Morgan Stanley Prefers Highest-Quality, Defensive Rails; CNR Is The Favorite

Morgan Stanley says Canadian National Railway (USA) (NYSE: CNI) is its favorite pick in the railway sector as it prefers highest-quality, defensive rails that have the best operating performance, least exposure to at-risk end markets and strongest balance sheets/management to drive industry consolidation.

Morgan Stanley's top pick is Canadian National Railway, which is rated Overweight, followed by Union Pacific Corporation (NYSE: UNP) Kansas City Southern (NYSE: KSU) and Genesee & Wyoming Inc (NYSE: GWR) all rated Equal-weight. Meanwhile, CSX Corporation (NASDAQ: CSX) is rated Underweight.

The emerging debate around Rails is whether easy comps in 2H16 and M&A catalysts make the Rails a buy after a dismal 2015 or whether further macro deterioration could make 2016 another disappointing year for volumes which, in turn, could affect pricing.

"The only things we know for certain are that visibility into 2016 is exceptionally poor and both investors and Rail management teams are going to react to data in real time. However, we believe the more pressing concerns around Rails could be more structural and longer-term in nature," analyst Ravi Shanker wrote in a note to clients.

Meanwhile, Class I Rails get 50 percent of revenues and 60 percent of their volumes from four end markets namely coal, energy, auto and intermodal. Structural weakness in these markets could mean virtually no volume growth for Class I Rails

Shanker said UNP is also a high quality operator, but are somewhat concerned by its end-market footprint. On KSU, though the analyst likes its growth story and footprint, he noted that the company is heavily leveraged to the auto.

GWR has a proven track record of acquisitions, but there is relatively limited scope of needle-moving deals in the near-term as the company is focused on cutting its debt load. The analyst is Underweight on CSX despite its cheaper valuation, given its tough structural position and operating metrics that lag peers.