WAB - Could negative sentiment spell opportunity in rail stocks?

2023-03-13 05:45:41 ET

Despite growing concern about a crackdown coming for the rail industry, analysts are advising that the punishment for stocks may be overdone.

Shares of Norfolk Southern ( NYSE: NSC ), the poster boy for the industry’s ills given the East Palestine, Ohio disaster, has paced the sector’s declines. Yet, all of the major operators in the space are in negative territory to start the year.

Regulatory Overhang

The disaster in East Palestine, Ohio resulting from the derailment of a Norfolk Southern Corp. ( NSC ) train has, justifiably, raised concerns about the sector’s safety precautions.

Indeed, the National Transportation Safety Board opened a special investigation into the company, adding to escalating calls from members of congress for action and multiple congressional hearings .

The regulator noted that, subsequent to the early February derailment in East Palestine, major derailments occurred in both Springfield and Cleveland, Ohio. The agency said that a late 2022 derailment in Sandusky, Ohio will also be part of the special investigation of the incidences.

“The NTSB is concerned that several organizational factors may be involved in the accidents, including safety culture,” the regulator said late last week. “The NTSB will conduct an in-depth investigation into the safety practices and culture of the company. At the same time, the company should not wait to improve safety and the NTSB urges it to do so immediately.”

Investigators were dispatched to a derailment in Alabama on Thursday as well, shortly after the special probe was announced.

Norfolk Southern ( NSC ) is not the only operator to receive attention for derailments either as multiple Union Pacific ( UNP ) derailments attracted attention since the start of 2023. For example, over 30 train cars carrying coal derailed in late February in Nebraska, adding to other derailments in Kansas and Utah in 2023. Meanwhile, a CSX Corp. ( CSX ) struck a rockslide in West Virginia in just the past week. Even railcar manufacturers like GATX Corp. ( GATX ) have attracted attention from regulators.

As such, new bipartisan efforts like the Railroad Safety Act, sponsored by JD Vance and Sherrod Brown.

“This bill will make important progress – and we need to do even more, like require state of the art braking systems, provide more funding for federal safety inspections, invest in worker safety, fortify state emergency management and response, and hold companies like Norfolk Southern accountable not just for the immediate damage, but also the long-term health and economic damage to communities like East Palestine,” the White House commented, applauding the bill.

Overall, proposed legislation is expected to be a significant cost headwind for rail operators moving forward.

“There is widespread bi-partisan attention and anger centered on the industry following a high-profile derailment, and congressional hearings, forced safety initiatives, and the threat of heightened regulatory oversight do not portend well for long-term cost structures,

even if it’s more smoke than fire over time,” Evercore ISI analysts wrote in a recent note to clients.

Derailment Dynamics

However, the rail industry has gotten progressively safer in recent decades, according to the statistics provided by the Bureau of Transportation statistics. Train accidents have fallen sharply in the past 20 years and even more starkly on a 40 year timeline.

For example, there were nearly 7,000 derailments in 1980. In 2021, there were just over 1,000. Additionally, hazardous materials accidents are heavily weighted towards highway incidents rather than rail accidents, with highway accidents increasing by contrast.

That said, the magnitude of crashes is a cause for concern.

According to JP Morgan the introduction of Precision Scheduled Railroading has steadily increased the size of trains in order to decrease operating ratios. This has increased the size of the average derailed Norfolk Southern ( NSC ) train from about 60 cars in 2013 to over 120 by 2022. Both CSX ( CSX ) and Union Pacific ( UNP ) have seen similar dynamics as well. While Canadian operators Canadian Pacific Railway ( CP ) and Canadian National Railway ( CNI ) were not included in JP Morgan’s analysis, the analysts noted they “typically run some of the longest and heaviest trains across North America.”

The Berkshire Hathaway-owned ( BRK.A ) ( BRK.B ) Burlington Northern Santa Fe has remained conspicuously steady over the past decade with a train size near 80 cars. The railroad operator also performed best in terms of derailments per million miles, according to JP Morgan data, followed closely by CSX. Norfolk Southern was the worst performer.

Opportunity Available?

Despite the negative implications for Norfolk Southern ( NSC ) in JP Morgan’s research, the bank’s analysts suggested the stock has been properly punished, perhaps even more than it deserves.

“Figuring out when the stock can start to work is likely tied to the intensity of the news cycle and Congressional scrutiny,” the team told clients. “When this peaks we expect NSC could start to regain its footing and attract more interest on the fundamentals which have been better than expected in 1Q23.”

While litigation and an NTSB probe hang over the stock and are likely to remain for quite some time, he remained positive on the long-term trend for the stock.

“We believe the NTSB’s public investigative field hearing could mark the peak of the recent news cycle and represents a potential positive catalyst for NSC,” the team said.

Evercore’s analysts echoed that analysis, noting that while Norfolk Southern remains the “most complicated trade or investment of the North American rails today,” it could see significant upside if investigations and payments related to its derailments are not as dire as the market currently expects. Still, the risks still present were enough to keep the team on the sidelines.

“We feel the risk of stepping in too early to the reversion trade outweighs the potential downside

of being a bit late once there is more clarity on the ultimate long-term financial and operational impact of the event,” they concluded.

Instead, the team prefers “the most actionable short-term call” in Canadian National ( CNI ) and Buy-rated Union Pacific ( UNP ). Evercore said its “top overall pick” in rails remains CSX Corporation ( CSX ).

“The network has vastly improved from a service, velocity, and fluidity perspective and is now nearly appropriately resourced, which should result in some consistent volume growth once the macro provides a bit of a tailwind,” the team said of CSX. “In addition, coal prices remain

resilient, which could provide upside to RPU and EPS throughout the year.”

Outside of the rail space, the potential to lay blame at the feet of Precision Scheduled Railroading could be a major tailwind to manufacturers like Wabtec ( WAB ) as demand for locomotives increases. Investment in safer tank cars is also projected to boost Greenbrier Companies ( GBX ) and Trinity Industries ( TRN ), according to Wells Fargo.

For further details see: