CSX - The Road Ahead Remains Bullish
- CSX did a fantastic job in 2Q21, growing shipments, lowering its operating ratio, and boosting free cash flow.
- The company spent roughly all of its free cash flow on shareholders thanks to an already healthy balance sheet.
- The valuation is very fair and I continue to advise investors to add into weakness.
The CSX Corporation (NASDAQ:CSX) recently reported its 2Q21 earnings. This is the only railroad I haven't discussed (with the exception of Kansas City Southern (KSU)). In this article, I will discuss these earnings, which came in higher than expected thanks to a focus on operating efficiencies and the ongoing rebound in transportation volumes. I'll also give you my thoughts on the road ahead and the company's ability to generate value. I think we're at a point where we can encounter some market weakness due to peak economic growth (expectations) and the ongoing pandemic difficulties. Nonetheless, I think that's a blessing as lower entry prices will do wonders to the long-term impact this dividend growth stock will/can have on investors' portfolios. So, bear with me!
Here's What Happened In 2Q21
Let's start by mentioning the numbers that hit the wires first after an earnings release. Non-GAAP earnings per share rose to $0.40. That's slightly above expectations. GAAP EPS soared by 136% to $0.52, which is also above expectations.
Source: Seeking Alpha
None of this would have been possible if it weren't for the company's phenomenal revenue growth of 32.3%. This, too, is higher than expected even though the difference of $50 million is neglectable.
Sales growth is mainly impacted by total volumes. In 2Q21, the company was able to report 27% higher volumes. Thanks to higher revenues per unit, the company was able to turn this into >30% sales growth.
Source: CSX 2Q21 Earnings Report
The simple reason that explains this huge boost in total carloads and intermodal is the fact that economic growth has rebounded. We're comparing 2Q21 to one of the weakest quarters in modern history as 2Q20 saw significant lockdowns. Even certain factories were closed back then.
Nonetheless, let's go through the company's comments as it's interesting to see what the company witnessed when it comes to shipments across different industries. For example, chemicals saw a 10% boost due to higher shipments of plastics, waste, and other core chemicals. Crude oil shipments were slightly lower. Agriculture and food products benefited from higher ethanol, good, and consumer product shipments as well as higher domestic grains and feed ingredients.
Mineral shipments increased primarily as a result of higher cement, lime, and limestone demand. Automotive shipments exploded as demand is higher and because last year, major auto plants were closed.
Forest products benefited from a healthier (read: booming) housing market while metals and equipment got a tailwind from higher steel demand.
Fertilizers volumes were up as growth in long-haul fertilizer shipments more than offset lower short-haul phosphate shipments.
Intermodal shipments benefited from tight truck capacity, inventory replenishments, and growth in rail volumes from east coast ports. In this case, railroads have benefited from a tight trucking market for years as railroads are simply more efficient, better for the environment, and less dependent on labor. Unfortunately (but not unrelated), they are dependent on their tracks, which gives trucks an edge. Nonetheless, the company is having trouble finding good employees according to CEO James Foote.
Last but not least, coal volumes benefited from higher international shipments of both thermal and metallurgical coal. Domestic coal increased due to higher shipments of utility coal and because of higher steel and industrial shipments.
With that in mind, and using the table below, let's take a look at how expenses changed as this drives the operating ratio. In this case, operating expenses fell by 9% despite much higher volumes? In this case, it's due to the gain on property dispositions - all other costs were higher. These benefits were a result of an agreement to sell property rights in three CSX-owned line segments to the Commonwealth of Virginia over three phases for a total of $525 million. Hence, the operating ratio of 43.4% should be ignored. This is not sustainable. Adjusted for the property disposition, we get an operating ratio of 55.7%, which is still a very good number because the company achieved higher operating efficiencies across the board.
Source: CSX 2Q21 Earnings Presentation
And speaking of efficiencies, the company is increasingly incorporating technology in its operations. For example, autonomous track inspection is up by 27%. This is also used by other railroads who use scanners to identify maintenance needs. CSX also uses drones and increases the number of distributed power ("DP") trains. DP means putting locomotives in the middle of the train to increase the total train length, and to distribute power more evenly. I've also been told that this reduces the stress on equipment (cars), which makes sense from a physics point of view.
With that said, CSX reported a significant boost in free cash flow. Year-to-date, free cash flow grew to $1.87 billion. That's up from $1.39 billion in the same period in 2020. As CSX already has a healthy balance sheet with net debt close to 2x EBITDA, it spent most of its free cash flow on dividends and buybacks. In 2Q21, CSX returned $913 million to its shareholders. $212 million through dividends and $701 million as buybacks. Year-to-date CSX has returned close to $1.7 billion, which is roughly all of its free cash flow.
The company is maintaining its full-year revenue outlook, which forecasts double-digit full-year revenue growth excluding Quality Carriers. This deal closed on July 1st. Quality Carriers' sales will be reported under 'others' and add approximately 6% to this year's sales. This acquisition will provide CSX with the opportunity to deliver both rail and trucking services as Quality Carriers operates more than 2,500 trucks and 6,400 trailers that serve mainly chemical producers and processors. This won't turn CSX into a trucking company, but it increases the company's capabilities to connect trucking and rail services.
Operating income and EPS are not expected to be impacted due to the impact of transaction and integration-related expenses. Capital expenditures are expected to be in the $1.7-$1.8 billion range.
As a result, we're looking at roughly $3.4 billion in 2021/2022 free cash flow. To give you an idea of how much that is, the company needs roughly $840 million to service its annual dividend of $0.37 per share (1.15%). That's just a quarter of expected free cash flow and leaves a lot of room to buy back shares and to further increase its dividend. Hence, analysts do not expect that net debt will be lowered as railroads (not just CSX) are very eager to use every penny they generate in FCF to reward investors. I'm fine with that as these companies will report sufficient free cash flow in bad economic times to service debts and dividends. So, there's no need to get net debt down. On top of that, CSX is expected to maintain a net leverage ratio close to 2.0x EBITDA, which is sufficient.
Source: TIKR.com (Includes 2021/2022 expectations)
With that said, the valuation looks good. Using a $72.9 billion market cap and $14.2 billion in expected net debt, we get an enterprise value of $87.1 billion. That's 12.4x next year's expected EBITDA. Using the historic valuation range, we're dealing with a valuation that has come down significantly from recent highs and is now close to the upper bound of the post-2017 range. Moreover, using an expected FCF value of $3.4 billion we get a free cash flow yield of 4.7%. That's close to the upper bound of the 10-year valuation range (the higher the better). While I have used FCF yield a lot, I will increasingly focus on this when it comes to valuation as it makes more sense when dealing with dividend growth. EBITDA is one thing, but monitoring the FCF yield really allows investors to avoid paying an unnecessary premium in certain cases.
You probably guessed it already, but I obviously remain a long-term CSX bull. The company's second-quarter results were good. Shipments rebounded significantly, pricing was better, and higher operating efficiencies allowed the company to once again lower its operating ratio. Thanks to its focus on shareholders, the company spent almost all of its free cash flow on dividends and buybacks and is set to continue high dividend growth in the future thanks to its ability to generate strong and rising free cash flow.
The stock is attractively valued as investors are not overpaying for the company's potential free cash flow. If you're a dividend investor, keep buying CSX on weakness. Right now, I own three railroads: Union Pacific (UNP), Norfolk Southern (NSC), and Canadian Pacific (CP). I will add CSX on larger drawdowns. Right now, the stock is roughly 6.5% below its all-time high. This could fall further as we're dealing with unfavorable macro conditions at this point. However, if anything, I think that's a blessing as we can potentially buy more at a higher yield/even better valuation.
You can also ignore any potential macro headwinds and buy if you have a long-term horizon. The valuation is good and missing upside in case the stock does not drop any further could be a costly mistake. But then again, that's something investors need to decide for themselves as it's dependent on one's willingness to take risks.
(Dis)agree? Let me know in the comments!
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