Railroads have been one of my top picks for some time now (see here). They are well positioned to gain from the end of economic stagnation, relatively safe from competition given barriers to entry, and trade at attractive multiples. Having provided investor relations services to the transportation in the sector, I say confidently that secular trends are pointing in railroads' favor. The industry still remains the cheapest form of good transportation.
In this article, I will run you through my DCF analysis on CSX (CSX) and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to Norfolk Southern (NSC) and Union Pacific (UNP). According to T1 Banker, CSX is rated a "strong buy." I recommend that investors also consider other smaller rail firms, like Providence & Worcester (PWX) and Pioneer (PRRR.PK), which are possible takeover targets given their access to strategic locations.
First, let's begin with an assumption about revenues for CSX. The railroad company ended FY2011 with $11.7B in revenue, which represented a 10.4% gain off of the preceding year. Analysts model a 15.5% per annum growth rate over the next five years, and I share this sentiment.
Moving onto the cost-side of the equation, there are several items to address: operating expenses, taxes, and capital expenditures. I model that cost of goods sold, COGS, will eat 32% of revenue over the next few years compared to 27.5% for SG&A and 0% for R&D. These estimates are roughly around historical 3-year average levels. Capex is estimated the same way, so I assume 17% of revenue. Texes are also estimated at around 37%.
We then need to subtract out net increases in working capital: we model accounts receivables as 10% of revenue; inventories as 7% of COGS; accounts payable as 16.5% of OPEX; and accrued expenses as 16.5% of SG&A.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9% yields a fair value figure of $21.62, implying 4.1% upside for the conservative case. This is on top of a 2.3% dividend yield.
All of this falls under the context of strong recent quarter results:
Last evening, we were pleased to report record earnings per share for the fourth quarter and full year 2011. Fourth quarter EPS was up 13% to a new fourth quarter record of $0.43 per share. These results were driven by top line growth, reflecting strong core pricing and fuel recovery, as well as an excellent service product. Service measures are now at high levels, thanks to the outstanding execution of our operating team and the resource investments we made in the second half of the year. We expect service levels to remain high going forward…
For the full year 2011, CSX generated record performance in operating income, operating ratio and earnings per share. In addition, we strategically positioned the company for long-term growth and set the stage for our 65% operating ratio target.
From a multiples perspective, CSX is the cheapest compared to peers. It trades at a respective 12.4x and 9.8x past and forward earnings versus 12.5x and 10.3x for Norfolk Southern and 16.5x and 12x for Union Pacific. Assuming a multiple of 12.4x and a conservative 2013 EPS of $2.09, the rough intrinsic value of the CSX is $29.26. This upside is plausible if CSX is assumed to have a perpetual growth rate of 3% and a WACC of 9% - these figures are, after all, reasonable.
Consensus estimates for Norfolk Southern's EPS forecast that it will grow by 9.3% to $5.89 in 2012 and then by 12.4% and 10.3% in the following two years. Assuming a multiple of 14.5x and a conservative 2013 EPS of $6.53, the rough intrinsic value of the stock is $94.69, implying 39% upside. Union Pacific and Norfolk Souther, like CSX, have benefited from industry momentum. Union Pacific is arguably the safest given its leading scale and limited exposure to volatile coal markets. Management has also shown a strong ability to control the cost base in the midst of volume uncertainty. Overall, I recommend an investment across the entire industry.
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