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From the Survey: CSX Corporation
The earnings of railroad giant CSX (CSX) rebounded nicely in 2010, and the share price has picked up steam since midyear. Below, we take a peek at the outlook for 2011 and beyond to see if investors should hop aboard or wait for the next train.
Eastern railway operator CSX recently announced an ambitious goal of achieving a full-year operating ratio (rail operating expenses over revenues) of 65% within five years. This compares to an adjusted operating ratio (allowing for the integration of CSX Intermodal into CSX Transportation) of 74.9% in 2009 and our estimate of 71.0%-71.5% for 2010. (Through the first nine months of the year, the company’s operating profit jumped 33% on a revenue increase of 16 %.) At 65%, CSX would be on par with Canadian National (CNI), by far the most profitable Class I railway in North America, with an operation ratio in the recession year of 2009 of 67.3%, and a record low (better) score of 60.7% in 2006.
This is a tall order indeed, for eastern railroads face a few extra profit margin hurdles when compared to their western or Canadian transcontinental counterparts. In the East, distances between stops tend to be shorter and there are fewer straightaways. Too, densely populated service areas mandate more hazard and other safety precautions, and creates more congestion, including crossroads and the sharing of track with slower passenger trains (Amtrak). So, while there are more potential customers in the East, rail fluidity can be upset and trucks are more competitive. Moreover, shipments in the East consist of fewer high-margined bulk commodities, such as forest products, minerals, and agricultural loads (though transportations rates for grain in Canada are regulated and margins can be thin in any given year), and a greater proportion of more difficult-to-transport consumer goods. Norfolk Southern (NSC), CSX’s most comparable peer had an operation ratio of 75.4% in 2009.
That said, CSX has a three-pronged strategy to reach its profitability target: productivity and service improvements, pricing strength, and volume growth.
Over the past few years, CSX has stepped up its investment in infrastructure and projects designed to vastly improve rail performance and enhance customer service. Capital spending increased from $1.0 billion in 2004 to an estimated $1.8 billion in 2010, and we expect it to remain at elevated levels for the next three or so years. Key routes between the Midwest and Florida and the Midwest and the Port of New Jersey/New York have been double-stacked, allowing intermodal trains to piggy-back containers on a flatbed car, greatly increasing asset utilization. The finishing touches on the state-of-art terminal in Northwest Ohio are being completed this winter. The yard is expected to help build density on main rail lines, improve traffic flow balance, and provide long-haul opportunities. And CSX is leveraging technology, highlighted by the roll-out of remote-control devices at rail yards, which reduce crew starts and headcount. The railroader has also been seeing efficiency gains through established Process Improvement Teams (PIT), assigned to develop more innovative ways to operate.
Productivity, as measured by gross ton miles per employee, was up substantially, year over year, in the third quarter of 2010. The pace of improvement may slow in the near term as employees are hired to handle increasing volumes. Furthermore, as older locomotives are brought back on line, fuel-efficiency may suffer. Note, however, that CSX has plenty of stored engines and rolling stock to grow volumes significantly, without major investments in equipment. The company is targeting productivity savings of between $130 million and $150 million in 2011, with additional savings over the next five years. This is on top of $581 million accomplished in 2009, including $317 million in rightsizing initiatives.
An ongoing large project, called the National Gateway, should improve connectivity between the Midwest and the mid-Atlantic ports. This plan involves double-stack clearances through tunnels and under bridges and upgraded track and switching networks. CSX is currently receiving taxpayer assistance on this project, but its argument for these scarce resources is solid, as the government has been subsidizing trucking for decades via publically financed highways (rails pay fuel taxes too), and communities are eager to reduce pollution and congested, dangerous travel. The National Gateway is expected to be completed in 2014. To date, investment returns have easily exceeded the cost of capital, and the National Gateway should be no exception.
Railroad industry pricing remained strong throughout the economic recession and 2010. In the third quarter of 2010, CSX’s yield was up 6.0%, year to year, and 6.6% on a “same-store’’ basis (comparing the same types of cargo on the same routes). We attribute the strength to the service enhancements made possible by the aforementioned infrastructure investments. More efficient operations have increased speed of service and on-time performance. In addition, rail offers an attractive alternative when transportation budgets are tight. For one, total labor costs are less expensive by train versus truck. For another, fuel consumption can be reduced three- to five-fold, depending on freight type and route. And that brings us to another advantage for trains; their carbon emissions are much lower per ton, at a time when shippers have become very environmentally conscious. CSX is confident that it can maintain core pricing ahead of rail inflation by 2% to 3%, boosting profit margins. The railroader has the vast majority of its contract business for 2011 booked at favorable prices, so visibility is good for the next 12 months.
Freight volumes are on the rise as the economy pulls out of the recession. CSX saw a 10% increase in carloads for the September period of 2010. But volumes are also increasing for many of the same reasons that pricing has been strong. Railroad service has become more competitive with all-road service. Intermodal traffic, where loads are transported to and from the rail yard by truck and carried by trains over the long haul, has become one of CSX’s fastest-growing segments. The company intends to capture even more market share, thanks to its new double-stack capabilities. And better access to ports will allow it to carry more import/export business. The incremental profit margin on added volumes was 61% in the third-quarter of 2010. While that figure may not be sustainable, profit margins should benefit as volume grows.
CSX is now launching its Total Service Integration (TSI) carload plan. This initiative focuses on end-to-end service excellence, building on the One Plan, which concentrated on mainline operations. TSI creates a new local service product offering, promising to improve reliability and consistency for the customer and more volume and efficiency for CSX.
Our main concern over the long term is the potential loss of coal traffic to natural gas, either through regulation or economic concerns. Natural gas prices have remained very low due to growing reserves, especially those discovered in shale deposits in CSX’s territory. Natural gas is also a cleaner-burning fuel. Coal represents about 32% of CSX’s revenues and has better-than-average profit margins. The main consolation is that CSX has expanded its ability to carry western coal and coal exports, which have been very strong, and still have plenty of room to grow.
All in all, we believe the stock of CSX is a good play for momentum investors. The company has emerged from the economic recession with an improved cost structure. And strong cash flows have allowed it to reinvest in the network, aggressively repurchases stock, and regularly increase the dividend, all while maintaining an investment grade balance sheet. We project that share net will advance 15%-20% in 2011 from an estimated $4.05 in 2010.
Freight transportation stocks tend to be early-cycle performers, though, and this one is up over 200% from its low in early 2009. Share appreciation potential to mid-decade is only about average. However, we’re calculating $6.50 a share in earnings assuming an operating ratio of 67% and revenues of $13.4 billion. Using the company’s targeted operating ratio of 65% and the same fair mid-cycle price-to-earnings ratio of 14.0, produces share-net of about $7.00, making the issue a nice longer-term selection.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.