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By Matthew Young, CFA | 01-04-2017 11:00 AM

Union Pacific Is Our Favorite Railroad Today

Valuations have become lofty in much of the intermodal space, but there are still some opportunities for investors, says Morningstar's Matthew Young.

Matthew Young: The $18 billion rail intermodal industry (referring to the movement of shipping containers on rail cars) ran into a few stubborn headwinds in 2016, but we don't think these factors will derail its long-term growth potential. Intermodal has also become the secular growth story for the North American railroads, and we think it will continue to offset the impact of lackluster coal carloads. That said, investors should tread carefully. Opportunities exist in the space, but in some cases valuations have become lofty.

The broader intermodal landscape enjoyed solid expansion throughout most of the current economic expansion phase, with 6% average container volume growth between 2010 and 2015. And over that period, robust truck to rail conversion activity played a key role in its growth over and above retail sales. However, container demand hit a rough patch in 2016 for two key reasons. First, cheap diesel fuel, and second, falling rates across the competing over-the-road truckload industry linked to excess capacity.

Essentially, these factors have compressed intermodal's cost discount relative to trucking, thus pressuring its value proposition to shippers. On the other hand, we think the intermodal landscape is headed for a turnaround this year, with container volume trends swinging into positive year-over-year growth territory by the second half.

Longer term, we think normalized industry gross revenue can expand in the 5% range. A key reason for the improvement, is we expect truck to rail conversion activity to recover in the year ahead. Now, why is that? Well, capacity trends in the competing truckload industry should find better balance by the second half of 2017, with help from new regulations requiring widespread electronic logging device adoption, which will very likely pressure truckload carriers' productivity. This should help push truckload rates back up, and that will improve intermodal's cost discount to trucking.

In terms of specific companies, Union Pacific is currently our favorite class I railroad based on a few attractive free cash flow metrics. On the other hand, we would caution that valuations for the pure play intermodal marketing companies like Hub Group and JB Hunt, while those are excellent franchises, are baking in overly optimistic assumptions, and we would wait on the sidelines.

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