CSX Adapting To New Realities

By Stephen D. Simpson, CFA | April 17, 2013 AAA

It wasn't long ago at all that the rails seemed to have things pretty much all going their way. Better management was producing better margins, pricing advantages over trucking were leading to good intermodal growth, and a recovering economy was supporting higher traffic and strong pricing. Then came a structural shift in electricity generation and a serious drought that hammered both coal and agricultural volumes.

To its credit, eastern rail operator CSX (NYSE:CSX) is rolling with the punches. The company is largely through the worst of the volume reset caused by declining coal demand, and while management has stretched out its margin improvement targets, there's still a pretty good case to be made for solid operating performance over the next few years. Unfortunately, the market has been quick to anticipate this and the shares don't look like a tremendous bargain today.

SEE: A Primer On The Railroad Sector

Q1 Not Quite As Good As It Seems, But Okay All The Same
With most banks citing economic uncertainty as a leading cause of stagnant loan demand and many industrial companies talking about weak demand, this wasn't set up to be a great quarter for CSX. Even so, it turned out to be an okay quarter and management continued to deliver margin improvements.
Revenue fell slightly this quarter, as the company couldn't completely recapture a 1.5% volume decline with better pricing. Intermodal remained a source of relative strength, with revenue up almost 4%, but at less than 15% of revenue it can only help just so much. Merchandise revenue rose more than 2% on good pricing (up more than 3%), while coal was down nearly 13% on a greater than 10% decline in volume.
Operating income improved about 2% from the year-ago level and nearly 9% from the prior quarter, as the company saw a big benefit from lower material and supply costs. The company's operating ratio (basically in the inverse of operating margin) improved by 70bp to 70.4. While CSX's reported EPS did benefit from liquidated damages and the MSO benefit, the company still managed a small beat (relative to the average estimate) on the operating line on an adjusted basis.

Life After Coal
It may be hasty to completely write off coal for the major rails, but it looks like 2013 is shaping up to be another poor year, as natural gas prices still make it a more cost-effective fuel source and coal export volumes to Europe remain weak. While CSX does have some exposure to Illinois Basin and Powder River Basin coal, the historically core Appalachian coal business may be permanently impaired due to the higher production costs.
In the short term, there's not a lot CSX can do about this. While the transportation of shale oil to Eastern refineries does offer some growth potential, CSX isn't going to benefit from shale-by-rail nearly as much as Berkshire Hathaway's (NYSE:BRK.A) Burlington Northern, Kansas City Southern (NYSE:KSU), or even Norfolk Southern (NYSE:NSC). Likewise, while CSX continues to invest in opportunities in intermodal (including the National Gateway project), it's all but impossible to replace a large (nearly 20% of volume) and profitable business quickly.

Still A Long-Run Economic Play
Even with the disruption in the coal business, CSX (and other Class 1 railroads like Union Pacific (NYSE:UNP), Norfolk Southern, BNSF, and Kansas City Southern) is still a leveraged play on the health of the U.S. economy. Taking business away from trucking (largely through intermodal) certainly sweetens the pot a bit, but ultimately revenue growth here will rest on the underlying growth in the economy.

Over the long term, then, I'm not too worried about CSX's revenue performance. The bigger worry is with margins and cash flow conversion. Losing all of this coal volume has forced management to stretch out its target date for the ambitious goal of a 65% operating ratio, and average cash conversion over the past few years has been significantly higher than the long-term average. I do believe the rail industry has made some significant changes that should allow these improvements to stick, but I don't believe investors should completely ignore the risk that this is a peak scenario and that mean reversion could kick in again in a few years' time.
More: CSX Corp. Slips To Underperform

The Bottom Line
I'm relatively ambivalent on most rail stocks today, as I believe investors may be a little too casual about the risks to U.S. economic growth and/or too confident in the possibilities for ongoing margin improvement. To that end, CSX already trades basically in line with historically normal EV/EBITDA, and a cash flow analysis suggests mid-single digit appreciation potential. Rail stocks make sense for investors who think the economy will stage a big second-half rebound, but in terms of likely total return there seem to be higher-potential ideas out there today.

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