The Railroad Week in Review:
Week Ending November 7, 1999

Florida East Coast Industries (NYSE: FLA) is enjoying a nice run. Last week majority owner St. Joe Industries (NYSE: JOE) said it would divest itself of the 54% interest it has in FLA. In exchange JOE gets an equal number of shares of a new class of Florida East Coast common stock.

The holders of the new class of Florida East Coast common stock will be entitled to elect 80% of the members of the Board of Directors of Florida East Coast, but the new Florida East Coast common stock will otherwise have substantially identical rights to the existing common stock. The recapitalization, exchange and spin-off are expected to be completed during the second quarter of 2000.

Kansas City Southern was in town and of course much of the talk revolved around the impending split -- FAM to Stillwell, RRs to KCSI. Which naturally brings up the question of how much for the railroad? My process begins with earnings through 3Q98, $2.01 a share for the whole, $0.15 a share for the transportation side, which includes all the US ops plus TFM. For 4Q98, look at the estimates -- the consensus is $0.79 for the whole; I arbitrarily said $0.05 for the RR, in line with the past three quarters. That gave me $0.20 a share for the RR full year. A nominal 15 RR multiple gets you to $3.00 a share.

Another way, $0.20 a share is $22.8 mm net income for the rails, which seems reasonable given the $17.4 mm posted for three quarters. It's also 7% of the total earnings, based on FY 99 estimates of $2.80 a share for KSU (0.20/2.80). Today's share price is about $47, and 7% of that is $3.36. I've heard numbers in the $7 a share bandied about. Where's the spread? Anybody?

I was looking over the numbers presented by NS and CSX at the analysts' meetings in NYC last week and it struck me that, yes, business is up, but then again a whole chunk of CR is now being counted. Take NS -- it's simpler as Intermodal and merchandise/coal are all counted as RR -- and business as it seems it should be is off. Or is it?

My premise is that if you take CR's 3Q96 carloads and revenue, increase that by the same percent as NS grew 3Q96-3Q98, and split the pro forma numbers between NS and CSX, you'll get a sense of the combined roads at 3Q98. At NS, I find carload business off 6% from the combined pro formas and revenue off 5%.

Digging behind these numbers one will find NS "revenue opportunity losses" (read diversions) on "new" NS of $73 mm, essentially the same as the $72 mm revenue shortfall between 3Q98 NS+CR and pro forma 3Q99 developed above. Bottom line: business is down, and the reason is diverted traffic. Let's run the same exercise in Jan and see what we get using the same rules. How many shippers will still be diverting themselves elsewhere?

Wisconsin Central (Nasdaq: WCLX) earned $16 mm, $0.31 a diluted share, in 3Q99. This was down from $19.4 mm, $0.38 a diluted share, in 3Q98 thanks in part to a one-time, pretax personnel reorganization charge of $3.9 mm, a nickel a diluted share. Other one-time hits were $1 mm in cross-training fees necessitated by a union agreement and $1 mm in lost revenues and added costs due to the Conrail transaction follies, total effect $0.3 a share. Putting back the extraordinary charges the company would have been up a penny a share.

Using our Rule Maker spreadsheet from we see that revenues were up 3.7% and expenses were up 6.7%, leading to the 17.7% decline in net income. Still in all, the net margin decreased to 17.4% from 21.9%. LTD rose 21.9% to $33.4 mm, debt/equity went up to 67.6% from 61.7% and interest went to $4.7 mm from $4.3 mm and interest coverage dropped a point to five times from six. Still, in most circles, that's respectable. No comment on why debt was up. North American rail operations earned $21.5 mm with the one-time charge vs. $26.4 mm last year. Revenues were up nearly 4%and set a new quarterly record with added revenues in metallic ore, intermodal and wholesale freight haulage. Operating expenses however were up 7% even without the cross-training charge, driving the OR to 72.5 from last year's 70.3.

EWS, said Tom Power, "isn't out of the woods yet, but we're encouraged." Loco use and crew scheduling are being handled more efficiently, on-time train performance is improving, and better scheduling means fewer penalty track access charges. Topping it all off, the announcement of a full-time CEO for EWS can be expected shortly. The outlook for increased freight business is good, and the government's serious focus on more rail, less truck for goods movement is a huge help.

Tranzrail and Australian Transport both reported greater contributions than last year. WCLX continues on the acquisition trail as the Jordanian project becomes a reality and new ventures in Australia are sought. Lastly, Power said there would be additions to the leadership team in the next few months as the company continues its focus on long term results. I'd say it was a very positive call.

It's been said that the word best describing "market-timer" investors is "broke." But one thing about watching prices is that the historical relationship between stock direction and the 200-day moving average has been well documented by no less an authority than University of Pennsylvania professor and author Jeremy Siegel.

In his book, Stocks for the Long Run, Siegel notes that players who bought stocks thst were on the way up when they crossed the 200-day average did better than the hangers-on through thick and thin. The flip is that the same buyers had to sell when stocks crossed the 200-day line on the way down. That being said this week for the first time in a long time all the class 1 rail stocks from Burlington Northern Santa Fe (NYSE: BNI) to Union Pacific (NYSE: UNP) are flirting with or have crossed their 200-day averages on the way up. May I suggest reading your own tea leaves and taking a good look at valuations and potentials before pulling any triggers.

In a recent article on Warren Buffett, the "Oracle from Omaha" remarks on the price investors are paying for earnings. In terms of the total stock market, "Investors were saying on March 15 this year that they would pay a hefty $10 trillion for the $334 billion in profits" What this means is that, in terms of actual earnings, investors will get only 3.4% on their money. If this is so, where are all these lofty multiples coming from?

Not all companies are created equal, of course. PE ratios are measures of expected earnings growth. The companies that will enjoy the strongest growth are the ones that have -- trot out your Marketing 101 texts, class -- a Unique Selling Proposition (USP). Buffet describes this as "competitive advantage" where the company supplies products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. How do the rails fare on both counts?

If you compare the 12 listed rails with readily accessible earnings estimates you'll find them trading anywhere from 6 to 15 times FY 2000 estimated earnings. On the other hand estimated dollar incomes (estimates times shares) represent market cap (stock price times shares) returns ranging from a high of 17.6% (GNWR) to a low of 6.8% (NSC).

To relate the PE ratio to estimated earnings as a percent of capitalization I simply divided the return by the PE and sorted from high to low. Not surprisingly the highest PEs are enjoyed by the class 1 rails with the lowest rate of return. From this it appears investors sense the class 1s as having the strongest USP since they all have unique franchises that are strong and sustainable. And the class 2 and 3 roads are dependent on these behemoths for their own existence.

It should be noted, however, that the small-cap rails can grow their on-line customer base more rapidly and at lower cost than the class 1s. Moreover, they can deliver carloads to the class 1s at lower cost to the class 1s -- no capex or direct operating cost other than the handling fees and administrative costs. So clearly the small railroads have moats of their own. Investors should take note.

--Roy Blanchard

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