CSX - Buy Into Weakness
- CSX is currently in a correction due to market fears related to supply chain issues and inflation.
- However, while supply chain issues will persist, CSX is well-positioned to generate strong free cash flow used to reward its investors.
- Additionally, the valuation has come down, providing a good buying opportunity for long-term dividend growth investors.
It's time to talk about one of my favorite stocks on the market: CSX Corp. (NASDAQ:CSX). This Florida-based railroad has been on my radar for years and I have written a large number of articles on this Class I railroad. In this article, I will update my bull thesis and explain why I'm a big fan of the company's stock price weakness. While the stock is down for a number of reasons including, but not limited to, supply chain issues, high inflation, and peaking economic expectations, I like the valuation and I do expect a very strong dividend hike going into 2022. While its yield is still somewhat low, I think CSX is a great pick for dividend growth investors who don't want to wait too long until their investments generate some cash. So, let's dive into it!
Supply Chain Issues & Inflation Pressure Stocks
So, what's going on? The market is weakening, taking everything with it except for energy.
As the graph below shows, over the past 4 weeks, the S&P 500 fell by 5.4%. Energy stocks, as displayed by the Energy ETF (XLE) rose 12.6% while growth-oriented assets fell by 7.6% - in this case, represented by the overweight tech ETF (QQQ). CSX slightly outperformed and has been unchanged since late September, ignoring recent stock market weakness.
While we don't necessarily need a good reason for every stock market dip (it's not even a correction yet), we're dealing with a number of forces that are currently a headwind for CSX, but (I think they will) might turn into a long-term tailwind.
What we see below is one of Barron's most recent covers, highlighting one of the cornerstones of the current supply chain crisis. Ships, and therefore precious cargo, are stuck at sea as ports cannot handle high volumes for a number of reasons. One of the reasons is labor. As discussed in a recent Wall Street Journal article, companies like Nike (NKE) and Costco (COST) are struggling to meet demand due to low inventories while ships are waiting to be unloaded. The problem is that ports cannot deal with these volumes because they do not have enough labor. This is also caused by a labor shortage in trucking, which makes unloading even more difficult.
The graph below displays the situation at the port of Los Angeles. CSX does not service this port directly, but it is a good visualization of ongoing problems that seem to get worse.
On top of that, we're dealing with an ongoing problem in automotive (and related) due to the chip shortage. This is rapidly reducing car inventories as production rates drop.
This is one of the reasons why inflation is rising, which is putting tremendous pressure on consumers and their willingness to spend money.
Source: University of Michigan
So, here's what that means for CSX.
CSX Offers Value And Growth
When taking a look at CSX's most recent shipments (week 39), we see that total shipments have dropped to 120.5 thousand carloads and intermodal units. This is down 1.5% compared to the prior year week and lowers the year-to-date growth rate to 9.5%, which is still an impressive number. My point is not to make the case that shipments are in trouble - they are not - but that we're seeing significant changes due to supply chain issues.
In this case, the company is doing surprisingly well when it comes to intermodal, growing container shipments by 3.3% last week, pushing the year-to-date performance to 6.1%. Union Pacific (UNP), which services all major West Coast ports saw an 8% decline in intermodal. Nonetheless, the company was unable to escape auto weakness as shipments fell by 26%, reducing the year-to-date performance to -1.3%. Interestingly enough, ongoing supply chain issues do support coal shipments, which are up 16.9% - outperforming growth in total carloads.
In its second quarter, the company benefited from an easy comparison as 2Q20 was a total mess as even factories were shut down. Hence, in 2Q21, automotive transportation volumes were up 132% with 42% growth in intermodal.
These effects are now fading, which was expected.
This is pretty much where the bad news ends.
So far, the company is still expected to generate $3.4 billion in free cash flow this year. Next year, that number could rise to $3.5 billion. These numbers are fairly unchanged compared to when I wrote my most recent CSX article. What these numbers mean is that the company has (very likely) $3.4 billion left after subtracting capital expenditures from operating cash flow (earnings adjusted for non-cash items). To give you an idea of how much that is, we can compare it to the company's $67.4 billion market cap. Right now, this implies a 5.0% FCF yield. The company's dividend yield is just 1.2%. This gives you an idea of the company's dividend growth potential. Even if FCF remains unchanged on a long-term basis - which won't happen.
Source: TIKR.com (Includes 2021/2022 expectations)
In light of that, it's important to mention that the company is expected to end this year with $13.7 billion in net financial debt. That would imply a 2.3x net leverage ratio.
This means that the company will not prioritize its balance sheet but spend all of its FCF on its shareholders. In 1Q21 and 2Q21, the company generated $1.9 billion in FCF. $1.7 billion of this went to its shareholders. Most of it using buybacks.
The number of diluted shares outstanding has been reduced by more than 3.5% in most years while dividend growth was always in a double-digit territory as soon as economic growth picked up.
In February of this year, the company raised dividends by 7.7%. I expect this to accelerate and reach at least 10% in the first weeks of 2022.
This also resulted in strong outperforming growth as the table below shows. Over the past 10 years, the stock has returned more than 470% including dividends. That's well above the iShares Transportation ETF (IYT) performance of 265% and more than 100 points above the S&P 500 total return. I expect outperformance to continue, especially because the company will benefit from a long-term need to refill retail inventories (including cars).
So, now let's talk valuation.
One of the reasons why I'm writing this article is the company's increasingly attractive valuation. Using the aforementioned $67.4 billion market cap and $13.7 billion in net financial debt, we get an enterprise value of $81.1 billion. This is 12.3x this year's expected EBITDA and 11.6x next year's expected EBITDA.
This valuation has come down a lot and is making CSX attractive. Especially because the company's yield is now off its lows and back in its 4-year range. That range is low, but it makes sense as investors are looking for quality yield. It also helps that railroads, in general, are able to use pricing power. This protects investors in times of high inflation.
CSX is down, and that's great. Unless I'm dealing with trades, I'm always happy when great long-term dividend growth stocks offer discount opportunities. However, screaming buy when stocks are down only makes sense when it's backed by quality. In this case, we're dealing with a stock that offers value through a dividend yield close to the S&P 500 yield and a business model that allows for inflation protection and long-term growth along with the U.S. economy. Moreover, CSX is doing a great job raising free cash flow used to boost dividends and buybacks.
The best strategy is to start buying CSX on weakness - like we're seeing now - and add on a long-term basis whenever the stock drops more than 10%. I recently added to UNP and will start buying CSX during the next wave of weakness - I don't own CSX yet.
(Dis)agree? Let me know in the comments!
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