CSX Corporation's (NYSE:CSX) stock is overvalued by roughly 30%
1. CSX's financial results over four years show no improvement
After the market close on Wednesday, April 19, CSX Corporation released its highly anticipated earnings report for the first quarter of 2017. It was indeed highly anticipated since Hunter Harrison, a railroad veteran, has joined the company as the new CEO in January (named in March). Harrison is well known by Wall Street for his miraculous turnaround of Canadian Pacific Railway (NYSE:CP) a few years ago, backed by none other but Bill Ackman himself.
CSX stock has been trading around $22 per share just over a year ago. Now, it's trading around $51. Company's market cap has increased by $25 billion. Has the change been backed up by performance? NO. In fact, the company is in worse financial shape than it was in the last three years due to growing debt. Let's break it down.
Taken from company's Q1 earnings report:
As you can see in the statements above, the company has only increased its revenue and net income compared to the year before, while still lagging behind 2015 and 2014 by roughly 5%. Especially lagging on the EPS, considering that the share count has gone down 7% since Q1 2014. Also, please notice that the dates of Q1 end have always been shortened to the last working Friday, while in the Q1 2017, the report goes all the way to March 31, giving it a six-day extension, that is a 6.66% increase in the books. Not very noticeable at first.
As for the net earnings, Mr. Harrison and the report itself have mentioned numerously that there was a $173 million restructuring charge, while labor costs have gone down $7 million for the same reason - firing American workers. But that's fine, that's a huge ratio.
Now, let's take a look at cash flow. It gets even more interesting here. Taken from company's Q1 earnings report:
Net earnings have come up a mere $6 million year over year. Remember that market cap went up by roughly $25 billion in the same period. $362 million for Q1 2017 is 22% behind Q1 2015, while Q1 2016 is 25%. From the Q1 2017 earnings call, Mr. Harrison sounded very optimistic when he promised 25% increase in net earnings compared to 2016; that would bring us to the same values as 2015. You may ask why I only use Q1 reports for each year. That's because Harrison only joined CSX this quarter, and the news of him joining brought in about $12 billion in value before he even took a seat at his new desk. Now, the interesting part - Q1 2017 has $161 million in remaining restructuring charge. Why would you add that amount to your cash flow? Let's just say that the net increase in cash was $166 million vs. $327 million reported. Not bad comparing to $103 million increase in 2016, where previous management decided to spend $270 million on locomotives, which Mr. Harrison now gets to use for free. Another line that bothers us is the $141 million in other operating activities. Read the whole report, didn't find any elaboration.
2. Now that we compared the first quarters, with some unanswered questions, let's take a look at company valuation over the same periods
2014 Q1 ER $28.03 PPS $28.25B MC 17.51 P/E
2015 Q1 ER $37.12 PPS $36.82B MC 20.62 P/E
2016 Q1 ER $27.53 PPS $26.51B MC 18.61 P/E
2017 Q1 ER $51.50 PPS $47.45B MC 32.05 P/E
Let's take overall market conditions into consideration and add 14% to the 2016 value, gained by XLI, we will get $31.40 per share, then we add the 5.4% increase in EPS, we get fair value of $33.09, plus dividends = $34.00 per share. Before you jump down our throats, this is a very simple market-to-market, year-to-year comparison. Let's continue.
3. Let's compare outstanding debt
Total Liabilities Long-Term Debt
Q1 2014 $21.877B $9.514B
Q1 2015 $21.823B $9.513B
Q1 2016 $23.720B $10.962B
Q1 2017 $24.043B $10.963B
Long-term debt hasn't decreased, while total liabilities have gone up $323 million. Please remember that interest rates keep going up, while the company hasn't paid back a penny of long-term debt in a year. Frankly, it can't afford to and will go deeper in debt, keeping up with dividends and buybacks that it just increased. That is why it filed to sell $850 million worth of notes. We will get back to how the new management plans on pumping the stock.
CSX announced Q1 dividend of 0.20 per share, which should come out to $180 million. It also announced a new buyback program of $1 billion. At this price, it should only buy back roughly 20 million shares. But there is a very interesting option deal that came with hiring Mr. Harrison equivalent to 9 million shares. Basically, the CEO just announced that it will use half of the buyback to buy nearly half of the shares that he will purchase if the price is right. In fact, this whole research is winding down to how Mr. Harrison is very motivated to pump the stock price. While Debt to EBITDA is growing from 2.3x to 2.5x YOY, according to Q1 ER CC slides.
4. Harrison's pay package outweighs the expense cuts made so far
Going back to the imaginary $0.51 EPS. Harrison numerously mentioned the restructuring charge of $173 million that dragged down the actual EPS to $0.39. He reiterated that this one-time charge will allow substantial cuts on labor costs. But he failed to mention that his salary alone is $5 million per year plus an $84 million reimbursement he left behind at Canadian Pacific Railway, plus, and this is awesome on his part, CSX would have to cover taxes on that payment, amounting to as much as $23 million. Including options for the next four years, Harrison will cost CSX roughly $220 million, or $55 million per year. He asked for the right to purchase 9 million shares at the strike on the day of his appointment as CEO. Harrison's pay package doesn't compare to previous CEO Michael Ward, who received $39 million for the last four years, and more than doubles his own pay package of $94 million for the last four years at CP.
According to Payscale.com, average CSX employee salary is $64,000 per year. The difference in Harrison's salary to previous CEO would pay for 718 average workers. The total amount of workers laid off (covered by $173 million restructuring charge) is 765, according to Q1 ER. CSX should save about $3 million per year by replacing 765 employees with Harrison. We do not even want to get into directors' compensations that came with the deal, led by Paul Hilal at Mantle Ridge. We are sure that the new staff will cost the company more than the 765 fired workers.
5. Short-term gains at company's expense
Let's talk a little bit about this deal that activist Paul Hilal made with CSX board. He replaced CEO with Harrison, a 72-year old veteran, who turned Canadian Pacific Railway around in the last couple of years. Well, first, it wasn't his idea. Before deciding to run CP, Harrison was in retirement after a five-decade career. He was convinced to come out of retirement by Pershing Square's Bill Ackman. Paul Hilal used to work at Pershing Square and left a few years ago to start Mantle Ridge. Before convincing Harrison to quit at CP and move to CSX, Mantle Ridge has built up a 4.9% stake in the company. Not a bad activist move but it's not original. The stake is now worth roughly $2.5 billion. In fact, Mantle Ridge agreed to guarantee the $84 million payment from CSX to Harrison by the annual CSX meeting. Who wouldn't agree to that if the news of possible move by Harrison brings your investment up by roughly a billion dollars? But we think it is not going to be so simple to keep the inflated valuation going forward. When Harrison joined CP, the company was in very bad shape. In fact, it was the worst performing company in the sector, which is not the case with CSX. CSX had a setback in 2016, as did the whole transport sector. It's a much easier task to improve a complete loser compared to improving the largest railway operator in Eastern US, margin-wise. Even Harrison said that he sees a 25% improvement in earnings in 2017 compared to 2016, which would basically bring it to 2015 levels, and it traveled the first 10% without him.
Mantle Ridge move was a basic activist move for the stock. Use a big, known name in the industry to raise the stock price and worry about the consequences later. Whether Harrison delivers is still unknown. We believe that CSX will not outperform its rivals, such as Norfolk Southern (NYSE:NSC). We believe that Mantle Ridge will do everything in its power to keep stock price inflated as it already paid Harrison $55 million according to Fortune.com. It was clear during the negotiation process that Harrison cares only about his financial gain from joining CSX and he is not likely to stick around if the stock price will stay below his strike of $49.75 per share after receiving the $84 million + tax package.
Kansas City Southern reported Q1 earnings on Monday. The improvements in financials were significantly better than CSX. Revenue increased by 8% YOY, while CSX has only gained roughly 2% on revenue YOY. Adjusted EPS came in 14% better than Q1 2016 for KSU, while CSX reported only 5.2% increase in EPS over Q1 2016. And, this whole time, KSU has been losing on the depreciation of the Mexican peso. As a result, the stock of the company fell 3% initially and closed slightly green, keeping P/E ratio of 20.24 compared to CSX's 32.05.
I waited to write this up until Norfolk Southern released its earnings report, and it came in exactly as I had expected. NSC is the closest peer to CSX in terms of revenue and business model. Also, its business area overlaps with CSX east and down from Indiana. NSC reported +14% on EPS YOY vs. +4% on YOY EPS at CSX. Norfolk Southern beat CSX increases on all metrics, especially coal. The stock reacted with less than 1% gain on the day while CSX went up 10% on the day of the release. NSC continues to trade at 20 P/E while CSX P/E is around 30. NSC stock is up roughly 50% YOY while CSX is up roughly 110% YOY.
The largest contributor to railway revenue is coal. In fact, Q1 2017 in coal revenue has added $123 million to CSX revenue. Basically, half of the net change in revenue YOY. The other half was brought in by the industrials, which include minerals, automotive, metals, and equipment. Then again, none of this increase has been contributed by Mr. Harrison's management. First half of 2016 was a difficult time all across the economy. Oil prices plummeted below $30 per barrel, and stock markets corrected roughly 15%.
YOY volumes and revenue at CSX according to Q1 earnings report:
Coal production 2015 - 2018
In this chart provided by eia.gov, we can see that overall coal production has increased by 3.9% from 2016. Meanwhile, according to Q1 ER, Q1 2017 coal shipping volume at CSX has increased 3%, adding roughly 4% to overall revenue. The EIA expects an increase of coal production of 2.2% through 2018, which is lower than the increase between 2016 and 2017.
But according to the chart above, coal production has been steadily declining since its peak in Q1 by roughly 20%. This is very bad news for Harrison and CSX.
So far, revenue jump since 2016 has not in any way been a result of hiring Harrison as new CEO but due to overall market and economy conditions.
8. Market is pricing Harrison for perfection, but he will likely fail at pulling off CP 2.0
We believe that the premium on the stock, brought by optimism about Harrison as the new CEO, doesn't make any sense, and soon enough, investors will realize this, probably after Mantle Ridge trims its position in the stock. The same happened with Pershing Square and CP stock. As soon as Ackman sold, the stock has gone down 33% from highs, while Harrison was still CEO. The problem is CP was in far worse shape when Harrison started there, with operating ratio of 83.3, while CSX's operating ratio is 69.4 (industry average).
We believe that management and activist fund that backs him are very motivated to overstating the actual conditions of the company. At the time of writing this article, the stock went up another 2% because Harrison reported buying 300K shares at $50.20. Why would anyone do that having 9 million options at $49.75 other than to pump stock?
9. Other concerns
We noticed a lot of repeating social media promotion on the stock. On Twitter, the buyback alone is mentioned every hour by new bot accounts. No one mentions the $850 million filed prospectus to issue notes on April 26, 2017.
We are also very concerned by President Trump's harsh words about NAFTA (North American Free Trade Agreement) and his idea of hiking import taxes at the border. If he either changes the deal on NAFTA or gets a positive reaction to hiking import taxes, CSX revenue will be hit substantially due to amount of shipments to and from Canada and Mexico. We are also concerned about dying retail sector, which accounts for a large part of intermodal revenue. I'm sure everyone is concerned about a possible trade war President Trump seems to favor.
The company will not outperform its peers, which are trading at much lower valuations. Harrison is unlikely to deliver what is expected of him. We see fair value at $37 per share.
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. I have no business relationship with any company whose stock is mentioned in this article.