Buy This Railroad Despite Coal-To-Gas Substitution

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 |  About: CSX Corporation (CSX), Includes: BTUUQ, IYT, NSC, UNP
by: Bidness Etc

CSX Corporation's (NASDAQ:CSX) stock has a high-dividend yield and has shown a better-than-expected performance in the first quarter. Additionally, its coal exports to Europe and China are expected to increase, while its merchandise and intermodal segments show increasing revenue. The company is diverting resources away from the declining utility coal segment to other profitable segments. Moreover, there are many growth opportunities open for the company such as supplying sand for shale gas production and diversification into other railroad-related businesses. It is because of these reasons that we recommend a long position on CSX to our investors.

Company Profile

CSX Corporation is one of the leading transportation (railroad) suppliers in the U.S., with 21,000 route miles of track that is serving 23 states, as well as the District of Columbia, and the Canadian provinces of Ontario and Quebec. The company's rail and intermodal businesses provide rail-based transportation services, including traditional rail service and the transport of intermodal containers and trailers. Its three broad segments of business are coal, intermodal and merchandise.

Industry Scenario

The primary problem facing the Railroad Industry is that of a reduction in coal carload traffic due to record-low natural gas prices. Earlier this year, natural gas prices fell below $2 per million British Thermal Units (BTU), and according to some forecasts, it is likely to fall even further. According to the CSX CEO, gas prices need to reach the $4-to-$4.50 per million btu range to encourage utilities to use more coal. Coal represents the largest volume of traffic on the U.S. railroads i.e. 43.3% of total tons and 25% annual revenue originated from freight in 2011. U.S. railroads have hauled nearly 200,000 fewer carloads of coal this year than they did last year. Coal carloads fell by 16.6% in April 2012 year over year. In the week ending June 2, 2012, the Association of American Railroads (AAR) said that carloads are down by 3.1% compared with the same week last year. Intermodal volumes for the week totaled 213,911 trailers and containers, which is an increase of 4.1% compared with the same week last year. The AAR said that major U.S. railroads reported increases for 11 of the 20 carload commodity groups compared with the same week in 2011, led by petroleum products, which were up 48.8%; motor vehicles and equipment, up 18.7%; and iron and steel scrap, up 16.2%.

Coal (down 11.2%) and farm products (down 9.5%), excluding grain, saw the steepest declines.

Competition

Norfolk Southern (NYSE:NSC) and Union Pacific (NYSE:UNP) are CSX's primary competitors. Of these three companies, CSX is the one that is most exposed to coal, which represents 31% of its revenue. UNP is the industry leader with the largest network, and is highly exposed to energy and intermodal segments of its business. Currently, 22% of its revenue originates from coal and petroleum. NSC is another leading railroad transport company, and as of December 31, 2011, the company operated approximately 20,000 route miles in 22 states and the District of Columbia. NSC has already started to exploit the increasing natural gas production by transporting sand that is used in fracturing rocks to extract the gas. As seen by the table below, all three companies have very similar ratios and margins.

Trailing P/E

Fwd P/E

EV/EBITDA

PEG

Profit margin

Operating margin

Fwd div yield

Revenue growth rate (quarterly)

ROE

CSX

12.04

10.27

7

0.89

16%

29%

2.6%

6%

21.74%

NSC

11.79

10.46

7

0.84

18%

30%

2.7%

7%

19.60%

UNP

15.69

12.26

8

0.91

17%

30%

2.1%

14%

19.11%

Industry

16.58

0.93

18%

8%

Click to enlarge

Stock Price Drivers for CSX

  • Carload traffic, which in the case of CSX is heavily dependent on the demand for coal by various utilities within the U.S. Consumption of coal, is still expected to be low due to utility coal stockpiles in 2Q2012.
  • Fuel price is the biggest expense of the company as CSX freight trains run on diesel. This makes having efficient trains very important.
  • A lawsuit against CSX and other major railroad companies accusing them of overcharging.

CSX Summary

  • Exposure to Coal: CSX has greater exposure to coal than its competitors like UNP and KSU. Coal forms 31% of its total revenue, and of this 31%, 55% goes to utilities. Hence a drop in demand has affected CSX more adversely. Apart from the coal supplied to utilities in the U.S., the company expects the export of coal to be flat internationally (which is a conservative stance as it is likely to grow with population growth and economic activity), and to industries to remain strong due to high steel production.
  • Lawsuit Gets Class Action Status: A recent drop (Friday, June 22) in the stock price of CSX and three other railroad competitors (who control 90% of industry revenue) has been due to a lawsuit filed on the basis of the accusation that the companies earned billions by levying fuel surcharge tied to overall transportation costs rather than actual fuel prices over a 3-1/2-year period. Shares of CSX fell by 2.1 percent to close at $21.63.The railroad companies are expected to seek a settlement, and so the stock is expected to trade down.
  • 1Q2012 Profitability Improves Despite Coal Situation: CSX reported better margins than the same quarter last year, even though the utility coal demand was weak. The EPS turned out to be $0.43 as compared with $0.35 last year. This was also greater than the $0.38 expected by the market.
  • Dividend Yield is 2.3%, which makes CSX a good investment compared with treasuries. Moreover, the last three years have seen the company raise its dividend 92% from a quarterly rate of $0.073 to $0.14. In 1Q2012, the company paid $125 million of dividends, and its cash from operations was $444 million. This shows that the company can sustain paying such high dividends in the future.

Upcoming Catalysts

New business in intermodal and effectively controlling cost and higher profits in the non-coal businesses remain primary catalysts for improved earnings.

However, tough competition, increased railroad regulation, a highly unionized labor and uncertain market conditions for some product lines are the main risks in our investment recommendation.

Bullish Scenario

We are optimistic about a healthy growth in the company's other major segments, namely Intermodal and Merchandise. Despite a slowing macroeconomic environment, we expect Intermodal to register double-digit growth based on expanded service offerings and investments. In 2011, it invested $2.3 billion in its network to further enhance its capacity, quality, safety and flexibility. Also, the merchandise segment is expected to fuel growth with higher volumes in phosphates and fertilizers. Industrial shipments are expected to continue being strong, driven by a growth in Automotive and Metals products. The housing/construction sector is expected to improve, driven by a recovery in multifamily housing.

CSX has also shifted some resources away from the utility coal sector into its other more promising business segments. In addition, the CSX COO sees growth opportunities for the company in shipping products such as frac sand, piping, crude oil and petrochemicals.

The stock is expected to trade at a P/E ratio of 10x, and in a bullish scenario, we expect a stock price of approximately $28.

Bearish Scenario

However, the current market conditions in utility coal will also remain unfavorable for the company in the near term. Given the low prices of natural gas, declining demand for thermal coal for electricity generation in the domestic market, and higher stockpiles, lower shipments of utility coal will maintain a downward pressure on the company in the near term.

Recommended Strategy

Currently, CSX is off 20% from its 52-week highs. We expect the current price to rise. There is no railroad ETF. However, the Dow Jones Transportation Average Index Fund (NYSEARCA:IYT) is the choice of some investors, though it is about 28% invested in railroads as of the end of last year. Its top holding is UNP, at 12%, while NSC is the fifth largest at 7.6%.

We advise a long position in CSX and a short position in IYT.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.