- We like the railroads, but CSX isn't our favorite.
- CSX's valuation is not as attractive as that of other highly-rated equities.
- Let's take deep dive into CSX.
As part of our process (you can read about the Valuentum® Buying Index here), we apply a three-stage discounted cash flow model that dives into the true intrinsic worth of companies. The DCF is the first of three pillars in the methodology -- the other two consider a robust relative value assessment and a timeliness overlay. Let's calculate CSX Corp.'s (NYSE:CSX) cash-flow-based fair value estimate and run shares through the Valuentum process.
CSX Corp's Investment Considerations
- CSX operates one of the largest railroads in the eastern US, with a rail network of approximately ~21,000 route miles, linking markets in 20+ states, the District of Columbia, Ontario, and Quebec. It has access to over 70 ocean, river, and lake port terminals along the Atlantic and Gulf Coasts, the Mississippi River, the Great Lakes, and the St. Lawrence Seaway.
- CSX Corp. has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 11.8% in coming years. Total debt-to-EBITDA was 2.1 last year, while debt-to-book capitalization stood at 47.7%. As long as railroads can hold capital spending in check, cash flow is quite robust.
- CSX is heavily exposed to a decline in US coal-fired power plant retirements (and higher-cost Central Appalachian coal), given its rail network in the eastern US. We think this is one of the least attractive attributes of CSX's business model, though pricing strength can help offset future weakness in this area.
- CSX is a solid railroad, but we prefer peer Union Pacific (NYSE:UNP). Union Pacific's operating ratio will be the best among peers, and we like its exposure to growth in Mexico and future export expansion on the West Coast. Union Pacific also has a stronger balance sheet.
- We expect the pace of CSX's dividend growth to face pressure in coming years on the basis of its poor Valuentum Dividend Cushion score and weakening free cash flow conversion rate. We fully expect CSX to keep raising its dividend through the course of the up-cycle, but we expect the dividend to be inevitably challenged during the next down-cycle, particularly if coal volumes and pricing suffer.
The Valuentum Dividend Cushion methodology is unique in that it combines future dividend obligations, capital expenditures, and debt obligations to ascertain coverage by future cash flow and balance-sheet net cash. It is a comprehensive cash-flow-based measure of dividend health. Its track record of predicting dividend cuts has been quite impressive.
Understanding the Valuentum Buying Index Rating
If a company is undervalued both on a discounted cash flow (DCF) basis and on a relative valuation basis, and is showing improvement in technical and momentum indicators, it scores high on our scale. CSX Corp. posts a VBI score of 6, reflecting our "fairly valued" DCF assessment of the firm, its neutral relative valuation versus peers, and bullish technicals.
Typically, we like firms that register a 9 or 10 on the Valuentum Buying Index (these ratings are equivalent to a "we'd consider buying" rating). Once a highly-rated firm is added to the Best Ideas portfolio, we typically hold on to it until it registers a 1 or 2 on the index (or the equivalent of a "we'd consider selling" rating). The performance of the Best Ideas portfolio has been fantastic.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. CSX Corp.'s 3-year historical return on invested capital (without goodwill) is 7.8%, which is below the estimate of its cost of capital of 9%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. We don't think CSX has much of an Economic Castle.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. CSX Corp.'s free cash flow margin has averaged about 7.7% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At CSX Corp., cash flow from operations decreased about 6% from levels registered two years ago, while capital expenditures expanded about 1% over the same time period.
Our discounted cash flow model indicates that CSX Corp.'s shares are worth between $23-$35 each. This is a wide range for a railroad, but its large dependence on coal carloads cannot be ignored. The company is trading just shy of $31 at the time of this writing. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $29 per share represents a price-to-earnings (P/E) ratio of about 15.9 times last year's earnings and an implied EV/EBITDA multiple of about 8.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.2% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 4.2%. Our model reflects a 5-year projected average operating margin of 30.7%, which is above CSX Corp.'s trailing 3-year average. Said differently, we think pricing will continue to drive stronger top line expansion in coming years, and we expect better revenue-per-carload metrics to then result in an improved operating ratio (1 minus the operating margin).
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.7% for the next 15 years, and 3% in perpetuity. For CSX Corp., we use a 9% weighted average cost of capital to discount future free cash flows. We think these long-term forecasts are consistent with a company of its size, growth profile, and risk.
We like to use relative valuation to further substantiate our DCF process. Using relative valuation by itself has its pitfalls, but if used in conjunction with other valuation approaches (namely the DCF), it can be quite informative. In this exercise, we compare CSX Corp. to peers Canadian National (NYSE:CNI), Norfolk Southern (NYSE:NSC), and Union Pacific, among others.
Though CSX's forward P/E is slightly lower than its peers', its PEG ratio is slightly higher. This mixed relative valuation assessment results in our "neutral" overall assessment of its valuation. We don't think many institutional investors are rushing into shares at the moment, which is why it doesn't register the highest of ratings on the Valuentum Buying Index.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $29 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for CSX Corp. We think the firm is attractive below $23 per share (the green line), but quite expensive above $35 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate CSX Corp.'s fair value at this point in time to be about $29 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of CSX Corp.'s expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $37 per share in Year 3 represents our existing fair value per share of $29 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.
Pro Forma Financial Statements
Additional disclosure: UNP is included in the Best Ideas portfolio.