The Railroad Week in Review:
Week Ending March 7, 1998

This week in another of our Industry Spotlights spotlight series we'll take a look at Harmon Industries (NASDAQ: HRMN). This supplier of all manner of railroad electrical equipment from computer-based traffic control systems to the blinking lights at highway crossings has customers in the US and abroad and has seen a near doubling of stock price in the past year. First Call gives it a 1.6 recommendation, a Buy.

The 1997 results just released tell of a phenomenal year with record sales, earnings, and backlog, up 22%, 17%, and 22%, respectively. The backlog closed the year at $75 mm, and they won a new $40 mm contract from BART for an Advanced Automatic Train Control system in the first quarter, There’s also a $10 mm contract for signal replacement on England’s Railtrack. And if that isn’t enough good news, shareholders of record on Friday The Thirteenth (Feb.) will get three shares for every two held.

This is a small-to-medium cap firm, under $200 mm. It is currently trading at a slight premium to its growth rate, which on a strict PEG basis may mean it is fairly priced right now at $30 3/8. The Year-forward PEG (YPEG) based on First Call consensus stands at 1.04, which means HRMN is presently priced at about a 4% premium to a strict numerical projection. Investors are generally willing to pay slight premiums for growth firms with good financials.

And in that regard HRMN is no slouch. The equity ratios are outstanding. ROE for this year was 16%, debt/equity is a meager 0.6%, debt/EBITDA is pushing zero, and shareholder equity has been increasing at an annual compound growth rate of 39.3% for the past seven years. Since we’re all investing to grow our stakes in the companies we own, growth in equity is paramount, even over growth in earnings. (Recall, if you will, a previous article on ROE in which Week in Review uses a computed ROE, the product of margin, yield, and leverage.) So, if HRMN management grew equity at 39% a year for the past seven years, it’s reasonable to say they can keep it up for the next five at least.

As of 12/31/97, HRMN shareholders had $9.34 of equity for every share for a price /equity ratio of 3.25. Grow the current equity/share at 39% a year for five years and you get forward equity/share of $49.34 (use PV = negative $9.34, n = 5, i = 39, solve for FV on your HP 12c or similar.) Multiply that by 3.25 for a forward price of $159. At this rate, HRMN at 17 times earnings looks pretty good, I’d say.

And, while we're at it, let's revisit MotivePower Industries (NYSE: MPO) from that same perspective. Two weeks ago (WIR 2/21/98) we wrote up MPO in the Industry Spotlight saying business is booming now but questioned company staying power. Looking back, equity has grown to $121 mm today from $69 mm in 1992, or an ACG of 12%. Do the same arithmetic as we did on Harmon above and we get a future price of $36.32, not much ahead of today’s price in the mid-20s, and surely not the five-fold increase we might expect with HRMN. As always, however, the caveat: we run the models to compare actual past and potential future results across company lines.

Time to buy Union Pacific (NYSE: UNP)? Last week I wrote, “Union Pacific is not going to go away, and UP at $50 could be the buying opportunity of a lifetime, assuming you have no intention to sell in that lifetime.” Now let's see where a projection of the past five years’ equity growth takes us. UNP equity at the end of 1992 was $4.6 billion; four years later it stood at $8.2 billion. Trot out the trusty HP12c. Let PV = -4.6 (do remember to make PV negative), FV= 8.2, n= 4, solve for i. get 15.5%.

In UP’s case, every share represents $40 in equity ($8.2 billion/203 mm shares). Compound $40 in equity at 15% for five years, get $80 per share in equity. With UNP at $50, the price equity ratio is 1.25. Apply that ratio to the FV equity and get a future share price of $100. Run this set of numbers with PV of $50 and FV of $100, n =5, and the HP12c gives 14.9%. I think I could live with that. After all, in the grand scheme of things, the momentary Texas mess is only another cross to bear, and the crossest bears of all will be the day-traders looking for the fast buck.

Meanwhile, an investor friend writes, "Back last fall, with the stock floating between 60 and 63, I suggested a good short on UP could be covered around 55, maybe lower. My reasoning was the market was not anticipating a dividend cut, or a significant amount of make good expenses, and the analysts who sit in the OCS on the way to the Rose Bowl didn't really understand the dynamics the railroaders had to live with.

"I believe the easy money has now been made, and I've covered my short. I expect to be a regular buyer in the 40 to 45 range once the new issue is priced, a little bit at a time with money I don't expect to need for another few years. Sentiment, which had been pretty good, has taken a nose dive with the revelations (which haven't been new news to anybody around this table) about Houston and the Chem Coast."

In the other merger, will Cleveland turn into another Houston? But in this case, if it does, the politicians will have only themselves to blame. A Don Phillips Washington Post article echoed in Friday’s Philadelphia Inquirer tells of neighborhood and ethnic groups that are upset about increased rail traffic in their respective back yards. What Phillips says “began as a success story” has turned into a battle over where the trains will or won’t go. In one alternative plan, proposed by Cleveland’s Mayor, CSX and NS mains would cross each other at grade. And that’s something the two have been trying assiduously to avoid.

The mayor says he is “trying to help the poor” by limiting the number of trains past the doors of some of their number. One must then ask what help he gives to the entire city if the benefits Cleveland stands to gain in terms of distribution, manufacturing and related jobs go away because CSX and NS can’t make Cleveland work right. A contact in the Midwest tells me that the last time the Cleveland NIMBYs got up in arms it was over an air cargo facility. The NIMBYs won, and the expansion and the jobs went to Cincinnati (whose airport isn’t even in Ohio).

Toledo, on the other hand, is having no such troubles. NS said on Thursday that it “has reached agreements regarding the Toledo Metropolitan Area Council of Governments (TMACOG), the Toledo-Lucas County Port Authority (TLCPA).” The agreements essentially have to do with alternative access to local facilities and retention of a key bridge.

This just in: Providence and Worcester (Amex: PWX) has filed a registration statement with the SEC concerning a proposed public offering of a 1,025,000 shares of common stock at $17.375. A million of the shares will come from the P&W, the other 25,000 are from “a selling shareholder.” A copy of the prospectus may be obtained by calling Jim Twaddell at Advest, Inc., in Providence, (401) 861-0320. Readers will recall the P&W has been growing its franchise (the Connecticut Central acquisition, expansion of rights to Fresh Pond, e.g.), operates 515 miles of railroad including trackage rights, and operates new England’s largest double stack terminal.

The purpose of the offering is to help finance further expansion and fund needed infrastructure improvements, acquire and develop other terminal facilities, grow the business base of existing customers, and acquire needed rolling stock to support the expansion and growth. (Oh, yes…also pay down $11 mm in LTD.) Over the past four years revenues have grown at an ACG of a modest 4% a year while diluted earnings per share have gone up 11% a year. In the same period shareholder equity has grown at a rate of 5% compounded. This Offering could be a good shot in the arm. Page 2 of 2

--Roy Blanchard

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