CSX: The Rally Is The Real Deal

| About: CSX Corporation (CSX)

Summary

The rally is the real deal and it's just getting started.

CSX's efficiency initiatives paid off in Q2 2016.

CSX is still incredibly cheap with a fair margin of safety at current levels.

Superb free cash flow margin could imply a dividend hike in Q3 or Q4 2016.

CSX Corporation (NYSE:CSX) enjoyed a fantastic rally this year and the very impressive Q2 2016 earnings could sustain the rally back to new highs. In my previous piece I recommended CSX because of the huge discount to its intrinsic value. The stock has since gone up +12% in just under two months, and I still believe the stock is dirt cheap and has further room to run as the rail market sees light at the end of the tunnel.

CSX delivered a terrific second quarter; although revenue decreased 12% due to freight volumes dropping, CSX still managed to crush analyst expectations of $0.44 with a $0.47 EPS. This beat can be attributed to management's dedication to improve operational efficiency and reducing costs where the company could. The management team knew that the price of commodities was out of its control and that volumes would decrease, which was no different for any other railroad in the country. So CSX focused on what it could do in times of turmoil. The company took a long-term view and decided to invest in initiatives that would relieve short-term pain of declining volumes, as well as drive huge value for investors in the long term. Once commodities do rebound and volumes increase, we can expect CSX's investment initiatives to deliver outstanding results. This is why I believe the current rally is the real deal, and is only the start of what I believe is a sustained rally to new highs.

CSX's operational efficiency measures have shown to work in Q2 and the proof is in the pudding. Coal demand was expected to be weak for Q2, as volumes were down a whopping 34% in Q2. But CSX did what it could to weather the storm. Expenses decreased by 9% YoY, which saved the company an additional $183 million. Total savings are near $350 million and are expected to increase with greater momentum as we head into the latter part of 2016. While its initiatives were not enough to completely offset the weakness in freight volumes, they still were enough to allow CSX to beat analyst expectations.

The major headwinds facing the rail industry will inevitably go away and CSX will come out of this tough economic environment a better company that is more efficient at delivering profits to shareholders. CEO Michael Ward stated that CSX "continued to drive strong customer service and network efficiency in a challenging market and is expected to persist throughout this year." I believe management is very capable of steering CSX back on the right track and attribute its investment efforts to its terrific Q2 earnings beat.

In my previous piece I stated that I do not expect short-term value being generated from its investment efforts, but I was proven wrong and I believe CSX is actually cheaper than I originally anticipated. CSX is focused on long-term project and if you're an investor with an investment horizon over five years, there is no doubt that CSX will deliver fantastic value to you. It's been quite a rally from the bottom, but the stock is still very cheap at current levels and there is a fair margin of safety. The P/B and P/CF are at 2.3 and 8.1, respectively, both of which are lower than its five-year historical average values of 2.8 and 9.1, respectively. CSX has a fantastic operating margin of 30.2% thanks to its long-term investments in improving efficiency. The operating cash flow is at 2.1x net income with a 12.6% free cash flow margin. This is quite impressive considering the headwinds that the entire rail sector is facing. Such a strong free cash flow position could imply a dividend hike in one of the remaining 2016 quarters. Buy CSX and enjoy the ride up while you collect a very bountiful 2.54% dividend yield.

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.