By The Valuentum Team
Just because CSX is a railroad doesn't mean that its dividend is strong. We're concerned about the pace of its dividend growth over the long haul, even as management raises it in the near term.
--> CSX (NYSE: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 is a solid railroad, but we prefer peer Union Pacific (NYSE:UNP). Union Pacific's operating ratio should be the best among peers by the end of this decade, and we like its exposure to growth in Mexico and future export expansion on the West Coast.
--> The US Department of Transportation recently implemented regulations that require the installation of new braking systems on trains hauling more than 70 cars of crude oil by 2021. Industry participants have voiced concern that the new rules will make shipping crude oil by train prohibitively expensive.
--> 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 expect the pace of dividend growth to face pressure in coming years on the basis of its poor Dividend Cushion ratio and weakening free cash flow conversion rate.
--> CSX expects good times ahead, but the impact of low commodity prices will hurt a bit. Management is targeting a mid-60s operating ratio over the long haul, and we're building in significant profit improvements.
Note: CSX's annual dividend yield is above average, offering a ~3.1% yield at recent price levels. Though we prefer companies with yields above 3% in our dividend growth portfolio, other factors keep us from considering CSX for addition. This article explains why.
CSX benefits from being one of few railroad operators in North America, facilitating a mode of transportation vital to efficient movement of goods and commodities. 2015 marked the first year ever where the company achieved a sub-70% operating ratio, and
this came despite challenging market conditions. Pricing strength and cost cutting will be needed in order for the company to achieve its longer-term goal of a mid-60s operating ratio, however. Investors should be cognizant of CSX's coal-heavy exposure, and we think it's worth noting that coal revenue has declined by ~$1 billion since 2011. Still, management has been able to push revenue and operating income higher, though recent performance may prove more ominous.
CSX is committed to preparing its railroad for tomorrow, but that means capital outlays will continue to be significant. Since 2003, CSX has dropped ~$21 billion on its network and equipment, and while we applaud its efforts to modernize its capital, free cash flow has faced enormous pressure as a result. Railroads are capital- intensive and net-debt heavy businesses, and while impossible-to-replicate infrastructure may keep new railroads from entering the fray, returns often hover around the cost of capital. Buybacks will absorb cash resources, and ongoing weakness in energy will pose challenges. We expect dividend growth at CSX to slow in coming years.
From the Comments Section: How to Interpret the Dividend Cushion Ratio -- A Ranking of Risk
As for how to interpret the Dividend Cushion ratio, itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity. Said differently, a poor Dividend Cushion ratio of below 1 or negative doesn't imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow. That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash, and that means the dividend becomes increasingly more risky.
We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.
We think the safety of CSX Corp's dividend is very poor. Please let us explain.
First, we measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.
That has led us to develop the forward-looking Dividend Cushion ratio, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.
As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For CSX Corp, this ratio is -0.3, revealing that on its current path the firm could encounter difficulty being able to cover its future dividends and growth in them with net cash on hand and future free cash flow. We don't think a negative Dividend Cushion ratio should be taken lightly.
Dividend Cushion Ratio Cash Flow Bridge
The Dividend Cushion Cash Flow Bridge, shown in the image to the right, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. CSX Corp's Dividend Cushion Cash Flow Bridge reveals that the sum of the company's 5-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is less than the sum of the next 5 years of expected cash dividends paid.
Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the 5-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.
Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk of a dividend cut or a suspension of growth, all else equal, in our opinion. Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less durable a company's dividend.
Dividend Cushion Ratio Deconstruction
The Dividend Cushion Ratio Deconstruction, shown in the image to the right, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, CSX Corp's numerator is smaller than its denominator suggesting weak dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.
Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks."
Now on to the potential growth of CSX Corp's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we characterize its future potential dividend growth as excellent. However this is not the case for CSX Corp which we categorize as very poor.
Because capital preservation is also an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In CSX Corp's case, we currently think shares are fairly valued, meaning the share price falls within our estimate of the fair value range, so the risk of capital loss is medium (our valuation analysis can be found by downloading the 16-page report on our website). If we thought the shares were undervalued, the risk of capital loss would be low. Please be sure to visit the website for more information on our valuation assumptions.
Wrapping Things Up
We don't like what we've seen at CSX lately. According to the firm's CEO, its rail cargo volumes are at levels not seen outside a recession, and material risk lies in its exposure to the US coal industry. It will face additional pressure as a result of increased regulations on the shipping of crude oil via rail as well. We think investors must be cognizant of these risks, which will eventually weigh on its dividend prospects. Though management has not been bashful about raising its payout recently, we have serious concerns about the dividend on a long term horizon. Investors should take note.
Breakpoints: Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.