It is a well-established fact that the widely-diversified transportation sector including airline companies, railroads, truckers, shippers to name a few, has struggled for the better part of 2017. Sector participants have been plagued by a number of headwinds like disruptions from back-to-back hurricanes, the devastating earthquake in Mexico, declining automotive volumes, issues related to customer dissatisfaction and high costs (labor as well as fuel).

The lackluster performance of the sector in the first nine months of the year can be seen from the graph below. The chart clearly indicates that the sector has climbed only 8.8%, underperforming the S&P 500 Index, which appreciated 12.6% over the same period.

Uptrend Over the Last Few Months

However, matters have been changing for the better over the past few months on the back of several tailwinds. We are optimistic about the fact that the sector has outperformed the S&P 500 index in a month. It has gained 6.8% compared with the S&P 500 index that advanced 3.5% over the same time frame.

Railroads Poised for a Great 2018

Railroads have been benefiting since the beginning of 2017 after struggling for the past couple of years. The prime factors contributing to this improved scenario are increased coal and intermodal revenues.

Particularly with Donald Trump’s presidency, the coal industry is seeing better days. The President is aiming to revive the industry by relaxing regulations, which were hurting its prospects.

The rise in natural gas prices is also favorable to boosting demand for coal. Moreover, per the U.S. Energy Information Administration (EIA), coal production in the United States will increase in 2018. Since revenues from coal contribute significantly to the railroads’ top line, any positive development for the commodity means good news for the sector.

Apart from coal, the scenario pertaining to another key source of revenues for railroads and intermodal, has improved by leaps and bounds this year. In fact, intermodal shipments are expected to grow 4.2% in 2018. This in turn will drive the top line for railroads.

Moreover, railroads like Union Pacific Corp. (UNP - Free Report) have hiked their quarterly dividend payouts this year, indicating their financial prosperity. The solid financial status of these companies bodes well for 2018.

Recovery of the U.S. economy is also likely to pave the way for railroads. Notably, U.S. GDP is expected to increase by 2.4% in 2018, higher than what was achieved in the last two years. Generally, a buoyant domestic economy results in an uptick in rail shipments of goods across the United States.

The improved economic scenario is evident from the fact that in the third quarter of 2017, the domestic economy expanded at an impressive annual rate of 3%, per the latest report from the Commerce Department. The reading was above the consensus estimate of 2.6%.

Trump’s Tax Overhaul — A Boon

The biggest overhaul of the U.S. tax code in 30 years is a positive for the transport companies and should propel the sector’s growth in 2018. Corporate tax rate will be lowered from 35% to 21% as a result of this move.

Transportation stocks — mainly railroads and airlines — invest significantly for capital expenditure as the industry is capital-intensive in nature. In the current scenario, capital expenditures cannot be deducted in the year they are incurred. Consequently, U.S. companies need to plan judiciously regarding their capital expenditures. However, companies will be able to deduct their capital expenditures from the taxable income immediately, per the U.S. tax overhaul. Naturally, this aspect hugely favors transports.

As and when the companies are able to reduce capital expenses in the year of their occurrence, their tax bills for the year would be lowered significantly due to higher deductions. This will in fact leave more cash in the hands of these companies to fund their capital expenditures, acquisitions, share repurchases among others.

Notably, FedEx Corp. (FDX - Free Report) has already indicated that it will increase spending on its various logistics and delivery businesses with the windfall payout the tax cut will grant.
 
Apart from railroads and package delivery companies, stocks belonging to the airline spaceare also expected to be huge benefactors from the U.S. tax overhaul. The capital-intensive nature of the industry implies that the above-mentioned benefits pertaining to capital expenses should assist the carriers as well.

Since most airline companies are almost entirely exposed to the statutory corporate tax rate, the massive tax cut is expected to help them save a considerable amount in tax payment in the United States.

Airlines’ Profitability to Rise in 2018

The International Air Transport Association unveiled a rosy view for carriers with respect to the profitability level for 2018. The research firm predicts global net profit of $38.4 billion for the industry. This is much higher than the 2017 profitability forecast of $34.5 billion (increased from the $31.4 billion predicted in June). This bright projection despite increased costs can be attributed to the strong demand for air travel.

The top line is predicted to come in at $824 billion next year compared with $754 billion, forecast in the current year. Cargo revenues are likely to increase to $59.2 billion for 2018 (estimated revenues for 2017 are $54.5 billion).

Per the forecast, 6% air travel growth is expected in 2018 compared with 7.5% rise in 2017. This estimated figure for 2018 is however, above the average growth of 5.5% in the last 10-20 years.

The research firm has also predicted that the average net profit per departing passenger would be $8.90 in 2018 compared with $8.45 in 2017.

Declining air fares have been hurting the top lines of carriers. Although low airfare brings good news for flyers, it is a bane to the airline companies. However, air fares are expected to rise in 2018, thanks to the likely oil price surge of 10.7% to $60/barrel for Brent Crude. High air fares will boost the top lines of carriers.

Moreover, the bullish unit revenue forecasts projected by several carriers in the recent times reflect their easing revenue related woes. Notably, in December, JetBlue Airways (JBLU - Free Report) provided a raised guidance for the fourth quarter. This Zacks Rank #3 (Hold) company now expects RASM in the range of down 0.5% to up 1.5% (on a year-over-year basis). The revised view reflects an improvement from the prior outlook of a decline of 3% to flat year over year. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Southwest Airlines (LUV - Free Report) now anticipates operating revenues per available seat miles (RASM: a key measure of unit revenues) for the fourth quarter of 2017 to increase 1-2%, higher than the previous guidance of a slight rise of up to 1.5%.  

The progress in the condition of the sector is highlighted by the upgrade in the Zacks Industry Ranks of most components in the transportation space. For instance, the Transportation-Airline division carries a bullish Zacks Industry Rank of 72 (out of 250 plus groups). This favorable rank places the companies within the top 28% of the Zacks industries.

With things looking up for the transportation sector, we have zeroed in on four stocks with potential to outperform in the upcoming year.

4 Prominent Picks

Given the vast size of the sector, it is no mean task to zoom in on the likely outperformers for the coming year. This is where the Zacks Rank, justifying a company’s strong fundamentals, can come in really handy. In addition to a favorable Zacks Rank, the stocks have a sound VGM Score. Here V stands for Value, G for Growth and M for Momentum and the score is a weighted combination of these three scores.

Such a score allows you to streamline your search and eliminate the negative aspects of the stocks to select winners. However, it is important to keep in mind that each Style Score will carry a different weight while arriving at a VGM score. Our research shows that stocks with an impressiveVGM Score of A or B when combined with a Zacks Rank #1 or 2 (Buy), offer the best upside potential.

Apart from a favorable Zacks Rank and a VGM score, the stocks also possess large market capitalizations to their credit.This is because focusing on such stocks is considered safe. Their large market capitalizations provide the requisite cushion to combat economic downturns and stringent credit conditions.

Deutsche Lufthansa AG (DLAKY - Free Report) , commonly known as Lufthansa is one of the largest German airlines and is headquartered in Cologne, Germany. The company carries a Zacks Rank of 2 and has a market capitalization of $16.59 billion. It has a solid VGM Score of A. The forward price-to-earnings (P/E) ratio for the current financial year (F1) is 8.3, lower than the industry average of 11.1.

The stock has returned more than 100% so far this year, outperforming the Transportation sector’s gain of 11.8%. (Looking for the Best Stocks for 2018? Be among the first to see our Top Ten Stocks for 2018 portfolio here.)

FedEx Corporation offers customers a one-stop source for global shipping, logistics and supply chain solutions. This Zacks #2 Ranked player has an encouraging expected earnings growth rate (next 3-5 years) of 12.8%, higher than the industry’s 11% growth. The forward price-to-earnings (P/E) ratio for the current financial year (F1) is 20.1, lower than the industry average of 26.5.

The company has a market capitalization of $63.95 billion and a strong VGM Score of A. Additionally, the stock has returned 34.4% on a year-to-date basis.

Gol Linhas Aereas Inteligentes S.A. (GOL - Free Report) is a low-cost, low-fare Latin American airline, headquartered in Sao Paulo, Brazil. The company has a market capitalization of $1.43 billion and is a #1 Ranked player. It has a commendable VGM score of A. The stock has seen the Zacks Consensus Estimate for 2018 being revised 23.3% upward over the last 30 days.

The company has returned more than 100% so far this year.

SkyWest, Inc. (SKYW - Free Report) is the holding company for two scheduled passenger airline operations and an aircraft leasing company. The company carries a Zack Rank #2 and has a market capitalization of $2.70 billion. It has a VGM score of A.

The stock has seen the Zacks Consensus Estimate for current-year earnings being revised 1.5% upward over the last 60 days. For the upcoming year, the metric has moved 4.3% north over the same time frame.

The stock has returned 49.4% on a year-to-date basis.