Investors in CSX (CSX) continue to be wildly enthusiastic about the prospects for the railroad, now being led by Hunter Harrison. The company reported strong first-quarter earnings, largely driven by the existing management team, as Harrison laid out ambitious targets for this year.
While the company projects spectacular earnings growth for this year, further gains can reasonably be anticipated in the years thereafter. This makes that shares now trade at market-equivalent multiples projected by 2018/2019. The truth is that these earnings still will have to be delivered upon and will take some time to be realized, making that expectations have been running very high as shares nearly doubled over the past year.
While I think that Mr. Harrison will be able to deliver on his promises, I believe that it remains a relatively safe bet to lean short on CSX against long positions across the remainder of the sector.
Quick Review Of The Quarter
CSX reported very decent first-quarter earnings, albeit the comparison was rather easy. Volumes were up by 3%, driven by automotive, minerals and metals. Coal volumes were up 3% as well, the first increase in a very long time.
This volume growth was accompanied by very strong pricing gains of 7%, driven by a 28% increase in coal shipping prices. Intermodal price increases of 6% were decent as well, as general merchandise pricing was up by 2%. Part of the 7% increase in prices was driven by higher fuel surcharges. Fuel surcharge revenues rose by $33 million compared to the same period last year, adding roughly 1.2% to the overall increase in prices.
While the revenue side of the business was well taken care of this quarter, CSX showed real expense discipline as well. Fuel costs were up by 68%, increasing by $68 million in absolute terms. Of course, half of this increase was "recovered" through higher fuel surcharges. Despite the increase in volumes, CSX managed to cut labor costs by a percent. Expense discipline was very good as material costs were up by just 3%, while depreciation charges increased by 2%.
If not for a $173-million restructuring charge, total costs were up just 3.7%, largely driven by fuel expenses. Even if we include the restructuring costs, which relate to an effort to reduce the workforce by 765 workers, earnings per share were still up two cents to $0.39 per share. If not for this charge, earnings would have improved spectacularly to $0.51 per share. The spectacular earnings improvement is driven by a 380-basis point improvement in the operating ratio to 69.2%, for operating margins of 30.8%. The good performance has been driven by both very strong execution on the revenue and cost side of the business.
The Short Term Plans
Mr. Harrison started 2017 on a solid note, but has real ambitions for this year. It should be said that much of the Q1 results cannot be attributed to him, as he only worked 30 days in the quarter. For 2017 the operating ratio is targeted to come in the mid-sixties.
Combined with top-line growth, these efforts should support 25% earnings growth. As earnings came in at $1.81 per share in 2016, earnings are expected to come in at or above $2.25 per share this year.
Much of the improvement in terms of margins should be the result of the so-called "Precision Scheduled Railroading," a concept which was actually developed by Mr. Harrison himself two decades ago. This theory is based on the philosophy of constantly monitoring and optimizing the utilization of all the assets. Rather than running operations more efficiently, this strategy has the potential to free up a lot of cash as well as CSX could potentially shed some idle assets.
The increased cash flow generation following the anticipated improvement in margins will be used to please investors through a $1 billion buyback program. These repurchases will be sufficient to reduce the outstanding share base by some 2%, as the quarterly dividend will be hiked by 11% to $0.20 per share. The dividend yield remains very modest at 1.6%, however.
The multi-year plans will only be announced later this year, but given the continued ambitions I would not rule out a bull case in which operating ratios are targeted to fall towards 60%.
Looking At The Potential
CSX is delivering on impressive operational results and that is necessary as the expectations have been very high ever since speculation emerged that Mr. Harrison would return to the industry and join CSX.
Shares of the company are up 90% over the past twelve months, far outpacing the 30-40% gains reported by Union Pacific (NYSE:UNP) and Norfolk Southern (NYSE:NSC), not even mentioning the underperformance by the likes of Genesee & Wyoming (NYSE:GWR) and Kansas City Southern (NYSE:KSU).
This means that the company really has to deliver as shares traded around $28 at this period last year when earnings power came in at $1.80 per share, for a modest 15-16 times earnings multiple. Even as earnings are set to increase spectacularly to at least $2.25 per share this year, multiples have risen to 22 times. This indicates that much of the stock returns have been the result of increased earnings expectations rather than current earnings improvements.
Let's assume that the company targets a 40% operating margin target by 2018-2019. If we assume that revenues continue to grow towards $12.5 billion, operating profits might come in at $5 billion. With interest charges running at $500-600 million and assuming a conservative 38% tax rate, earnings potential comes in at around $2.75 billion. Combined with modest share repurchases, that lays out a road map for earnings of $3 per share by 2018/2019. That translates into a market multiple of 17 times projected earnings in a favorable scenario a year or two from now.
That seems like a fair valuation which is in line with the market, taking into account that cash flow generation for railroads typically is not that great. This follows the fact that even maintenance capital spending requirements are very high in relation to depreciation charges as a result of the very long-term duration of the assets.
Investing is a balancing act and this case is no exception. Shares of CSX have vastly outperformed its peers on the back of the prospects for the future improvements under its new leadership, while current earnings momentum has improved meaningfully as well.
That said, earnings multiples have unmistakably increased over the past year, as investors bet on further profit improvements. If the company could attain an operating ratio of 60%, as has been somewhat discussed on the very eventful and insightful conference call, shares now trade at market-equivalent multiples based on earnings a year or two down the road.
If that would be realized, earnings potential looks solid again, as free cash flow conversion will improve dramatically. This is certainly the case if the company might be able to shed some non-used or underutilized assets as well. That said, CSX is close to priced-for-perfection at these levels. If the company delivers a 60% operating ratio, shares appear reasonably valued and could deliver on market-equivalent returns; yet, optimism is on the high side.
This allows me to lean short on the shares versus longs across the remainder of the industry. After all, quality in terms of great management and margins does pay off over time, but even quality has its price.
Disclosure: I am/we are short CSX.
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.
Additional disclosure: No directional bet on railroad industry through diverse long positions across the remainder of the industry.