CSX: Riding The Rails To A Double-Digit Yield

| About: CSX Corporation (CSX)

Summary

CSX has had a tremendous investment past.

However, in the past 15 months or so the share price has declined materially.

This article demonstrates a way that you could both own shares and potentially receive a 10% yield.

At the end of 2014 shares of CSX Corp. (NYSE:CSX) were trading hands around $36. As I write this, that number is closer to $26 - a decline of nearly 28% in the last 15 months. And to be sure there are underlying reasons that you can point to.

In my view there are a few things going on here. First, you have renewed worries related to decreased volumes, coal in particular, general economic cyclicality and the ongoing costs associated with needed capital expenditures. There's no better time for sentiment to turn sour than when things actually look a little more bitter than usual. Of course there are always going to be reasons for concern.

The second idea is what I would call the "carry through effect."

UNP

CSX

NSC

Revenue Growth

6.5%

4.4%

3.5%

Start Profit Margin

6.7%

9.0%

13.6%

End Profit Margin

21.6%

15.2%

17.2%

Earnings Growth

21.3%

10.7%

6.2%

Yearly Share Count

-2.4%

-3.0%

-3.1%

EPS Growth

23.7%

14.4%

9.5%

Start P/E

24

15

16

End P/E

21

19

17

Share Price Growth

21.8%

17.5%

10.4%

% Of Divs Collected

39%

40%

30%

Total Returns

22.7%

18.7%

11.9%

Click to enlarge

The above table shows the business and investing results for CSX along with Union Pacific (NYSE:UNP) and Norfolk Southern (NYSE:NSC) during the 2005 through 2014 period. All three companies share similar characteristics, but take a look at CSX in particular.

The business performed quite well - growing company-wide earnings by over 10% annually. An investment in the company did even better - increasing by nearly 19% per annum. To be sure this is an incredible result. However, it also means that the "investment bar" is now higher as well.

As compared to a decade ago, CSX now has a higher profit margin and earnings base. Both of these items make future company growth harder. Not impossible naturally, but still more difficult to formulate.

On the per share level, you had a higher payout ratio to go along with a higher valuation as well. In turn, less "organic" funds can be diverted toward share repurchases and the likelihood of an ever increasing P/E ratio declines. Taken collectively the incredible past investment performance for CSX could very well act as a drag moving forward.

That's not to suggest that it has to occur immediately, but it makes sense that share performance could trail business performance in the years to come. Those two aspects: an incredible past history and current business concerns, are reflected in the current share price.

Still, that doesn't mean that all must be lost. Far from it. With shares declining so much in such a short amount of time, you now have a company trading below its average earnings multiple and with an above average dividend yield. Sentiment is lower and so too is the "investment bar."

A lot has changed since the end of 2014. Profitability is expected to be more or less the same, but the sentiment and valuation are now drastically different. Personally this is when I tend to get interested in securities.

This is the first part of thinking about a security and particularly about one that has declined materially as of late. You want to decide whether or not the much lower share price is justified. You're always going to have a reason to explain the fall, but the real question is whether or not the long-term economics of the business are severely affected. This is a personal judgment, but it's important to come up with a thesis prior to partnering with a business.

To continue with the article, let's suppose that you believe in the long-term prospects of the company and believe the short-term pricing is either reasonable or else compelling. You'd like to become a partner in the business.

The second part is figuring out in what capacity. If you'd like to be a long-term shareholder and see the next few decades play out, there's an easy way to accomplish this. You can buy shares, hold and do exactly that, all the while collecting a (hopefully) higher and higher dividend.

Of course that's not to suggest that this is the only possibility. There are alternatives out there that would allow you to check off the first step, but structure your cash flow in a different manner. This idea works particularly well for those with a higher cash flow ambition, but really I'd contend learning about your alternatives is always a prudent move (whether you end up doing something about it or not).

With a share price around $26, the $0.72 annual dividend equates to a "current" yield of about 2.8%. That's solid, but perhaps a touch below what you're trying to generate from your portfolio. You could look elsewhere, but there's not much need. You can both own shares and generate a much higher yield.

I'll give you an example. If you owned 100 shares of CSX, you could agree to sell those shares by using a call option and receive a premium. Naturally there are hundreds of possibilities, but the idea is get an idea of what might be out there.

For instance, the January 20th 2017 call option with a $27 strike price has a current bid of $1.95; call it $1.85 with fees. This means that you could receive ~$185 for agreeing to sell your 100 shares at $27 anytime between now and the next 10 months.

Let's think about the basic outcomes here. If the option is not exercised, you keep your 100 shares and continue to collect dividend payments just as you normally would. In addition, you still have the upfront option premium (which may be taxed differently than qualified dividends). In total your cash flow might be around ~$257, good for a yield of 9.9%. Should CSX raise its dividend, you'd expect to receive over 10% of today's value with that agreement.

If the option is exercised, you are forced to sell at $27, giving you proceeds of $2,700. This is a true risk, as shares might go to $30 or $40 and you're "stuck" selling at $27. You might be kicking yourself for taking the extra time to make an agreement, only to "cap" your eventual gains. Yet I would contend that this isn't the worst of news.

In addition to the $2,700 you'd also have the ~$185 in option premium (which you could reinvest right away). So your total gain would be about 11% in less than a year. If you also collected dividends along the way, your return might be as high as 14%. Sure it's not the 15% gain that you would have achieved by simply holding if shares go to $30, but it's not a "bad" result either. Show me a 11% to 14% return every 10 months and I'll show you a place to create a good chuck of wealth.

And naturally you don't have to agree to sell at this price. If you're looking for the possibility of a double-digit yield or a 10%+ gain, this is likely the simplest option for that expiration date. Yet you could still significantly increase the amount of cash that you receive by agreeing to sell at $30 or $35, as examples. It all comes down to one's individual portfolio ambitions.

In short, CSX has had an exceptional investment past. In the last 15 months or so the share price has declined materially, offering a "fresh look" for current or prospective partners. You could buy shares, hold and watch to see what unfolds in the years to come. Alternatively, if you want to generate a bit more cash flow, you could both own shares and agree to sell at price that you would be happy with. Whether that means think about adding 7% more income or 1% depends greatly on your underlying goals.

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.