Warren Buffett has stated his favorite holding period for a stock is "forever." This is in stark contrast to stock and fund salesmen who utilize slogans such as "buy and hold is dead." The most important determinant of an investment is the price that is paid in relation to the value one receives. If an investor can buy a business at a cheap price that is likely to earn higher returns on invested capital than its cost of capital over a long-term time horizon, then a buy and hold strategy can make a lot of sense. Right now few industries are struggling more than the domestic coal market, as historically low natural gas prices are diverting domestic utility demand away from coal. We are using the weakness in domestic coal to build long-term positions in the railroad industry, which we believe to be undervalued and likely to provide attractive long-term total returns at current prices.
Coal has long been a huge market for the railroad industry, particularly for the East Coast operators such as CSX Corporation (CSX) and Norfolk Southern (NSC). We currently find both stocks quite attractive but for this article we are going to focus on CSX. Historically around 32% of consolidated revenue for CSX has been related to coal. While I believe that the economics of natural gas have fundamentally changed the outlook for coal, particularly in the utility space, I also believe that new uses for natural gas in addition to the potential for a strong LNG export market could ultimately lead to higher prices for the commodity. Global energy needs are complex and evolving. Coal exports are up and likely to continue to increase even if domestic consumption is down the next year or two. Coal will still be needed but overall too much focus is put on this one portion of the railroad revenue model.
Since de-regulation the railroad industry's economics have changed dramatically for the better. Few companies have improved their operations more than CSX, which had historically been one of the real laggards in the industry. Since 2003-2011 operating income has increased at a compound annual growth rate of 19%, from $861MM to $3.418 billion. The Operating margin has jumped from 11% to 29%, while earnings per share have increased from $0.26 to $1.67 over the same time period.
Between 2006-2011, CSX has returned $9.1 billion to investors via dividends and stock buybacks, while still spending $10.6 billion on capital investment. In 2012, the company will likely have hit its target of $2.25 billion in capital investment and most likely will have finished the final part of its $2 billion stock buyback program. Because CSX is generating strong free cash flows, I'd fully expect to see another large buyback program announced, which at current prices would be highly accretive to long-term shareholders. CSX generally reinvests 16-17% of revenue into capital, but fortunately for the industry the economics are somewhat similar in that the companies are generally able to achieve a reasonable return on these large and regular investments. CSX has increased its quarterly dividend ten times since 2005 and the company targets a dividend payout of 30-35% of TTM earnings per share. In the 2nd quarter of 2012 the dividend was increased by 17%, and management has forecasted that another possible increase may be announced next May.
The beauty of the railroad industry is that the assets are the definition of long-term and really are irreplaceable. I may not be able to forecast what cell phone will be the most popular device 10-years from now, but I'd bet that CSX' tracks will be busy transporting increasing amounts of goods across the United States, and that pricing should improve at a rate slightly higher than rail inflation costs. Highway congestion continues to get worse and fuel prices are increasingly enhancing the competitive advantages of rail versus long-freight trucking. CSX railroads are centered on the eastern United States and serves roughly two thirds of the U.S. population. The network spans from south Florida to the Northeast United States where the majority of consumption and high-density population centers are.
Because CSX connects many ports to the major cities it continues to win business, particularly in intermodal transportation. CSX can take containers to and from the ports to the large population centers and it seems likely that international growth can be a huge benefit for the company. CSX also enters into partnerships with trucking companies where it takes goods part of the way, while the trucking companies handle the short-haul final delivery phase. An improving housing sector, which is likely to see increased homebuilding due to a dearth of available new homes, should slightly offset the headwinds in coal as well. Agriculture and phosphates transportation should continue to be strong markets over the long-term. Over the next 5 years it seems likely we'll enter at least one recession, and current GDP growth is anemic at best.
Investing in the railroad industry is a long-term bet that things will get better in the United States and I'm very confident that this will indeed be the case. When Warren Buffett established Berkshire Hathaway's (BRK.A) (BRK.B) ownership of Burlington Northern Santa Fe, he was extremely patient and price disciplined. If I recall correctly, I believe that he used put options at one point to establish a cheaper entry price into the stock. I believe that an investor in CSX would be well-served to use a similar tact, and to really focus on dollar cost averaging. While the current price is very cheap, if we have a recession it could get cheaper so you want to plan for that before you first start buying the stock. Selling puts is a great way to manufacture pricing discipline in that the investor will either generate income, or get into the stock at a more attractive price.
CSX' 3rd quarter results were decent with revenue down 2% to $2.894 billion, largely because of the decrease in domestic coal. Operating income was down about 3% YoY to $854MM. Net earnings were down 2% to $455MM. I like that the company has bought back stock and I'd prefer a heavier weighting towards buybacks at current prices, as opposed to the large dividend payout. Buybacks make more sense for the railroad industry because they can be done with sensitivity to price, and they are less permanent than dividends so companies can adjust as needed to reduce expensive debt, or increase capital investments when opportunities are attractive. After the 3rd quarter the share count was down to 1.040 billion, and earnings per share for the quarter were $0.44, up 2% YoY. CSX had done a great job at improving the operating ratio, which now sits at 70.5%. The 2015 goal is to get that number down to 65%, but this might be overly optimistic with the difficulties in coal.
At a recent price of $19.95, CSX has a market capitalization of roughly $20.75 billion. I believe in a more buoyant economy, CSX has the potential to earn more than $2 billion in net income. The stock trades at just under 10 times forward earnings, but those earnings estimates might be a bit high for 2013. The company has a return on invested capital greater than 10% and a return on equity greater than 20% over the last twelve months. The company has not consistently generated such high returns so a regression to the mean is possible, particularly in a recession. The stock yields roughly 2.7% and I believe the dividend should grow steadily, as will stock buybacks. I believe that CSX is worth roughly $30 per share looking 3 years out. If the company can get close to its target efficiency ratio by 2015 or 2016, there is considerable upside to the company's earnings power. Volatility in the options market is fairly low, but you can currently sell the January 2014 $20 puts for about $2.50 per contract. This would create a breakeven of $17.50, and assuming your options expire worthless would net a very respectable 14.3% return. We've also employed covered calls when the stock was at a higher price so a combination of selling puts and buying the stock might make sense for the patient long-term investor.