CSX Corporation (NYSE: CSX), based in Jacksonville, Florida, is the third largest railroad company in the US, with a network of approximately 21,000 route miles located throughout 23 states in the eastern one-third of the country, connecting the east coast, mid-west and gulf coast (see the diagram below).
The five leading haulage segments by revenue share are coal (24%), chemicals (16%), intermodal (14%), agricultural products (11%) and automotive (10%).
Clearly railroads and CSX benefit from an expanding economy. That’s one reason to like CSX.
But the investment case for CSX is also based on other factors:
- A significant acceleration in earnings per share (EPS) growth in 2015 and 2016
- Management’s renewed focus on costs following Canadian Pacific’s offer to merge.
- The company moving closer to an industry average operating ratio.
CSX has had eight quarters of sub-10% EPS growth. 2014 was notable for a series of weather related headwinds where network congestion left the company temporarily underprepared to take advantage of increasing traffic. This situation is now behind them if the most recent earnings report (January 14, 2015) is any indication.
In the fourth quarter of 2014, earnings growth accelerated to 17%, driven by improvements in core pricing and intermodal growth. Chemicals and materials volumes were the category growth drivers, up 15% and 13% respectively. This report builds on a surprisingly good (and unexpected) third quarter 2014 earnings release where earnings growth finally broke the 10% barrier with a 14% year-on-year gain.
On the conference call following the earnings announcement, management’s tone was positive:
“We continue to see broad-based strength across our diverse business portfolio and the strength is translating into more visible and more meaningful earnings improvements. CSX achieved double-digit earnings growth in both the third and the fourth quarters and incremental operating margins expanded throughout the year. For the full year 2015 CSX still expects to achieve double digit EPS growth. Even as we cycle strong 2014 volume growth we expect merchandise and intermodal to again grow at a faster pace than the broader economy.”
While volumes will be incremental to earnings growth going forward, “core” pricing is the most important. Accelerating economic growth combined with high volumes and tight capacity in the trucking market due to driver shortages should underpin the core pricing environment in 2015 and 2016 across the majority of CSX’s business segments.
Railroads are capital intensive and have unionised work forces. Cost containment and productivity gains are paramount. In the most recent quarter management flagged over $US200 million of productivity gains in 2015, driven in part by the ongoing workforce reduction program. A significant reduction in fuel costs should also be a nice tailwind in 2015.
Activist investors and possible suitors can also focus management on operational efficiencies. In October 2014, Bloomberg reported that Canadian Pacific (Canada’s second largest rail) had made overtures to CSX regarding a merger but was rebuffed. The merger makes geographic sense, creating a carrier with transcontinental reach, connecting CSX’s network in the eastern US with a Canadian Pacific system spanning the width of Canada. Even with CSX’s backing, a deal would face regulatory scrutiny, however.
Given the improved operating environment, I expect that CSX’s operating ratio (the operating ratio is a major measure of profitability in the railroad industry by calculating operating expenses as a percentage of revenue) should converge toward the industry average of 65.2%. In the fourth quarter of 2014 CSX’s operating ratio was 71.8%, the worst in the industry in spite of a 1.4% improvement quarter-on-quarter. In the fourth quarter 2014 earnings presentation, management said it is targeting a mid-60s operating ratio along with the resumption of margin expansion.
Wall Street has not yet warmed to the CSX recovery story, if the number of “buys” and “holds” are any indication. 11 analysts have a “buy” on CSX but 19 analysts still have a “hold” on the shares.
Given that earnings upgrades and changes of opinion from industry analysts are strong predictors of stock performance, I expect more positive sentiment towards the stock in 2015 as the US economy continues to improve and CSX volumes (up 16% so far this month) and pricing are seen to follow.
CSX is a “buy” at current prices. It is a quality way to play the ongoing US economic expansion and I believe that significant operational improvements due to volumes, pricing, and management focus will result in earnings upgrades and a higher stock price.
The target price is $US44, or 18 times EPS in 2016.
- Economic cyclicality. CSX’s volumes are subject to cyclical factors, including economic conditions, customers’ business conditions, credit markets, and seasonal patterns, which may adversely affect freight volumes.
- Rail is a competitive market. Freight rates may be subject to significant competitive pricing pressures from other transportation providers, including other modal providers (trucks), which may limit the growth opportunity and adversely affect operating results.
- A highly regulated industry. The railroad industry is subject to various laws and regulations that govern industry-related and environmental activities. Changes or violations of these laws or regulations could adversely affect operations.
- A unionised workforce. Most of CSX's employees are represented by labour unions and are covered by collective bargaining agreements. Inability to negotiate acceptable agreements may result in loss of business and increased operating costs from higher wages or benefits paid to union members.
- Volatile fuel prices. Fluctuating fuel prices may adversely affect operating results, as increases in fuel surcharge revenue may not offset increases in fuel costs, and increases in freight revenue may not offset reductions in fuel surcharge.
CSX network map
To see CSX's forecasts and financial summary, click here.