In addition to writing, I do a lot of reading and over the weekend I have been absorbed in Atlas Shrugged by Ayn Rand. I don't typically enjoy fiction carrying a political or philosophical message. Like 1984 and Catch 22 but at least it's much more bearable if you like the message.
The best thing about the book so far is the determination of the female main character (Dagny Taggart) who is determined to pull her beloved but struggling railroad company (Taggart Transcontinental Railroad) through hard times and put it back on track as the great railroad her grandfather founded.
The book reminded me that I should revisit my thesis on CSX Corp (CSX), an undervalued Florida based railroad company. Its stock price has been under pressure because of depressed natural gas prices, which decreased domestic demand for coal. Hauling coal used to be a very important part of CSX business. Five reasons why I like the company and think it's currently trading at a discount:
1. Pricing power and Competitive Advantage
In the Q3 2013 transcript there were several interesting questions but this one, regarding pricing, stood out to me by Thomas Kim of GS.
Thomas Kim - Goldman Sachs
And if I could just ask a follow up question with regard to pricing, we've noticed in the latest quarter Q some of the companies, in particular some of the brokerages, are starting to face a little bit of pressure with regard to the pricing environment coming from shippers showing reluctance to pay higher freight rates. And I'm just wondering to what extent are you beginning to see any concerns with your ability to raise pricing, and particularly, let's say, in the intermodal side, where there are ongoing pressures within the retail environment, with their own ambitions to be pushing up their margins by cutting costs.
Clarence Gooden - EVP, Sales and Marketing and CCO
We think we offer a good product, a good value. We think our fundamental economics are good. We think that the environmental aspects of the product that we offer are pretty good. As always, you get pushback from many of your client base on price increases, but we've been able to get those increases in the marketplace.
And as you can see, in the same-store sales results that we had today, we had a 3% year over year improvement in our same-store sales pricing. And that compares with last year on the same comparison basis of 3.3%. Most of the difference there has been the difference in what the escalators were for inflation. So we feel pretty solid about being able to get above the inflation pricing going forward here in the next quarters, as we move forward.
The fact that CSX is able to increase prices above and beyond inflation is very important. It reinforces my belief CSX has a durable competitive advantage and will be able to outperform the market over longer periods of time. Without a true competitive advantage its very hard to increase prices over inflation.
CSX derives its competitive advantage from owning rail in attractive geographic regions (very densely populated). A railroad is almost impossible to copy for a competitor because usually the first railroad can increase capacity, or there isn't enough demand to support two railroads, which makes it impossible to fund construction of a second one. Not to mention regulatory concerns a new incumbent would need to overcome.
Rail competes with trucking, airfreight, pipelines and shipping. Usually rail is not laid next to a shipping route. That's because shipping is hard to compete with, but luckily (for railroad shareholders) limited to areas connected by waterways.
Pipelines can also transport at lower costs but are obviously limited to transporting liquids.
More flexible trucking and airfreight are much more expensive than transport by rail because of fuel costs.
2. Consolidation in Sector and Sensible Competition
There has been an interesting development going on in railroads. A consolidation process has decreased the number of major rail companies from 40 to 7. Competition on price between these railroads has become less cutthroat.
In chapter 8 in Competition Demystified, called "Games Companies Play," an excellent book on business strategy by Bruce Greenwald and Judd Kahn, they treat price competition strategy and how the problem of price competition should be approached.
A sensible approach where competitors are comfortable in the existing equilibrium leads to great profits. All out price wars hurt everyone. As long as no market participant is tempted into starting a price war to attempt to grow its market share this equilibrium can continue to exist.
3. Streamlining Operations
The company has been restructuring its business over the last few years. CSX has been vigilant in reducing overhead by reducing management layers and driving down labor costs. At the same time, it is reporting increases in safety levels and other operating improvements quarter after quarter.
4. Serves Attractive Areas
CSX is in the highly populated Eastern part of the U.S where two-thirds of the US population lives. There are different industries where future growth can materialize but one thing is for certain, being near people will be helpful. The map below shows trackage rights of CSX in 2009.
5. Returning Cash to Shareholders
CSX is doing a great job of returning cash to shareholders. It has been and will continue to return 30% of profits through dividends. In addition, in 2012, CSX fulfilled its commitment to complete its 2 billion share repurchase program by repurchasing $734 million during the course of the year. Collectively, CSX has repurchased $7.9 billion of shares since 2006, representing approximately one-third of total shares outstanding today. It has doubled its dividend since 2008. Looking forward, CSX remains committed to return free cash flows to investors, which is an important quality to look for in large caps.
Negatives and Risks
It's rare to find an attractively valued company or business that is not facing any problems and CSX is no exception in that regard. These are some of the bigger problems they face:
Domestic Coal Demand
Coal is a commodity that is often shipped by rail, yet because of the cheap natural gas prices, it's not very popular right now. With the demand reduced and uncertainty if demand will return, CSX stock price is under pressure. This is a quote from management in the Q4 2012 earnings call:
Furthermore we anticipate our rates to be pressured as we work with producers to keep U.S. coal competitive globally in an environment where underlying commodity process for thermal and metallurgical coal are low. At the same time domestic coal headwinds will persist but we expect them to continue to moderate throughout 2013.
Vulnerable to Natural Disaster
Railroads are vulnerable to natural disasters. For example: CSX was impacted by Hurricane Isaac recently. The storm caused significant damage to a stretch of the railroad near New Orleans, causing outages and reroutes for several weeks. Ultimately delays suffered by customers were limited, but this goes to show that there is very little a railroad operator can do to protect its business against nature.
The coal problems put enough pressure on CSX to create an interesting opportunity. With a P/E of 14.4 and a Enterprise value/EBITDA of 7.69 the railroad appears attractively valued. I do count on management continuing to successfully replace the lost coal business or demand for coal picking up somewhere in the next few years.
Compare CSX Enterprise Value/EBITDA to that of competitors in the railroad industry. EV/EBITDA is a reasonably fair stick to measure them all with, and CSX holds up very well.
With an Enterprise Value/EBITDA of 7.69, it actually looks attractive compared to Canadian Pacific Railway Ltd. (CP), Union Pacific Corp. (UNP), Canadian National Railway Co. (CNI) and Norfolk Southern Corporation (NSC).
CSX management is doing a great job with this company and efforts are masked because of the drop in coal demand. These problems will turn out to be temporary or will get worked out. When the market realizes this, the stock price will rise to a level more in line with valuations of competitors.
At $26.28 it still looks quite attractive. If an increase in stock price of 25%-30% were to materialize, within reasonable time, that would be quite satisfactory.
Clear catalysts would be rising natural gas prices and management reporting that lost business from hauling coal is fully replaced. It's possible it will take some time for CSX to trade closer to intrinsic value but at least there are clear identifiable catalysts that can spur its stock price in the right direction.