February 02, 2022 - 6:19pm EST by
2022 2023
Price: 34.70 EPS 0 0
Shares Out. (in M): 2,218 P/E 0 0
Market Cap (in $M): 77,008 P/FCF 0 0
Net Debt (in $M): 14,050 EBIT 0 0
TEV (in $M): 91,058 TEV/EBIT 0 0

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We put CSX as the headline pitch but the thesis is on the broad railroad industry with inflection driven by the recent supply/demand imbalance we’ve experienced as of late. 

As many of member of VIC already know, rail-roads have been an attractive industry to invest in given the large barriers to entry + consolidated nature of the industry resulting in a duopoly structure for each major region which gives each operator pricing power.  Major players in the industry have been growing earnings at low to mid-teens CAGR since the financial crisis driven by combination of revenue growth of ~2-3% (mix of volume growth of <1% and pricing growth of ~2%) + margin expansion from 25% to ~40% + buybacks. 

The biggest structural change driving the margin expansion to the current 40% rate has been the introduction of Precision Scheduled Railroading (PSR) by Hunter Harrison, first to the Canadian railroads and then subsequently copied by most of the US railroads.  Key to PSR’s tenet is making trains run more efficiently by maximizing asset utilization and reducing idle times, which ultimately leads trains to run on time and reduces costs leading to improved operating ratios. 

On top the mid-teens earnings growth, railroads multiples have also expanded during this period from ~12x to current 19-20x level.  Given this backdrop, railroad stocks have been able to generate annualized returns of ~20% between 2009-2021, exceeding S&P’s return of ~15% over the same period.

As we sit today, we think railroads will benefit from two key drivers that will potentially serve as inflection point on their earnings outlook that is underestimated by consensus estimates – volume and pricing.  Volume growth in 2021 was disappointing due to significant disruptions in the supply chain network that we’ve all been hearing – while demand recovery was strong across the board, low inventory, capacity constraints, and congestion across ports all contributed to disruption of the supply chain within the intermodal market and ultimately affecting volumes at the railroads.  Looking at the most recent disclosed #s from Q4, we’ve seen volumes decline across various end segments, with autos down low to mid-teens (due to chip shortage and plant closures) and intermodal also down high single to low double digits (due to port congestion + shortage of truck drivers).  Clearly, no one has visibility in the short term of when these disruptions will stop, but we believe over the medium-term, these supply/demand imbalances will normalize which will lead to a normalization and most likely, significant pick-up in volumes. Given the underlying segments the railroads service, volumes tend to be tied to industrial production.  In UNP’s Q4 call, management stated “With volumes, we stated that we would outpace industrial production through our business development efforts….the current forecast for 2022 industrial production is 4.8%. To outperform that forecast, we have new business wins…as well as the anticipated recovery of autos and international intermodal. We also expect to have the added benefit of coal volume growth.”  To the extent this supply/imbalance corrects itself in the second half of 2022, we will see a big acceleration in volume growth in the range of 5%+. 

An additional benefit from the reacceleration in volume growth will the higher incremental margin potential given the embedded operating leverage in the business.  In a recent note from GS, the analyst provided the following comment on this upside risk: “[increased volume growth] could cause current rail estimates to prove conservative given more volume-related density can lead to better leverage than currently in forecasts. Should volume growth re-accelerate sharply relative to other asset-based subsectors, we think this could push the rails to outperform especially given the lagging position in 2021.” Despite the recognition of the upside, analysts continue to forecast revenue to grow only 3% between 2023 and 2022 while EBIT margins will remain at the 42% range.  We think this is far too conservative given the current dynamics we are facing in the market.  In fact, management of UNP reiterated the upward trajectory of margins in their Q4 call “At our Investor Day, we targeted incremental margins in the mid to upper 60% range. For 2022, we would expect to be at the low end of that range given the significant mix shift to intermodal growth. The combination of growing volumes, pricing above inflation, and strong incremental margins should lead to the achievement of our long-term goal of a 55% operating ratio. Putting a little finer point to it, we would expect to achieve around 55.5% operating ratio for full-year 2022.”


The second lever is pricing.  If we look at truck freight rates, which is the main competitor to trucks, rates are currently 25-30% higher than pre-pandemic levels.  The American Trucking Association VP and Chief Economist made the following comment recently “In 2021, we moved about the same amount of goods via truck freight in the U.S. as we did in 2020, but it cost more than 25 percent more to do so….The demand for trucking services continues to be high, but until driver shortages, as well as various supply chain challenges—such as those that are causing new truck and equipment shortages—are improved, capacity will be constrained.” The natural benefit for rail is that because of its cost structure (less levered to fuel and labor than trucking), rail should disproportionately benefit from taking volume from trucking.  In CSX’s Q4 earnings call, management reflected on this dynamic: “The market is -- clearly, there's tight from the supply chain, from the transportation side. You've seen our primary competition. Truck rates are up significantly, and we're having to react to that, obviously, in what we're doing. But also working with customers on opportunities for them to convert more freight over to rail. In this high inflation market, they're looking for ways that they can save on their transportation costs, and rail is almost every time the most economical solution for them. And so those discussions, I'm happy to say, are really accelerating now…So I would say, certainly, the market is better than it was last year. We're working with customers. They understand the cost pressures that are out there across the world, they're seeing it. They're asking their customers for the same. So we're seeing some positive momentum on that side.”  And not only will rails be able to take volume from trucks, but they can increase pricing at high levels but still below those of freights and still remain competitive.  UNP  management stated that they have been increasing rates above inflation on ~10-15% of the intermodal renewals “We've got a favorable pricing environment. I am going to talk about call it our domestic intermodal business. We are about 10% to 15% in on a lot of the bids that we are looking at. And again, it's a favorable pricing environment. We'll have to see how that plays out in the second half of the year. Right now, it looks good, but we are going to be looking at it quarter by quarter. But, great environment to reprice.”

As a result of all the factors above, we think there is a potential for the rales to significantly accelerate top line growth via volume + price increases with disproportionate portion of this growth flowing through the bottom line.  GS has CSX generating an EPS of $1.9 in 2023. We think this could potentially be closer to the $2.5/share range.  At 20x, this would result in a stock price of $50/s vs. today’s $35.  If we have any re-rating on top of this, we could see stock closer to the $60/s range.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


Volume + pricing + margin acceleration driving inflection in earnings growth 

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