Seeing these sites firsthand helps one understand the struggles and accomplishments of the railroad over the past 150 years. There have been many.

All of this railroad talk, however, is not just for history buffs. In fact, it is extremely relevant in today’s market…

In early April, Berkshire Hathaway Inc. announced that it decided to jump into the railroad business by revealing that it had bought up shares of three of the four North American railroads: Burlington Northern Santa Fe (BNI: NYSE), Union Pacific (UNP: NYSE) and Norfolk Southern (NSC: NYSE). The Oracle’s fresh look at the railroad industry has gathered its fair share of attention from investors.

There’s a way you can piggy-back on this renewed interest in all things train-related with a $600 million company that plays an intricate part in rail transport. It all begins with coal…

Coal has once again (and it looks like it will for some time) become a main source of energy, over which this country and so many others have become desperate.

Coal is now on the forefront of the green energy wave. The technology is there to separate raw coal into three parts: Mercury-sulfur, CO2 and purified syngas. The mercury-sulfur is — then separated into its two elements. Mercury is used in various items ranging from diffusion pumps to batteries and advertising signs. Sulfur is used in many products such as pulp and paper products and even fertilizer. The harmful CO2 is injected safely underground. Most important part is the clean coal that is burned to create a clean energy source. This process has already been tested and used in many states in the Northwest and is starting to pop up across the rest of the country.

Of course, this coal needs to be shipped from the mines to these clean coal plants. The ownership of this transportation is in just a few companies’ hands. The railroads have already been exploited. Berkshire’s April disclosure made sure of that, but railcar manufacturing has not yet hit its peak. In fact, the company that leads the industry, FreightCar America (RAIL: NASDAQ), is trading at a significant discount.

FreightCar has manufacturing plants in Illinois, Pennsylvania and Virginia, which are in the Great Appalachian Coal Region. This region is known for its quality and quantity of coal– in fact, it is the best in the country in both aspects.

FreightCar looks to capitalize on this. After all, coal-carrying cars make up 96% of its production. And over the past three years, FreightCar has managed an 81% market share of coal-carrying car manufacturing.

Foreign demand is also a factor. BRIC (Brazil, Russia, India and China) are in high demand of natural resources including coal. China, more specifically, is estimated to import about two million tons per month by the end of this year, causing an ever-growing strain on other countries to transport the coal from their mines to their ports to China as fast as possible. This means more coal-carrying car production, which is good business for FreightCar.

FreightCar management mentioned during its first quarter conference call this year that they are looking into building plants in India, the third-largest coal producing country. This of course would be all big news considering both the demand for coal transportation and the geography of India and China.

A company that does good business but is already quite overpriced is still useless to a smart investor. But a company such as this one with a great market niche as well as a cheap price tag is obviously something to look into. With it trading at under five times its earnings, FreightCar does seem extremely cheap. Companies sporting super-low P/Es almost seem like a thing of the past. When you do come across one that at first glance seems to be trading at a hefty discount to its peers, it usually signals something has actually gone horribly wrong.

But that’s not the case with Freight Car America. Its current P/E is close to its five-year low. Its financial situation is in great shape with no debt and over $147 million in free cash just sitting waiting to act on an opportunity abroad. In fact, it currently has over $16 of cash per share on hand.

Not only is it cheap now, it is still growing at an impressive rate. Its sales grew 56% last year and its earnings 182%. In fact, one of the reasons it may be carrying such a low P/E is because investors are wary its 2007 sales can’t meet its 2006 numbers. The ‘07 earnings growth estimate is small compared to this past year’s, but with talks of Indian plants, these estimates don’t mean much in the long haul.

Either way, FreightCar America is certainly a good company to look into, as this clean coal concept grows nationwide and the worldwide demand stays high.

Until next time,
Jim Nelson
June 7, 2007

Value Investing in the Railroad Industry was originally featured in the Penny Sleuth.

And Buffett didn’t stop there. Berkshire confirmed it has also acquired stakes in two of the three remaining North American railroads: Union Pacific (UNP: NYSE), CSX (CSX: NYSE) and Norfolk Southern (NSC: NYSE).

Many people are speculating on the remaining two. I’m having more fun speculating on the one left behind.

Imagine the fate of the CEO whose company Buffett emitted. Talk about a public rebuke. Which one of the remaining three wants to step into his next board meeting as the “one” Buffett shunned?

Personally, my money is on CSX. I have no propriety knowledge other than a close friend who used to work there. He always described CSX as the black sheep in the American railroad family. To him, Norfolk Southern was the overachieving big brother.

That’s hardly an educated guess. But less I digress.

No one really knows why Buffett fell in love with railroads all of the sudden. Burlington certainly carries Buffett-like characteristics: Consistent earnings growth (22% annualized over 5 years), impressive margins and limited competition.

But none of the railroads typify your typical Benjamin Graham value play. The stock trades for more than three times book with limited liquidity and tangible debt.

So what was Buffett thinking? It’s anyone’s guess. But the prevailing consensus believes globalization…specifically, moving the major staples of trade — things like coal, oil, cars, and clothes…in other words, basic commodities and finished goods — from producer to consumer is the long-term trend at play here.

I’ll buy that.

It was about this time in 2002 that a rebirth in the tangible assets sector really began. Much of that growth can be directly attributed to the insatiable demand for raw materials that the developing giants known as China and India are now consuming.

These countries are still in the early stages of development. It takes about 30 years to go from an agrarian society to an industrial one. China is about one-third of the way there. China will continue to import commodities to sustain this enormous transition. India will do the same.

Furthermore, the golden era of stocks (1982-2000) directed capital in about every investing avenue except natural resources and raw materials. Hence, limited demand caused a decrease in available supply.

Now the entire world can’t get enough copper, zinc, lumber and oil. But bringing on new production takes time. Supply can’t catch up with demand overnight. In fact, it’s going to take quite some time, especially when you throw in the consumption potential of India and China (37% of the world’s population) to the mix. Consequently, commodities (the market for the essentials) will remain tight for the foreseeable future.

And commodity consumption won’t be limited to emerging markets alone. Let’s not forget… The United States has begun to embrace alternative energy. And the two greatest oil alternatives, coal and corn, are shipped by train.

So transport stocks like Burlington certainly play into this long-term trend. And considering rising fuel prices affect trucks more than trains, this idea begins to make more and more sense.

But many feel it’s too late. Many believe the upside is already priced in. Well, that may be true.

But I think there may be another way to piggyback Buffett’s investment thesis.

I’m talking about dry-bulk shipping.

Despite what many think, dry-bulk shipping companies are relatively new to public markets. In the past, most companies have stayed in private hands.

Better yet, these companies are all classified as small-cap stocks. The average industry market cap is just over $800 million. Therefore, companies this small (in fact, the entire dry-bulk industry) don’t effectively cross the radar screen of big-time investors like Berkshire Hathaway.

That’s where we come in.

As I’ve written before, one might think, with lightning fast courier services, airplanes, FedEx and UPS — a whole slew of modern transport services — that using ships to transport cargo would be antiquated.

That assumption couldn’t be further from the truth.

Shipping still serves as the world’s economic circulatory system. This business connects the world in ways technology never will. Roughly 90% of the world’s exports are still transported by ship.

Shipping is, and will remain, irreplaceable on the world stage. We can’t live without it. It won’t be replaced. It’s been around for centuries. Until we reach a stage of technological innovation in which the major staples of trade — things like coal, oil, cars, the finished products that fill Wal-Mart stores — can be disassembled, one molecule at a time, and instantaneously beamed to another location, our current means for commerce will remain the most efficient.

Readers of Penny Sleuth may remember this argument. Last December 1, I highlighted the small-cap shipping stock Excel Maritime Carriers (EXM: NYSE).

At that time, you could’ve bought the stock for 90 cents on the dollar for less than four-times cash flow. That’s not bad considering the stock offered an earnings yield of 26.3% on a company that produces operating margins well above 60%.

That Friday, shares of Excel Maritime closed at $13.76. They opened for $19.30 today. That’s a 40% return in just over four months.

The stock still trades at impressive multiples.

* In Millions

Now I’m hesitant to say this stock provides a fully adequate margin of safety for long-term investors (I want to stress long-term, especially in such a cyclical industry!). But, once again, I will give you this.

First, the business is easy to understand.

We’re not talking biogenetics or even the most basic automotive technology for that matter. The business is much more simple. You can have all the coal in the world, but it’s worthless if you can’t get it from point A to point B. That’s all shipping does…it transports commodities and finished goods from one port to another…nothing more, nothing less.

Second, the company operates with a sustainable long-term competitive advantage.

Like railroads, shipping is a very capital-intensive business. Shipping is a very capital-intensive business. Vessels can cost upwards of $50 million a piece. Hence, the barriers to entry in this business are quite high. But once you’re in, the margins are remarkable.

Finally, maritime shipping margins offer great downside protection.

The approximate cost of operating a dry bulk carrier on a daily basis is somewhere between $4.5 and $5 thousand dollars.

Depending on the size of the fleet, shippers can charge anywhere from $7,000 to $29,000 per day.

You’ll be hard pressed to find a comparable capital-intensive industry with unit margins like these.

You Be the Judge…

I’ve said it once and I’ll say it again.

The risk here lies in the assumption that the company can maintain steady revenues for years to come.

Well, if you believe globalization isn’t just a fad… If you’re convinced BRIC (Brazil, Russia, India and China) countries will continue to grow, there will be ships on the open seas to service their needs.

You can be sure there will be hiccups from time to time…some driven by excess capacity…some will be driven by nothing more than market exuberance. But as long as the fundamentals supporting your investment are still there, I believe pullbacks to be excellent opportunities to add to your position.

Until Next Time,
Christopher Hancock
April 13, 2007

P.S.: When you talk about international growth, you can’t forget about the immense strain on the Earth’s water supply. In fact, some of Wall Street’s biggest players have been making money off these “Invisible Investments” for years.

Investing in the Railroad Industry was originally featured in the Penny Sleuth.