CSX Appears Overextended Here

Aug.15.14 | About: CSX Corporation (CSX)

Summary

CSX has posted record numbers and shares have been driven up.

CSX has been assigned an industry-level earnings multiple but it isn't growing as quickly as its competitors, leading to a disconnect in the valuation.

CSX shares either need to grow into their valuation or the valuation must come down; there are better places to invest in the railroad space.

CSX Corp. (NASDAQ:CSX), a mid-sized North American railroad operator, has seen its shares up huge in the last two years, posting gains of $11 off of the $19 level it traded for in December of 2012. In other words, shareholders in CSX have done very well by being patient and waiting out the sideways trading that we witnessed throughout 2012. After the run, is the company's valuation stretched? In this article we'll take a look at the company's prospects in relation to its current valuation.

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To do this I'll use a DCF-type model you can read more about here. The model uses inputs such as earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at four cent increases per year, and a discount rate, which I've estimated at the 10 Year Treasury rate plus a risk premium of 6.5%.

 

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

             

Prior Year earnings per share

 

$1.83

$1.86

$2.12

$2.32

$2.55

$2.79

x(1+Forecasted earnings growth)

 

1.60%

14.00%

9.60%

9.60%

9.60%

9.60%

=Forecasted earnings per share

 

$1.86

$2.12

$2.32

$2.55

$2.79

$3.06

               

Equity Book Value Forecasts

             

Equity book value at beginning of year

 

$10.89

$12.11

$13.55

$15.15

$16.94

$18.93

Earnings per share

 

$1.86

$2.12

$2.32

$2.55

$2.79

$3.06

-Dividends per share

 

$0.64

$0.68

$0.72

$0.76

$0.80

$0.84

=Equity book value at EOY

$10.89

$12.11

$13.55

$15.15

$16.94

$18.93

$21.15

               

Abnormal earnings

             

Equity book value at begin of year

 

$10.89

$12.11

$13.55

$15.15

$16.94

$18.93

x Equity cost of capital

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

9.00%

=Normal earnings

 

$0.98

$1.09

$1.22

$1.36

$1.52

$1.70

               

Forecasted EPS

 

$1.86

$2.12

$2.32

$2.55

$2.79

$3.06

-Normal earnings

 

$0.98

$1.09

$1.22

$1.36

$1.52

$1.70

=Abnormal earnings

 

$0.88

$1.03

$1.10

$1.18

$1.27

$1.35

               

Valuation

             

Future abnormal earnings

 

$0.88

$1.03

$1.10

$1.18

$1.27

$1.35

x discount factor(0.09)

 

0.917

0.842

0.772

0.708

0.650

0.596

=Abnormal earnings disc to present

 

$0.81

$0.87

$0.85

$0.84

$0.82

$0.81

               

Abnormal earnings in year +6

           

$1.35

Assumed long-term growth rate

           

3.00%

Value of terminal year

           

$22.58

               

Estimated share price

             

Sum of discounted AE over horizon

 

$4.19

         

+PV of terminal year AE

 

$13.46

         

=PV of all AE

 

$17.65

         

+Current equity book value

 

$10.89

         

=Estimated current share price

 

$28.54

         
Click to enlarge

The model computes a fair value of $28.54, roughly $2 below where shares are trading as I write this. That valuation would imply that CSX shares are slightly expensive right now but before we hit the 'sell' button, let's understand why.

First, the model computes a fair value and not a price target. A price target is forward looking and would be somewhat higher, whereas the model is saying that CSX is a good buy at any price below $28.54. In other words, the present value of the company's discounted earnings, adjusted for dividends, is around $2 less than shares trade for right now.

So why is that? One reason might be that CSX has somewhat lower earnings growth estimates going forward than some of its competitors and thus, the market may believe that estimates are too low. If this were the case shares would be bid up to meet the higher expectations for growth. Curiously, analysts have not been moving earnings estimates up at CSX as they have for Norfolk Southern (NYSE:NSC), where earnings have been furiously upgraded by more than a dozen analysts recently. CSX has not experienced that kind of love from the analyst community despite record numbers posted during the second quarter; somewhere there is a disconnect between CSX's valuation and its expectations.

This causes me to be concerned on CSX shares' valuation as the company has been bid up to the same forward earnings multiple as its competitors, with that being 14, but appears not to offer the same in the way of earnings growth going forward. Thus, I believe the gap between the fair value of the model and the current price is likely justified as CSX shares appear overextended on a relative basis when comparing it to other railroad operators. There is certainly nothing wrong with the way the company operates and it is making plenty of money, but you can't just pay any price for a business. I think a more appropriate forward earnings multiple for CSX, reflecting its lower earnings growth prospects, would be 12 or 13 if its higher-growth competitors are trading for 14 times next year's earnings.

I still like CSX but it is too expensive here. I would need to see shares trade down towards $27 before finding value in them because there are simply better places to put your money in the railroad space. CSX, to me, doesn't deserve the same earnings multiple as its competitors but it is being assigned that multiple anyway by the market. As such, I think CSX has experienced the rising tide in railroad stocks but it has come too far. Either CSX needs to grow into its valuation or its valuation needs to come down to meet reality. Either way, those are unfavorable outcomes for shareholders and if you want to be in a railroad stock, I would prefer Union Pacific (NYSE:UNP) or NSC.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.