While the markets seem to only be interested in rising rates and earnings, an entire sector has gone unnoticed and blown the doors off the market.

The Dow Jones U.S. Railroad Index is surging with a 24% gain this year and has quadrupled since its 2009 low. Besides the general rebound in the economy, crude production is at 20-year highs, far exceeding pipeline capacity and growth. That means a massive surge in demand for transportation by rail. An estimated 1.4 million barrels of crude and refined products were transported by rail every day in the first six months of 2013, an increase of almost 50% from the first half of 2012.#-ad_banner-#

All signs pointed to another great year in 2013 and the sector again being a good investment. Then the unthinkable happened: Just after 1 a.m. on July 6, a freight carrier operated by Montreal, Maine & Atlantic Railway crashed in the Quebec town of Lac-Megantic, killing 47 people. Montreal, Maine & Atlantic filed for bankruptcy a month later.

The catastrophe in Canada will surely increase scrutiny on the industry. In addition, anecdotal evidence from Jeffrey Saut, chief investment strategist at Raymond James, points to an unbearable rise in insurance premiums for small short-line carriers:

“(Recently,) I met the CEO of a short-line railroad located in the Dakotas. He told me his insurance broker had just told him that because of the disaster … his insurance coverage is going to have to be increased by a factor of four with an attendant price increase — and his railroad doesn’t even transport crude oil! Such an increase in insurance cost will likely cause a massive consolidation for the industry.”

Lastly, possible regulatory changes by the U.S. Department of Transportation, which is said to be working on new policies for rail tank cars, could be the final catalyst for consolidation in the industry. These events have put the sector at risk — but with risk there is always return.

As Saut speculates, there could be a wave of consolidation as the smaller players get forced to sell to larger operators. These larger operators should be able to use their scale to negotiate smaller insurance increases and are better positioned to manage greater regulatory scrutiny.

Looking through the roughly 550 short-line railroad operators for good takeover targets is like finding the proverbial needle in a haystack — but I think I’ve found the needle and the seamstress.

Like the Pieces of a Puzzle, these Two Fit
After its acquisition of RailAmerica last year, Genesee & Wyoming (NYSE: GWR) management has said that it is “comfortable continuing to actively look at investment opportunities … in multiple geographies.” GWR has very little exposure to the New England area with just one route from New London, Conn., straight up to Canada. At a recent global transportation conference, the company’s chief financial officer pointed to building regional rail systems through acquisitions as one of its key growth drivers.

Enter Providence & Worcester Railroad Co. (Nasdaq: PWX), an $88 million short-line freight operator in Massachusetts, Rhode Island, Connecticut and New York. The company transported 31,727 carloads of freight for 140 customers in 2012 across a range of commodities. 

For prospective buyers, the company can offer important routes and connection points from Queens, N.Y., through New England and up to Canada. Comparing the company’s route map with that of GWR shows a good fit, with PWX providing a coastal transportation system to complement the Connecticut-to-Canada route.

	Wikipedia/P199
	Will Genesee & Wyoming make a bid to take over Providence & Worcester Railroad?

PWX’s revenue was down 7% in 2012 to $29.4 million, with hauling of chemicals and plastics accounting for almost 40% of the total. Despite the drop in revenue, the company was able to turn an operating profit by decreasing its operating expenses by 14%. 

The company has a fairly strong balance sheet with no long-term debt and $98 million in property, equipment and land held for development. These assets are booked at cost, not replacement value, and could be a significant prize for a buyer. Best yet, the company paid off all its $4.9 million in long-term debt last year, possibly making itself a more attractive target.

A takeover of PWX by Genesee & Wyoming is far from certain, but PWX would make an attractive target to other rail operators as well. An acquisition would add 516 miles of track in a region with a high density of business. As operators consolidate, efficiencies of scale in administration and marketing can be realized. The shares trade just above book value at 1.2 times, a steep discount to the peer average of 3 times.

PWX still has room for growth if it isn’t acquired. High operating costs, 92% of sales relative to an industry average of 75%, have held back profitability. These are mostly due to salary costs of union contracts and could become more favorable with the next round of negotiations. The massive layoffs resulting from the Canadian Pacific strike have set a precedent in the industry, and the union may be more amenable to negotiate. If the company can lower its operating expenses down to 82% of sales, still well above the industry average, it can add another $2.9 million to the bottom line and boost earnings per share by 82%, to $1.33 per share. 

An uncertain future for an industry with strong fundamentals

The bankruptcy of Montreal, Maine & Atlantic Railway after the July crash puts in question service throughout the New England area with opportunities for mergers to create a strong rail network. Larger players like GWR could combine assets from Montreal, Maine & Atlantic with those from PWX to create a competitive advantage. 

Aside from a buyout or interest from an activist investor, the Providence & Worcester Railroad Co. has a strong balance sheet and the potential to add significant shareholder value through cost management. 

Risks to Consider: PWX has had a problem with profitability and higher regulatory or insurance costs could hit the bottom line. While the company is a good takeover target, investors may need to wait on the shares for a while.

Action to Take –> Changes in the business costs for short-line railroads, combined with a strong book of a company assets, makes the Providence & Worcester Railroad Co. one of the best speculative targets. Even if an offer was made for twice book value, below the industry average, investors could realize a 66% return on the shares.

P.S. — Part of investing is finding opportunities no one is talking about — the needles in the haystack. That’s why we recently put together a special report on 17 little-known “spin-off” companies. Because of the way they were formed, these companies have beat the market 7-to-1 in the past decade and raised dividends as much as 600%, yet most investors don’t understand them at all. To get the names and tickers of some of these stocks, click here.