FEBRUARY 9, 2013
http://online.barrons.com/article/SB50001424052748703892404578271822719958506.html?mod=BOL_hpp_mag#articleTabs_article%3D0
The Bottom Line
Shares of the railroad operator could climb as much as 33% over the next year while paying a 2.6% dividend yield. It's diversified and more efficient—and coal demand is stabilizing.
Time to Hop Back Aboard CSX
By LESLIE P. NORTON | MORE ARTICLES BY AUTHOR
The sharp decline in coal demand over the last few years has forced the big freight carrier off onto a siding. It looks to be heading back onto a main track and powering ahead.
Flat revenue has forced CSX to lower costs, improve service, and develop new initiatives. As coal prices stabilize, its shares are poised to barrel ahead.
The Jacksonville, Fla.-based railroad traditionally has gotten a sizable chunk of its business—about 27% of revenue—from coal-related businesses. It hauls the fuel from mines in West Virginia to steel makers such as AK Steel (ticker: AKS) and big utilities such as Duke Energy (DUK), and transports it to places where it can reach fast-growing, energy-hungry destinations like China.
But the tough new pollution-control standards the Obama administration has imposed on coal miners and the collapse in domestic natural-gas prices persuaded CSX's U.S. utility customers to begin switching to cleaner-burning gas about six years ago. Last year, the volume of coal CSX (CSX) hauled to U.S. power generators fell nearly 30%, to 76.3 million tons, off 55% from the 2006 peak. The global economic slowdown has also reduced demand from emerging markets, and added to inventories. Slumping U.S. shipments cost CSX some $500 million in revenue in 2012, and as overseas markets slowed, CSX had to cut transport prices on export coal to hold on to customers.
Unfortunately for the company, CSX has become synonymous with coal's problems to many investors, because of its connection to central and northern Appalachia, thought to produce the "dirtier" sorts of coal the government was targeting. The stock has fallen 20% since July 2011.
"People have looked at the East Coast rails like they're dial-up [Internet] and they're going away," says Peter Nesvold, analyst at Jefferies. The drops are doubly painful because profit margins for transporting coal have been higher than some of CSX's other businesses. By comparison, hauling shipping containers brings in just a third of the revenue per car.
What a lot of Wall Street has missed, however, is CSX's aggressive response to the threat to its business. Remarkably, it has posted record profit in each of the past two years despite essentially flat revenue. It has held the line on costs by mothballing some locomotives and furloughing workers at times. Service improvements like more "on-time starts" mean railcars are in the yard for shorter times, so rent costs don't accumulate. It's also cut its fuel usage per gross ton mile since 2006. Today CSX has an operating ratio (costs divided by revenue) of 70.6%, down from 74.9% in 2009; by 2015, the aim is to get that down to 65%.
TO OFFSET THE DROP IN coal revenue, the company has pushed a number of noncoal-growth initiatives, including transporting containers, moving crude oil, and shipping goods that are benefiting from a recovering economy, such as autos and construction materials. Outside of coal, it moves orange juice from Florida to New Jersey and Ohio, and hauls trash from New York City to waste-to-energy plants in Maryland. The onetime B&O Railroad, the country's first common carrier, will spend $2 billion this year on capital projects including upgrading its tracks.
Sometimes overlooked is CSX's generosity to shareholders. It recently completed a two billion-share buyback, and has taken a third of its stock out of the market since 2006. That has helped profits. In 2012, CSX earned a record $1.87 billion, or $1.76 a share, on revenue of $11.8 billion. Analysts think CSX will earn $1.79 a share this year, on $11.9 billion of revenue.
Unlike a few years ago, the company has a few favorable macro trends running in its favor, such as "the reindustrialization of the U.S. economy, greater consumption, and a longer supply chain that lends itself very well for a railroad in the East where you serve two-thirds or more of the U.S. population," CFO Fredrik Eliasson told Barron's.
True, environmental regulation and cheap natural gas mean some demand is permanently lost. Between 2009 and 2011, 78 coal-fired generators were retired in the U.S. Many more are under way. Nevertheless, as CEO Michael Ward noted dryly in a conference call last month, "On a longer-term basis, I think there is an issue of how we make sure we turn the lights on, so we think some of those remaining coal-fire plants are going to be part of the energy mix in the Eastern half of the United States." Other potentially positive variables for investors to monitor: stable or higher natural-gas prices, more U.S. and Chinese industrial activity, and colder weather.
EVEN IF A COAL BOOM ISN'T in the offing, the decline in shipments is slowing and could reverse in the next year, as supply-and-demand forces equalize. CSX predicts its utility coal volume will fall 5% to 10% this year, a big improvement from 2012's plummet. Pricing is stabilizing in utility coal, too. During the fourth quarter, coal yields held steady at $2,449 per carload from a year earlier.
CSX essentially is a duopoly in the East with Norfolk Southern (NSC), so its ability to raise prices is strong as inventories wear down. Based on average volume levels from 2004 through 2011 and looking out to 2013, Nesvold figures domestic-coal volume could rise nearly 70%, giving the two railroads room to raise coal-shipping rates. By analyst Nesvold's reckoning, the volume gain translates into extra earnings of 35 cents a share that aren't reflected in current CSX forecasts.
Profit is expected to jump to $2.05 a share on revenue of $12.6 billion in 2014. CSX has vowed to keep spending cash flow on stock buybacks and dividend hikes. That spells opportunity for investors. CSX stock trades at 12 times current-year forecasts, the lower end of the range of 11 to 16 it's traded at historically; it yields 2.6%, higher than the market's 2.2%.
Putting a multiple of 14 to his conservative 2014 earnings forecast of $2.08 per share, Nesvold believes CSX is worth $29 a share, more than 30% higher than Friday's $21.97.
Norfolk Southern should enjoy the same sort of price and volume gains, but its shares are slightly more expensive and its productivity gains not quite as impressive as CSX's.
Richard Nackenson, a fund manager at Neuberger Berman, is a big CSX fan. Nackenson tries to find companies with identifiable, growing cash flows. He figures free cash flow will grow by at least 10% this year. CSX has vowed to use that added cash for dividends and stock buybacks, something that appeals to the money manager. Beginning in the second half of 2013, Nackenson predicts, "the decrease in coal volumes will start to mitigate." In 2014, they'll stabilize.
That said, Nackenson stresses that he's not betting on a bottom in coal demand. CSX, he says, should be to "able to rationalize with productivity improvements and growth in other segments" to meet its goals. A conservative estimate of the stock's worth is $26, or 13 times a profit forecast of just over $2 a share for 2014. Toss in the attractive dividend, and CSX shares look like a true engine of profit.