There has been a lot of talk about E. Hunter Harrison and his partner Paul Hilal taking control of CSX Corp. (NASDAQ:CSX).
Source: CSX
CSX stock is up 46% since the November election and up 35% since the company's announcement Hunter Harrison was taking over the railroad as CEO. Harrison took over as CEO in early March. CSX is overvalued when looking at its 26 P/E compared to its peers that are trading around a 20 P/E. But when looking at CSX on a price/book ratio, CSX actually trades at a discount compared to its peers, and Norfolk Southern (NSC) looks even cheaper. The important question is what will Hunter Harrison do at CSX? This article takes a hard look at Hunter Harrison and his track record and precision railroading model. Readers will come away with three actionable items. Consider buying Norfolk Southern and Union Pacific. And hold CSX. And be prepared for merger and acquisition activity within two to four years, maybe sooner.
Railroad | P/E | Price/Book | Dividend Yield | Carloads 2016 | Carloads 2015 | % YOY | Volume Growth YTD 2017 |
CSX | 26.3 | 3.78 | 1.51% | 6,371,404 | 6,759,829 | -5.7% | 1.1% |
Norfolk Southern | 20.6 | 2.70 | 2.12 | 7,242,857 | 7,452,055 | -2.8% | 4.4% |
Union Pacific (UNP) | 20.8 | 4.31 | 2.29% | 8,421,799 | 9,028,691 | -7% | 0% |
Canadian Pacific (CP) | 18.4 | 6.48 | 1.02% | 2,525,000 | 2,628,000 | -3.9% | -0.2% |
Canadian National Railway (CNI) | 20.5 | 5.03 | 1.69% | 5,192,463 | 5,464,688 | -5% | 7.2% |
Source: Charles Schwab for financial ratios; railroad web sites for volume data.
I believe journalist Fred Frailey, of Trains Magazine, probably knows Hunter Harrison better than any other journalist. Let us review what Frailey has to say about Harrison. Harrison will first examine employees he wants to keep around. He wants employees who know railroading inside and out and who are committed to helping him succeed as the five star general in command. If your allegiance is to the previous person in charge, get out and follow him. If you don't pass Harrison's tests, you will be let go. I suspect managers who have become complacent, wishy-washy and out of touch will be shown the door.
At the same time, Harrison is also gathering information on all company assets, locomotives and cars, rail yards, terminals, with the help of Mark Wallace, whom he hired away from Canadian Pacific.
Harrison will implement his intensive utilization of assets, routes, locomotives, equipment and people. Essentially he wants no idle assets. Train schedules will be customer friendly. The Harrison train model, Frailey wrote, is:
[A]lways operate the same number of trains in each direction and run them all seven days of the week. Try to avoid extra trains on busy days and don't annul trains on slow days. Instead, adjust to volume by raising and lowering rates. That way you'll always have just enough equipment and people and the excess can be stored and furloughed.
Harrison will look for assets to unload. If the asset cannot be used, it will be sold.
At CP, Hunter used this same precision railroading model to bring down adjusted operating ratio from 77% in 2012 to 58.6% in 2016.
In 2016, CP and its nearly 12,000 railroaders faced down a year in which stubbornly low commodity prices, tepid economic growth and a weather-delayed grain harvest tested the resilience and efficiency of its operating model. The company produced a record-low annual operating ratio of 58.6 percent, an improvement of 140 basis points from a year earlier. The company grew 2016 diluted earnings per share by 27% to $10.63, and adjusted diluted EPS climbed 2% to $10.29, compared to the previous year, said Keith Creel, president and CEO, in the company's annual report.
Th lengthening of trains on average by 4%, "slashing" average dwell time by 7% and increasing average network speed by 1% accelerated the network as a whole. The word, "slashing," actually comes from CP's annual report.
A look at CSX
CSX is a collection of railroads like all modern Class 1 railroads. It has its beginnings with The Baltimore and Ohio Railroad Company ("B&O") -- the nation's first common carrier -- was chartered in 1827.
CSX has 27,000 employees as of December 2016, which includes approximately 22,000 union employees. Most of the company's employees provide or support transportation services.
During 2016, CSX's services generated $11.1 billion of revenue, delivered earnings per share of $1.81, operating income of $3.4 billion and an operating ratio of 69.4%. The com served three primary lines of business:
- The merchandise business shipped 2.8 million carloads and generated 64% of revenue and 43% of volume in 2016. The company's merchandise business is comprised of shipments in the following diverse markets: agricultural and food products, fertilizers, chemicals, automotive, metals and equipment, minerals and forest products.
- The coal business shipped 838,000 carloads and accounted for 17% of revenue and 13% of volume in 2016. The company transports domestic coal, coke and iron ore to electricity-generating power plants, steel manufacturers and industrial plants as well as export coal to deep-water port facilities. Roughly one-third of export coal and the majority of the domestic coal that the company transports is used for generating electricity.
- The intermodal business accounted for 16% of revenue and 44% of volume in 2016. The intermodal business combines the economics of rail transportation with the short-haul flexibility of trucks and offers a cost advantage over long-haul trucking. Through a network of more than 50 terminals, the intermodal business serves all major markets east of the Mississippi River and transports mainly manufactured consumer goods in containers, providing customers with truck-like service for longer shipments.
Harrison has had his eye on CSX and Norfolk Southern for a long time. In 2014, while CEO at CP he tried to merge with either one of them. In extensive documentation, CP outlined how it would take over Norfolk Southern and reduce waste and create more profit. Both Norfolk Southern and CSX rejected his merger proposals. After CSX's management rejected Harrison's offer in 2014, Surface Transportation Board member Deb Miller told me the board was reluctant to do anything to make service issues worse. At the time, railroad volumes were growing and some railroads were struggling to meet demand, particularly in the northern transcontinental railway, with the growth of crude-by-rail and a bumper wheat crop in the Dakotas. Since then, BNSF Railway (BRK.B) has invested substantial dollars improving the Northern Transcon. Over the past two years, all Class I rail volumes fell, with a slowdown exports due to the high U.S. dollar, and a re-adjustment in the use of coal in the electricity generation business. Coal volumes fell 30% as utilities shift to burning natural gas, which is cheap and in abundant supply in North America. Wind generation, to a lessor extent, also contributed to coal's decline. Coal seems to have stabilized. Coal volumes at CSX were actually up 7% YTD through Week Ended March 11.
Under President Trump, I expect the Surface Transportation Board to strongly consider allowing mergers to move forward. People like Harrison believe a large, transcontinental single carrier network is the most efficient way to move freight.
Union Pacific is a dominant carrier in the West, Midwest and Southwest, with its 1990s acquisition of Southern Pacific. Burlington Northern & Santa Fe Railway is the dominant carrier in the West, Midwest and Northwest and Northern states like Minnesota and the Dakotas. Norfolk Southern and CSX both dominate the East Coast. I fully expect Harrison to approach Union Pacific with a proposal to merge. If UNP rejects him, he will talk to BNSF Railway. A CSX-UNP alignment would create a single carrier along the southern transcon and a Norfolk Southern-BNSF Railway alignment would create a single carrier for the Northern Transcon.
Railroads usually suffer from service delays immediately after a merger into a single company, but if the rail elite could come up with a merger proposal addressing ways to mitigate delays, the Surface Transportation Board would consider it.
Norfolk Southern was trading in the $80s last year, then climbed into the $90s by the November election and then ran all the way to $122 per share. The stock has fallen to $114 per share. Norfolk Southern is trading at 2.7 times book value, CSX is trading at 3.78 times book, Union Pacific is trading at 4.3 times book value, Canadian Pacific is trading at 6 times book and Canadian National is trading at 5 times book value. These numbers tell me there is a discount in Norfolk Southern's price to book for some reason. Perhaps there are some assets that are not worth much anymore. On the surface of things, I don't think CSX is overvalued and Norfolk Southern looks attractive.
Rail volumes are starting to improve after two years of declines that began in spring 2015. Coal may have a future under President Trump, who is calling for cutbacks in regulation and the Environmental Protection Agency. I like the railroads and would consider owning more shares. If Norfolk Southern falls below $100 per share, I may consider buying it. I already own positions in Union Pacific and Canadian National Railway.
CSX's operating ratio is around 69%. Under Harrison watch for incremental improvements in operating ratio at CSX through lengthening trains, selling off property and cutting headcount. If Harrison's health can hold up, he may get a lot done for shareholders in a couple of years, but I don't see employees liking him much with his slash and cut style.
For years railroad barons have dreamed of a single carrier from coast to coast. If Harrison merges CSX with UNP, that would be the biggest event in railroad history. We may see this happen in two to five years. Be a shareholder in North American railroads, hold on for the ride for the next five years, this is one train ride you won't want to miss.
