CSX (CSX) has seen a nice rally this year, as shares have risen 20% since January a despite continued fall in sales. The market has been anticipating improvements in terms of demand, as sales declines become less pronounced,. At the same time, CSX has delivered on great cost control, accompanied by a tailwind of lower fuel prices.
While cost control and pricing power is to be applauded, the rapid rise in the shares in combination with continued volume declines, is a trend which makes me very cautious. For that reason I am exiting most of my position in the low-thirties.
Third Quarter Shows Further Sequential Improvements
Third quarter revenues fell by 8% to $2.71 billion and while sales are coming down, it does mark a sizable improvement from the 12% sales decline reported in the second quarter. This improvement is very much driven by pricing as revenues per unit were flat for the third quarter, as overall volumes fell by 8%.
Lower volumes continue to be driven by coal with volumes down 20% in that segment, although higher coal prices did spark somewhat of a recovery on a sequential basis. Note that coal volumes were down as much as 34% in the second quarter.
Disappointing is that intermodal and general merchandise volumes have not improved, driven by weakness in agriculture & foods as well as metals and equipment. The automotive sector was the only bright spot this quarter. Lack of volume improvements are driven by a continued strong dollar and low commodity price environment.
The flat revenue per unit number is noteworthy as it includes fuel surcharges which are of course trending lower. Same store pricing increased by 2.3% despite sluggish volumes, and by 3.6% if you exclude the weak coal pricing. All in all, it is somewhat disappointing to see the sequential improvements in revenues entirely resulting from pricing as volumes continue to be dismal, while comparables become easier.
While it is good for investors to see strong pricing power, it might very well be that strong pricing is hurting volumes in itself on top of a slow economy. I fear that some clients look for alternatives after the company appears to have been aggressive on pricing for quite some time now.
Cost Performance Remains Excellent
The cost performance remains strong, summarized in the most important metric: operating ratio. This number, which is the inverse of operating margins came in at 69.0%, for margins of 31.0%. These margins were down by just 70 basis points compared to the third quarter of 2015, being quite an achievement given that volumes were down by 8%.
A 7% drop in expenses on the back of a 8% fall in revenues is a very strong achievement, especially given the asset intensive nature of the business, resulting in a natural upwards tendency in terms of depreciation charges. These costs rose indeed by 6%, as this is truly a mammoth tanker in the cost structure. CSX did a good job at containing labor costs which fell by 3%. Equipment and rent costs fell by 8%, while material and supplies costs were down by 13%.
With margins falling by 70 basis points and revenues being down by 8%, operating earnings are down 10%. This was in part offset by continued buybacks as CSX has net bought back 39 million shares over the past year, equivalent to 4% of the outstanding share base. This has somewhat limited the fall in earnings per share, coming in four cents lower at $0.48 per share.
Valuation & Balance Sheet Review
$2.00 earnings per share peak profits of 2015 are no longer attainable given the decline in volumes and modest margin pressure. Earnings are lagging by $0.20 per share in the first nine months of the year, although earnings developments could become pretty flattish going forwards, making a $1.75 per share outlook for the year pretty realistic.
At $31 per share, this translates into a 17-18 times multiple, for a 5.5% earnings yield. These earnings fund the 2.3% dividend yield, net capital expenditures and some buybacks.
The long term nature of the investments and large effect of cumulative inflation makes that capital expenditures typically exceed deprecation charges. This is the case, even as demand is coming down, allowing CSX to forfeit at least part of its investments. The reason is simple as depreciation charges on tracks being built decades ago are much lower than the replacement or expansion costs.
CSX invested $1.59 billion in its network and equipment in the first nine months of the year, partially offset by $953 million in depreciation charges, for net capital investments of some $650 million. These investments run at a rate of roughly $900 million by now as the value of the network and property carried on the balance sheet has risen towards $31 billion. The $900 million net investment requirement makes up nearly half of total earnings. In combination with the dividend and share buybacks, CSX continues to ¨grow¨ its net debt load.
Cash and equivalents stand at $750 million, as debt comes in at $10.5 billion, for a net debt load of $9.8 billion. That remains a very manageable situation however despite the fall in earnings. EBITDA runs at $4.5 billion a year, for a very manageable 2.2 times leverage ratio.
Time For Some Caution
I certainly applaud CSX for margin improvements, a long history of consistent buybacks, and prudent (balance sheet) management in what is a difficult environment. Despite these positive developments, volumes are still down 8% year-over-year, as the company relies on price hikes to protect margins and profits to some degree.
In combination with a 20% run-up so far this year, shares are not that appealing in my eyes, as I have exited most of my position. I note that shares have seen a huge run in recent months, trading as low as $22 in February of this year.
Shares now trade at a 30% premium to their ten year average in terms of EBITDA and profit multiples, while the enterprise valuation marks a 50% premium compared to the average sales multiple over this period of time. This creates an additional risk. In relative difficult times, CSX is actually still posting very fat margins, making me wary about any kind of reversal if pricing power comes down.
While the relative and absolute multiples looked much more appealing in the low twenties in the start of the year, this appeal is now gone. While I think that CSX continues to offer a nice long term growth opportunity and is a good inflation hedge, the risk-reward is not that appealing at this point in time.
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.