Description

I am recommending a long position in the common stock of CSX Corp (CSX). I wrote most of this report prior to last Thursday and Friday’s +10% increase in CSX stock price off its low on Wednesday. I still think the stock is attractive here and based on the JPM conference presentation there should be increased confidence in CSX’s 2012 performance and therefore possibly lower downside in the stock. On the other hand we’ve missed that +10% move and the upside over any time period is thus reduced by that amount.

The only long railroad recommendations I can find on VIC are UNP from 2004 (+322%), reiterated in 2010 (+69%), and BNI from 2001 (+293%) and 2007 (+23%). Otherwise there is a short CP recommendation from 2011 with some good Q&A around railroad valuations and Capex vs. depreciation, revenue adequacy, and the probability of future regulation that will possibly hurt railroad profitability. The 2007 BNI writeup has some good background on the railroad industry as well. I mention this because the railroads are very solid businesses with seemingly permanent cost advantages relative to trucking, which is an industry perhaps 8-9x the size in terms of total revenues. Yet the high capital expenditures required to maintain the business likely turns off many investors. Still railroads produce a lot of FCF and CSX in particular appears to be undervalued as I discuss further below.

Investment Highlights

Wide moat from network effects, barriers to entry, economies of scale, and efficient scale—assets are impossible to replicate, costs are low relative to the major alternative, trucking.

Oligopoly with rational actors in combination with competitive advantages leads to significant pricing power—pricing has increased at a 6% CAGR since 2001.

Well run business that has improved dramatically over the past decade—operating margin has increased from 18% in 2002 to 29% in 2011.

High incremental operating margin—due to both operating leverage and pricing power incremental operating margins are generally above 40%. Yet CSX demonstrated a much more flexible cost structure than expected when revenue fell -20% in 2009 while operating income only dropped -17.5%.

Shareholder friendly management—bought $1.56B of stock in 2011 or about 6% of shares outstanding and cumulatively $6.8B and 29% of S/O over the last 5 years. Transparent and ambitious financial targets for 2015. Frequent communication with analysts. Clearly focused on shareholder returns.

Financially flexible—Net Debt/EBITDA of 2.1x including underfunded Pension and OPEB plans and capitalized operating leases; recently issued 30-year bonds at 4.4%.

Valuation is low relative to its history, the S&P 500, and UNP—19% below its L10Y mean P/E, 5% below its mean relative P/E to the S&P, and 18% below its mean relative to UNP. On an absolute basis the stock trades at a 5% FCF Yield (CFFO-CapEx), compared to a median of 2.9% from 2001-2005 and 4.6% from 2007-present. Dividend Yield is 2.2%.

Company History

The Company’s heritage dates back to the early nineteenth century when The Baltimore and Ohio Railroad Company (“B&O”) – the nation’s first common carrier – was chartered in 1827. Since its founding, numerous railroads have combined with the former B&O through merger and consolidation to create what has become CSX.  Each of the railroads that combined into the CSX family brought new geographical reach to valuable markets, gateways, cities, ports and transportation corridors. CSX was incorporated in 1978 under Virginia law. In 1980, the Company completed the merger of the Chessie System and Seaboard Coast Line Industries into CSX.  The merger allowed the Company to connect northern population centers and Appalachian coal fields to growing southeastern markets.  Later, the Company’s acquisition of key portions of Conrail, Inc. allowed CSX to link the northeast, including New England and the New York metropolitan area, with Chicago and midwestern markets as well as the growing areas in the southeast already served by CSX.  This current rail network allows the Company to directly serve every major market in the eastern United States with safe, dependable, environmentally responsible and fuel efficient freight transportation and intermodal service.

Business Description

CSX provides rail-based freight transportation services including traditional rail service and the transport of intermodal containers and trailers. CSX serves major population centers in 23 states east of the Mississippi River, the District of Columbia and the Canadian provinces of Ontario and Quebec.  It has access to over 70 ocean, river and lake port terminals along the Atlantic and Gulf Coasts, the Mississippi River, the Great Lakes and the St. Lawrence Seaway.  The Company’s intermodal business links customers to railroads via trucks and terminals. CSX also serves thousands of production and distribution facilities through track connections to approximately 240 short-line and regional railroads.

Assets: 21,000 route miles (37,000 total track miles); CSX operates 4,116 locomotives, of which over 95% are owned by CSX, average age 20 years. In 2011, the average daily fleet of cars on line consisted of approximately 206,000; CSX owns 95,422 railcars.

CSX is one of two Class I (>$399mm in revenues) railroads with a network that covers the U.S. east of the Mississippi river, Norfolk Southern being the other. The biggest difference between their two footprints is that CSX’s tracks extend into Florida while NSC’s do not.

The U.S. demand to move more goods by rail is expected to rise along with the need to reduce highway congestion and greenhouse gas emissions. CSX and freight railroads are the best way to meet this demand while reducing environmental impacts. CSX can move a ton of freight almost 500 miles on one gallon of fuel and, on average, over three times more fuel efficiently than trucks.

CSX's network is positioned to reach nearly two-thirds of Americans, who account for the majority of the nation's consumption of goods. Through this network, the Company transports a diverse portfolio of products and commodities to meet the country's needs. These products range from energy sources like coal and ethanol, to automobiles, chemicals, building materials, paper, metals, grains and consumer products. The Company categorizes these products into three primary lines of business: merchandise, coal and intermodal.

Merchandise business—shipped 2.65 million carloads and generated approximately 54% of revenue and 41% of volume in 2011. The Company’s merchandise business is the most diverse market and transports aggregates, metal, phosphate, fertilizer, food, consumer (manufactured goods and appliances), agricultural, automotive, paper and chemical products.

Coal business--shipped 1.53 million carloads and accounted for nearly 32% of revenue and 24% of volume in 2011.  0.95 million of these carloads (62%) were to about 90 domestic utilities, about 24% of the carloads were exports, and the remainder (14%) shipped to industrial and steel plants. The Company transports utility, industrial and export coal to electricity-generating power plants, steel manufacturers, industrial plants and deep-water port facilities.  In 2011 37% of export coal (will be closer to 50/50 in 2012) and nearly all of the domestic coal that the Company transports is used for generating electricity. Export met coal contracts typically last 1 year; export thermal coal 1-2 years; export tariff rates are reset quarterly; and domestic coal contracts last 3-5 years.

Intermodal business—shipped 2.29 million carloads accounting for approximately 12% of revenue and 35% of volume in 2011. The intermodal line of business combines the superior economics of rail transportation with the short-haul flexibility of trucks and offers a competitive cost advantage over long-haul trucking.  Through a network of more than 50 terminals, the intermodal business serves all major markets east of the Mississippi and transports mainly manufactured consumer goods in containers, providing customers with truck-like service for longer shipments.

Competition

CSX primarily competes with Norfolk Southern amongst the other regional and local railroads and motor carriers. Barges, ships and pipelines compete to a lesser extent. One major competitive advantage that trucking and water transport have over rails is that they utilize public rights-of-way that are built and maintained by governmental entities while CSX and other railroads must build and maintain rail networks largely using internal resources.

Management

Management is clearly focused on operational improvement and shareholder return. In their presentation they highlight improvements in operating income, operating margin, and earnings per share, and how these improvements since 2006 stack up against the rest of the S&P 500 (top 26%, 13% and 16%, respectively). I have never seen this type of comparison made; clearly management is focused on the company’s financial performance and is proud of the improvements they have made. Rather than simply discussing the share price, however, I like how they show that the underlying financial performance has been really good (and the implication is that shareholder return will eventually follow).

Ambitious 2015 targets

On May 18^th of last year at its analyst day the company announced the following ambitious 2015 financial targets:

Operating ratio of 65%

Operating income of $5.5-6.0B (12-14% CAGR from 2010)

EPS of $3.09-3.36 (18-20% CAGR from 2010)

In 2011 the Operating ratio improved 20bps to 70.9%, Operating income grew +11% to $3.4B and EPS grew +24% to $1.67. So the operating ratio improvement is below the pace required, operating income is about on track, and EPS growth is better that expected. The targets are certainly ambitious but the company has said that despite the headwind that the large decline in utility coal shipments has created, they are still on track to reach these goals, although it will clearly be a lot more difficult than they expected when they set them one year ago.

Committed to stock buyback

In 2011, CSX repurchased a total of $1.56 billion of common stock, which includes $1.3 billion from the new share repurchase program announced in May 2011. As of December 30, 2011, the Company had remaining authority of $734 million under this new $2 billion program. CSX did not repurchase any shares in 4Q11. CSX expects to complete the remaining repurchase amount by the end of 2012. Since year end, the Company has completed $178 million of additional share repurchases through a trade date of February 15, 2012.

Shares repurchased by year:

2011: 67mm shares @ $23.20

2010: 80mm shares @ $18.14

2009: 0 shares

2008: 86mm shares @ $18.37

2007: 153mm shares @ $14.23

Cumulative L5Y: 386mm shares @ $17.50 for $6.8B or about 29% of shares outstanding at the beginning of the period. This compares to FCF of $5.15B (using CSX’s definition, which includes property dispositions which  have been significant in the last 3 years); so CSX has spent 131% of the last 5 years’s FCF buying back stock, a difference of $1.6B. But because operating income has grown so much over that period, leverage, as measured by Debt/EBITDA, has not increased. Perhaps more importantly, because interest rates have decreased, fixed charge coverage (EBIT/Interest expense) has increased from 5.03x in 2006 to 6.19x in 2011. CSX’s $9B of debt is comprised of more than 30 issues of bonds, 100% fixed, with a weighted average interest rate of 6.1% and a weighted average maturity of 14.5 years. They have $1.9B maturing over the next 3 years, which, if interest rates and their credit spread stays where they are today, would lower their average interest rate by 40bps. This will only increase EPS by about 2c, but it demonstrates the company’s increasing financial flexibility, even with significant debt.

With regard to 2012 guidance, the CFO recently said that even if utility coal volume continues to be down 25-30% YoY, CSX will still have a record year for earnings. Consensus EPS is $1.81 and 2011 EPS was $1.67.

Why is the stock mispriced?

I think there are two reasons the stock is trading at its current price, which is below fair value, in my opinion, both relative to the other railroads and on an absolute basis:

1)      Coal

There is a lot of concern around declining domestic coal shipping, and CSX has the highest exposure among the rails, possibly explaining why it is the cheapest stock among its peers (based on FCF Yield; NSC is cheaper based on EPS). One relevant point the CFO mentioned in his 3/15/12 conference presentation is that CSX carload volume declined by 882,000 from 2006 to 2011 and utility coal accounted for 530,000 of that decline—a -36% decrease—and yet operating profit increased +74% over that time frame. Coal powers about 39% of the country’s electricity today and the EIA expects the percentage to be comparable in 2035 but in absolute terms consumption will increase since our electricity production will increase over that period. So domestic coal shipping is not falling to zero any time soon, and in the meantime export coal will be flat in 2012 at 40mm tons, which was up 33% from 2010, mitigating the overall decline in coal revenues. YTD exports are up +5% so the forecast of flat volumes looks conservative thus far. There is also a positive mix shift here as export coal yields higher revenue per unit than domestic utility coal, so revenue will not fall as fast as total coal volumes. Export coal should have healthy demand for years to come due to rapid emerging markets growth and lower environmental standards.

From the 10-K:

Rapid economic growth in developing countries such as India, China and Brazil has generated a long term growth cycle in export coal demand. As a result of the increase in global steel production, demand for U.S. coal is expected to remain strong. Demand for coal used in electric power generation is also expected to remain high due to rising consumption as developing countries become more urbanized. These increases in global coal demand are expected to largely be met by export shipments with a considerable portion originating from the U.S. The Company is well-positioned to capitalize on this market growth through its network access to large U.S. coal suppliers and multiple port facilities.

Coal revenues as % of total in 2011:

CSX 32%, NSC 31%, BNSF 27%, UNP 22%

But the more important number is probably domestic utility coal revenues as a percentage of total revenues, because that is where the real weakness is, and for CSX based on the CFO’s recent remark that shipments are about 10% of volumes, that number is probably less than 15% on a run-rate basis. While 15% is not insignificant, weakness in that amount of the company’s business does not warrant a such a large discount as will be discussed later in the valuation section, particularly since every rail is experiencing some weakness, although not necessarily to the extent that CSX is.

2)      CSX has long had a reputation for being poorly managed

Based on current financial metrics this is simply no longer the case. Other service and operating measures might still lag but the financial metrics are what should matter most to investors and if CSX can translate subpar service and operating metrics into average to better than average financial metrics perhaps this indicates room for additional upside. Service measures such as on-time originations and arrivals have improved dramatically over the past four quarters to record levels for the company in 1Q12.

Operating Margin: Between 2000 and 2009 CSX’s operating margin averaged 5.2% below that of NSC. In the 1990s the gap was even wider, 9.2%. But since the beginning of 2010 CSX’s margin has averaged almost 1% higher than NSC’s. Similarly, CSX averaged an operating margin 3.5% below that of UNP in the 1990s. The gap widened to 6.5% from 2001-2004. But since 2005 CSX has actually averaged a 2% higher margin, although today they are about even. BNI had a similar advantage over CSX in the 1990s with a 5% advantage; the advantage increased in the early 2000s, averaging 6.7% until 2007. But since 2008 CSX has had the advantage by 2.2%.

Return on Invested Capital is another way to measure management quality within an industry. Since the current CEO assumed his post in January 2003, ROIC as Bloomberg defines it has improved from about 5% to about 12%. During those 8 years the average annual ROIC has been about 9.9%. Cost of capital is about 8.7% as I calculate it, so CSX has been earning far above its cost of capital in the last two years and should again in 2012, and has added value for the past 7 years. During the same 8 years UNP’s average ROIC has been 9.4%, NSC’s 10.5%, and BNI’s 10.7% (2004-2009). So CSX is middle of the pack on ROIC and leading on operating margin. Based on these financial metrics it doesn’t seem accurate to call CSX the worst managed railroad and to give it a large discount to its peers (all Class I railroads except NSC).

In terms of shareholder friendliness as measured by stock buyback, CSX has purchased $6.8B over the last 5 years (29% of S/O in January 2007) compared to $5.7B for UNP (15%) and $5.2B for NSC (22%). Dividend yield for NSC is 2.7% and 2.1% for UNP vs. 2.2% for CSX. So CSX appears to be returning more cash to shareholders than its two largest peers.

Finally, I think railroads have historically been viewed as regulated monopolies, like utilities, which seems to be only partially right. Here is Morningstar’s description of the industry:

“Heavy freight-hauling assets owned by North American railroads like CSX are practically impossible to reproduce. The costs and challenges of obtaining rights-of-way and building track erect a nearly insurmountable barrier to entry. Despite this powerful competitive advantage, railroads historically have failed to earn returns on investment greater than their cost of capital, due to heavy track reinvestment expenditures, government-mandated safety programs, some rate regulation, and competition from trucks in some commodities.”

While low ROICs were the norm in certain historical periods, (e.g. 1998-2004) this has not been the case in recent years as railroads have been able to increase prices above inflation. Morningstar also describes how powerful the moat is that railroads have established; and one benefit of their system is that the competitive advantage relative to trucking increases if the price of oil continues to rise. High CapEx is no doubt a permanent feature of railroad operations; but in spite of this the businesses have also produced significant free cash flow in recent years. CSX has averaged $1B over the last 5 years. Generally companies with nearly insurmountable barriers to entry and few substitutes that are growing EBIT at 12-14% per year do not trade at 6% FCF yields (CSX definition includes property dispositions which have been significant in the last 3 years), but that is where the stock trades if you believe their 2015 targets are achievable.

Valuation

L10Y TTM P/E Analysis

CSX

Mean: 16.3x

Low: 5.9x

High: 24.7x

Current: 13.2x

Relative to the S&P 500

Mean: 0.95x

Low: 0.54x

High: 1.32x

Current: 0.905x

Relative to UNP

Mean: 0.95x

Low: 0.59x

High: 1.5x

Current: 0.78x

Relative to NSC

Mean: 1.05x

Low: 0.63x

High: 1.5x

Current: 1.07x

BNI purchase by Berkshire Hathaway on 11/3/09:

19x TTM P/E

CSX is also trading at least 1 standard deviation below its historical average relative P/E to less comparable Class I railroads CP, CNI, and KSU.

Return forecasts and estimated probabilities:

Base case: $29, p=60%. Industrial production growth 1% + inflation 4% + pricing 1% = 6% growth.

Upside: $36, p=20%. IP growth 1.5% + inflation 3.5% + pricing 2% = 7% growth.

Downside: $19, p=20%. IP growth 1% + inflation 3% + no pricing = 4% growth, PTC cost $1.5B in present value.

Expected Value = $28, +28%

Base / Downside:  2 / 1

Upside / Downside: 4 / 1

Risks

• Increasing cost of PTC— In 2008, Congress enacted the Rail Safety Improvement Act (the “RSIA”).  The legislation includes a mandate that all Class I freight railroads implement a positive train control system (“PTC”) by December 31, 2015.  The Association of American Railroads recently advised the Federal Railroad Administration on behalf of the industry that a nationwide interoperable PTC network cannot be completed by the December 31, 2015 deadline. Federal legislation introduced in both the House of Representatives and the Senate would, if approved, delay the final implementation of PTC from three to five years. CSX previously estimated that the total multi-year cost of PTC implementation would be at least $1.2 billion for the Company. This estimate is currently being re-evaluated due to upward pressure on these costs.
• Legislation that limits fuel surcharges or price increases above inflation—fuel surcharges were first implemented in the early 2000s and have continued since that time which largely protects railroads from increasing locomotive diesel fuel prices. There have been various lawsuits filed against railroads alleging that fuel surcharges are illegal but thus far none have resulted in material fines or findings for plaintiffs. Prior to 2000 rail stock price movements correlated negatively (-0.4) with oil prices; between 2000-2006 the correlation was positive 0.9. If fuel surcharges were eliminated or minimized this would be extremely detrimental to CSX’s value.
• Worse than expected utility coal volume declines—in the near term, 1-2 years, this would weaken the investment case for CSX as earnings would barely grow. Over the longer term, 3-5 years, as utility coal would shrink to an immaterial percentage of the business, this would not impact the value proposition.

Catalyst