In this article, we need to talk about a few important things. As usual, we will combine macro trends with a stock that I believe makes sense to own. In this case, we're dealing with high inflation, which could cause real dividend growth to remain subdued on a longer-term basis. This calls for companies that can deliver consistent and above-inflation dividend growth. Moreover, as economic challenges are causing turmoil in the stock market, I believe it makes sense to look at companies with high share buyback programs as well as companies that can accelerate share repurchases at better prices due to consistent free cash flow.
CSX Corp. (NASDAQ:CSX) incorporates all of these things. In this article, I will give you the details and explain why I'm very close to adding CSX despite being massively overweight industrials already.
So, bear with me!
Earlier this month, I wrote an article titled, "We Desperately Need High Dividend Growth - Deere Provides It." As most of my readers know, I like to buy a mix of lower-yielding stocks with fast dividend growth and higher-yielding stocks with somewhat subdued dividend growth to get an all-weather portfolio capable of delivering dividends and outperformance. I'm not someone who needs high yield stocks with a big moat to sleep well at night, but investments that give me a shot at outperformance. Missing long-term growth for the sake of a few basis points of additional income is what I consider to be a huge trap.
With that said, the dividend investment sky is becoming a bit cloudy as slower (expected) economic growth and above-average inflation are set to create an environment where dividends aren't able to keep up with inflation. Meaning lower real dividends.
This week, CME Group Inc. (CME) published an interesting article showing the expected trajectory of nominal and inflation-adjusted (real) dividends. This is based on the company's S&P 500 dividend futures and inflation-protected bonds. In other words, market expectations instead of the opinion of the author.
According to the article:
[...] there are many reasons to be skeptical of the idea that dividend payments will continue to grow rapidly in the 2020s, including the fact that corporate profits are near a record as a percentage of GDP, which might not bode well as input costs soar and as economic activity potentially slows amid tighter fiscal and monetary policy.
These numbers are obviously subject to change as economic developments change. However, in general, I agree with the notion that real dividend growth trends are a reason to adapt. Economic growth is indeed likely to be slower due to ongoing supply chain problems, the absence of QE, and slower growth in key markets like China. Meanwhile, inflation is more than likely to remain at above-average levels due to the impact of "greenflation," supply chain reconfiguration (away from low-cost producer China), ongoing issues related to the pandemic, labor shortages, and more.
In other words, I believe that it is important to prioritize dividend growth. However, please be aware that this does not apply to people dependent on income from stocks (retirees).
Now, onto buybacks.
The "are buybacks good or not?" debate is a fascinating debate as it shows the different views of investors. Personally, I'm in favor of buybacks if a few conditions are met. First of all, buybacks are one of two ways for a company to distribute cash. Buybacks are an indirect way to give back to shareholders. Dividends are a direct way to give back. Dividends mean cash in your pocket. You can decide what to do with it. Buybacks end up reducing the number of shares outstanding. This increases the value per share (i.e., earnings per share). It tends to boost the share price. It's also way more tax-friendly as dividends are outgoing cash flows taxed on multiple levels.
I like the combination of dividends and buybacks for companies that do not need to heavily invest in future growth. Also, be aware that companies sometimes use buybacks to offset a higher share count as a result of high executive compensation. That often ends up in free cash flow being used to pay bonuses instead of supporting a company's bottom line.
That said, and with regard to the current market, companies who can maintain high free cash flow can buy back a lot more shares thanks to lower share prices (the same amount of free cash flow buys back more shares).
According to the Wall Street Journal article that goes with the screenshot above:
Buybacks by S&P 500 companies in the first quarter generated a yield of 2.54%, up from 1.48% a year earlier and down from 3.37% in the first quarter of 2020, when share prices fell during the early days of the pandemic. These yields are calculated by comparing companies’ market capitalizations and the volume of buybacks they executed.
The article gives a few examples of companies that buy back shares and mentions that some companies shouldn't be doing buybacks. In other words, these companies should invest in their business or reduce debt. If companies use debt to buy back shares, shareholders do not win as higher debt increases the enterprise value. The same goes for companies who neglect business investments. That creates short-term value but also a breeding ground for long-term problems.
That's where CSX comes in.
I've covered CSX Corp. a lot for a number of reasons. I'm fascinated by the business. I own its largest competitors, and I care a lot about its quarterly earnings, which also tell us how the economy is doing.
The only reason why I don't own CSX is that I own its competitors and because I have close to 50% industrial exposure. However, I could see myself starting a small position with the dividends I have on a smaller brokerage account.
In this article, I want to focus on dividend growth, buybacks, and outperformance based on the macro themes we just discussed.
CSX Corp. is America's second-largest stock listed railroad. It's the fourth-largest railroad when incorporating Canada's US-listed railroads. The railroad operates in all major economic areas in the east. While Norfolk Southern (NSC) has rights in Florida, it's the only major railroad serving the Sunshine State.
What I like about major Class I railroads is their ability to generate a ton of cash and outperformance based on a rather simple business model: it transports goods using rail. Over the past 10-15 years, these railroads have become very efficient due to technological advances and a shift away from coal that free cash flow has accelerated.
With that said, CSX is not a fast-growing dividend growth stock like Apple (AAPL) or any major tech stock. However, it's consistently growing. These are the growth rates (on a CAGR basis) for EBITDA and free cash flow ("FCF") during the 2012-2024E period:
In general, it's fair to say the company is maintaining satisfying growth rates in all areas, instead of just the two I just showed you.
With that said, next year, CSX is expected to do $3.9 billion in free cash flow. FCF is operating cash from minus capital expenditures. It's cash a company can distribute without the need for external funding or existing cash on its balance sheet.
$3.9 billion is 5.8% of the company's $67.7 billion market cap. This implied free cash flow yield is one of the highest of the past 10 years. So, not only does this mean investors are not overpaying to get access to FCF, but it also means that the company can technically buy back 5.8% of its shares per year or distribute a 5.8% yield using only its (expected) free cash flow.
In the case of CSX, the company buys back shares and distributes a dividend. The current quarterly dividend is $0.10, which translates to $0.40 per year and a 1.28% yield using the current $31.15 stock price. The company's dividend has been raised gradually as my chart below shows with growth rates in the 7-11% range since 2017.
These growth rates are OK. They beat inflation and will more than likely continue to do so. The yield of 1.28% is slightly below the S&P 500 average and not something that gets people excited. When it comes to the dividend, it's more of a dividend growth stock than a high-yield stock.
Based on this yield, one can assume that there's a lot of excess cash after paying a dividend. And that's right. Total distributions often equal, or even exceed, available free cash flow as the graph below shows.
After the surge in productivity in 2017, the company stepped up its game and boosted total distributions.
CSX mainly used buybacks in order to distribute cash. It's easier and tax-friendly, as I already briefly mentioned in this article. While 2020 buybacks were subdued due to market uncertainty, 2021 distributions were back and very close to $4.0 billion.
What's important is that buybacks lead to a lower number of shares outstanding - it's not offset by executive pay and related. Between 2006 (when buybacks started) and the end of 1Q22, the company bought back 47% of its shares outstanding. Over the past 5 years, it bought back 17.6% of its shares. This beats companies like Home Depot (HD), which bought back 11.0%, and its competitor Norfolk Southern, which bought back 14.3% - to give you two examples of two companies known for their buybacks.
With that said, the company's distribution policy did not lead to unsustainable debt. This year, the company is expected to lower net debt to $13.5 billion, which would imply a sideways trend since 2018 (when buybacks became more aggressive). It implies a 1.8x net leverage ratio, which is more than fine.
Note that the graph below implies that net debt will fall to $6.4 billion in 2024. However, I wouldn't bet on it as it seems that analysts are not incorporating high buybacks in their model. I believe that debt will remain above $10.0 billion for the foreseeable future.
So, what about the valuation?
CSX is down 17% from its all-time high. I added that performance to the year-on-year chart below. In other words, the stock is not down 17% year-on-year, but that's where that number will be headed if the stock price remains unchanged for the remainder of this year.
What we see is that a lot of economic weakness has been priced in. The S&P 500 came close to a bear market and tech stocks did much worse.
Using the $67.7 billion market cap, $13.0 billion in expected net debt (to price in some debt reduction), and $300 million in pension-related liabilities gets us an enterprise value of $81.0 billion. That's roughly $10.7x next year's expected EBITDA.
That's one of the best valuations in years using the EV/(NTM)EBITDA history. NTM stands for the "next twelve months."
In addition to that, the implied free cash flow is at elevated levels as I showed in this article, which means investors are not overpaying to get access to free cash flow. I believe that's very important.
CSX Corp. is a fantastic dividend growth stock for a wide range of investors who are not dependent on high income from their investments at this stage of their investing journey. Especially in these times when real dividend growth is expected to be weak, or even negative, it's important to buy quality dividend growth. While the CSX dividend yield is somewhat low, it has consistent and inflation-outperforming dividend growth. Moreover, it uses high free cash flow to aggressively buy back shares, which it can now do at a much better valuation.
While it's hard to tell if the stock market has bottomed, I believe that CSX offers great value for long-term investors. New investors who are interested should consider breaking up their initial investment. I.e., buy 25% now and add gradually over time. This allows investors to average down if the market continues to fall while it gives them a foot in the door if the stock market takes off again.
Either way, it's hard to go wrong with a stock like CSX.
(Dis)agree? Let me know in the comments!
This article was written by
Disclosure: I/we have a beneficial long position in the shares of CME, NSC, HD either through stock ownership, options, or other derivatives. 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: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.