In my last article on CSX Corporation (NYSE:CSX), I made the case that returns on capital should be similar across major railroads, and if all railroads earn similar returns on their PP&E, then they should logically trade at similar valuations compared to PP&E. I went through the math of what CSX would be worth if it made 12% after tax returns on its capital, and showed that the stock could return around 24% compounded until the end of 2018 (and likely 8-10% per year after that).
A couple of astute commenters replied that the whole valuation rested on CSX being able to hit 12% and that there were some roadblocks to the company getting there. The two biggest problems are CSX's dependence on coal and a shorter average length of haul than Union Pacific (NYSE:UNP), Canadian National Railway (NYSE:CNI), and Burlington Northern.
I wanted to go through the valuation exercise a second time assuming that the coal market never returns to profitability and that returns for the rest of the business are impacted by a shorter length of haul and only reach 10%. In order to be conservative, I assume that all of the PP&E related to the coal market is instantly worth nothing. I can't say exactly the value of those properties, but I will estimate it by volumes: in the first six months, coal made up 18.3% of CSX's volume, so I will reduce the PP&E on the balance sheet by that same 18.3%. Then, I will use the 10% ROIC number to estimate net income.
That gives us net PP&E of $22.6 billion and net income of $1.92 billion after taking interest expense into account. With 1.003 billion shares outstanding, that gives you EPS of $1.91. I would conservatively value a company earning 10% returns on its capital at about 16x earnings (or about 10x pretax earnings), which would give you a value of $30.55 per share. That value should be going up around 8% per year (including reinvested dividends), and since the current value is right around the current market price, you should make around 8% per year over time with those assumptions.
I want to stress that I view every single part of this valuation as very conservative - I think it is very likely that the coal market returns to some semblance of profitability, that ROIC at the other businesses gets closer to 12%, and that the company will trade at around 18-20x earnings. However, I want to be absolutely sure that I err on the side of conservatism so that we can find a real lower bound for the valuation.
I have never viewed shares of a company having a "margin of safety" as meaning that they will never lose value, since everything can always get cheaper; instead, I view a margin of safety as meaning a price that still allows you to make a decent return even if the business performs relatively poorly over time. And that is exactly how I see CSX - if the company can become as profitable as Union Pacific (and I believe that the odds are high), then it could return over 20% compounded over the next few years, but even if they never make another dime off of coal and the returns on their remaining businesses stay relatively low, then you should still make 8% or so over time. To me, that's a margin of safety.
Railroads are one of my favorite businesses: their competitive advantage over other modes of transportation is born from physics, which means you can hold shares forever; volumes are almost certain to increase over long periods of time; companies have good pricing power; massive amounts of capital can be reinvested into the business at good rates of return; and management teams sensibly return excess capital back to shareholders via dividends and repurchases. When you are combing a company like that with the margin of safety that CSX now has, you have a very good investment opportunity.
Disclosure: The author is long CSX, UNP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Many of my clients are also long CSX and UNP. I am a registered investment adviser. However, this commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.