomotives together represent an almost insurmountable competitive advantage for each of the North American rail carriers. Furthermore, absent new regulations that would create the rights of way needed, new railroads will probably not be built in North America. Changes to regulations under the Staggers Act of 1980 that allowed deregulated load pricing, abandonment, mergers and divestitures have created a highly consolidated industry. The rail industry of today may further consolidate into just two or three transcontinental companies. However, even at the current level of consolidation, only two railroads operate in most regions in North America, and a single railroad often serves as the only option for large bulk shippers such as coal mines or grain elevators. Where the option of barge transport does not exist, railroads are by far the lowest-cost option for most bulk goods. Industry Focused on Efficiency The primary measure of efficiency for railroads is the operating ratio, which is simply total costs divided by total revenue, with a lower ratio being better. The industry has made tremendous strides since 2000 when the average efficiency ratio for the industry peaked at approximately 88%. Since this time, management teams across the North American rails Page 2 of 6

3 have focused on cutting unnecessary costs while increasing train speed and decreasing the amount of time that cars sit in yards (terminal dwell time). With the focus on efficiency, the rail industry reached revenue adequacy (returns above the cost of capital) in Since that time, one of the main drivers of earnings growth for the North American rails has been an increased focus on controlling costs and increased efficiency across the railroad network. As one can see in Figure 1, the push for efficiency has resulted in a more streamlined rail network, with an average operating ratio across the industry well below 65% in We expect the North American rails to continue to focus on efficiency, resulting in lower operating ratios going forward. Figure 1: More Efficient Operations Source: EDJ models, company reports. The operating ratio depicted here is the average of the ratios of the following rails followed by Edward Jones: CNI, CP, CSX, NSC, and UNP. Investing in the Railroads We view the U.S. rails as a core holding of a welldiversified portfolio of industrial stocks. In our view, the rails are attractive not only for capital appreciation, but also for attractive dividend growth opportunities. We expect the rails to continue to return capital to shareholders in the form of share buybacks and increased dividends over time. We currently follow five North American railroads. Canadian Pacific, CSX, Norfolk Southern and Union Pacific are our Buy-rated names. Canadian National is rated a Hold because we believe its current share price is already appropriately reflecting our positive industry outlook. All of the North American rails stand to benefit from some of the same future longterm tailwinds, including U.S. economic growth and continued pricing power. Canadian Pacific (Buy) - We believe that Canadian Pacific will continue to improve the operating efficiency of its rail network, which should be a major benefit to earnings if volumes rise in the future. Having the team of the highly successful former Chief Operating Officer Hunter Harrison stay in place for the next few years should help sharpen the execution of those improvements. Using longer-term valuation measures, such as discounted cash flow, Canadian Pacific shares look attractively valued at current levels. CSX (Buy) - With Hunter Harrison joining CSX, we believe that the company will become much more efficient. Furthermore, with coal volumes stabilizing, management's cost-cutting efforts should flow relatively quickly through to earnings. Using longerterm valuation methods such as discounted cash flow, we believe that the current price reflects an attractive entry point for long-term investors. Norfolk Southern (Buy) - In our view, Norfolk Southern is creating positive change within its network that should both lower its cost base and position it to grow its business. Both of those factors should be positive for earnings growth. Although the company is trading above its historical price-toearnings (P/E) ratio based on our 2018 earnings estimate, we are optimistic about the company's outlook, and we believe that the shares represent a good value for long-term investors at current levels. Union Pacific (Buy) - Union Pacific is constantly becoming a more efficient operator and has set lofty long-term efficiency goals. Union Pacific has delivered on such goals in the past, and we believe that over time it is likely to reach these as well. As Union Pacific becomes more efficient, it should generate even more free cash flow for shareholders. Although Union Pacific is trading near the top of its long-term range, we believe it is attractively priced for long-term investors. Canadian National (Hold) - If North American freight volumes continue to turn up, Canadian National appears well-positioned to benefit. However, Canadian National has much less room to expand margins than it did in the past, and the shares look to be fully priced. Canadian National Railway trades at the high end of its historical price-to-earnings (P/E) ratio based on our 2018 earnings estimate. Valuation Methods we use to evaluate the attractiveness of rail stocks include traditional ratios such as priceto-earnings (P/E), both on an absolute and relative Page 3 of 6

4 basis; PEGY ratios (P/E vs. estimated growth and dividend yield); and discounted cash flow (DCF) analysis. Risks There are several risks associated with investing in the railroad companies. In our view, the biggest risk facing the rails is a prolonged economic downturn. Another recession or a sustained period of little to no economic growth will negatively impact rail volumes and profitability. Given that coal is still one of the largest freight categories, any additional negative environmental regulation related to coal or emissions, or a switch from coal to another power source for electricity generation, would negatively affect earnings growth. Other risks include loss of pricing power, unfavorable rulings or regulations from the Surface Transportation Board, union-related issues, the capital-intensive nature of the industry, the overall competitive nature of the freight industry, and prolonged economic downturns. Please see your financial advisor and read the individual company research reports, which contain additional information on valuation and risks, to see which stocks may be appropriate for you and are good values at their current price. Required Research Disclosures Analyst Certification I certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers; and no part of my compensation was, is, or will be directly or indirectly related to the specific recommendations or views contained in the research report. BUY HOLD SELL Stocks 44% 54% 2% Investment Banking Services 2% 2% 0% Other Disclosures All the proper permissions were sought and granted in order to use any and all copyrighted materials/sources referenced in this document. This report does not take into account your particular investment profile and is not intended as an express recommendation to purchase, hold or sell particular securities, financial instruments or strategies. You should contact your Edward Jones Financial Advisor before acting upon any Edward Jones Research Rating referenced. All investment decisions need to take into consideration individuals' unique circumstances such as risk tolerance, taxes, asset allocation and diversification. It is the policy of Edward Jones that analysts or their associates are not permitted to have an ownership position in the companies they follow directly or through derivatives. This publication is based on information believed reliable but not guaranteed. The foregoing is for INFORMATION ONLY. Additional information is available on request. Past performance is no guarantee of future results. In general, Edward Jones analysts do not view the material operations of the issuer. Diversification does not guarantee a profit or protect against loss in declining markets. Special risks are inherent to international investing including those related to currency fluctuations, foreign political and economic events. Dividends can be increased, decreased or eliminated at any time without notice. An index is not managed and is unavailable for direct investment. U.S. only: Edward Jones - Member SIPC Dan J. Sherman, CFA Analysts receive compensation that is derived from revenues of the firm as a whole which include, but are not limited to, investment banking revenue. Buy (B) - Our opinion is to Buy this stock. We believe the valuation is attractive and total return potential is above average over the next 3-5 years compared with industry peers. Hold (H) - Our opinion is to keep this stock. We believe the stock is fairly valued and total return potential is about average over the next 3-5 years compared with industry peers. Or a special situation exists, such as a merger, that warrants no action. Sell (S) - Our opinion is to Sell this stock. We believe the stock is overvalued and total return potential is below average over the next 3-5 years compared with industry peers. In some cases we expect fundamentals to deteriorate considerably and/or a recovery is highly uncertain. FYI - For informational purposes only; factual, no opinion. The table below lists the percent of stocks we follow globally in each of our rating categories. Investment banking services indicate the percentage of those companies that have been investment banking clients within the past 12 months. As of: 4 October 2017 Page 4 of 6

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