CSX (NASDAQ:CSX) stock has been on a tear over the past few years. Shares in the railroad stock are up approximately 27% year-to-date. With strong operating margins, favorable economic conditions and a history of disciplined capital allocation, CSX stock has been a solid name to own for the past decade.
But with shares treading between $75 and $80 per share since April, will investors see a continued increase in the CSX stock price? While there are few red flags at the moment, a cooling U.S. economy may mean an end to continued earnings growth.
Read on to see why CSX Corp may be sell for now:
CSX Continues to Squeeze Out Earnings Growth
For Q1 2019, revenues rose 5% from Q1 2018. With the company able to keep costs constant, operating income rose 17%. Revenue increases from transporting agricultural/food products, forest products, chemicals and coal offset declining intermodal transport revenues.
Thanks to price increases, the company was able to generate revenue growth from flat volume. This indicates that while CSX (like the other Class I railroads) have been able to increase revenue per unit, it could be a sign that the company has reached the limit in terms of revenue growth.
But the company has a strong track record of maintaining low operating costs. Among the Class I railroads, CSX has the lowest operating ratio (operating expenses as a percentage of revenue).
With additional layoffs expected in 2019, CSX may be able to bring down costs further. This means even with projections of low single-digit revenue growth, the company could continue to produce satisfactory earnings growth.
CSX Stock Price Vulnerable to Coal Demand
Based on a May 2019 investor presentation, coal makes up 19% of the company’s revenues. Coal revenues for Q1 2019 were up 7% year-over-year.
Continued reduction in coal demand could materially impact the CSX stock price. With the EIA’s short-term energy outlook showing continued consumption declines (567 million short tons in 2020, down from 687 million in 2018), this trend does not show any signs of reversing.
The counter to this is heavy demand from the domestic steel industry. International demand for American coal exports also helps to support the railroad’s coal business. But any negative impact to these customer bases (downturn in economy hurting steel demand, reduced global use of coal) would affect the company’s revenue.
CSX Trades at Similar Valuation Levels to Peers
CSX stock currently trades at a trailing price-to-earnings ratio of 19.25, and a forward P/E of 16.46. There is little variance between its valuation, and the valuation of its peers:
- Canadian National Railway (NYSE:CNI): 16.13 trailing P/E, 18.04 forward P/E
- Kansas City Southern (NYSE:KSU): 21.63 trailing P/E, 16.34 forward P/E
- Norfolk Southern (NYSE:NSC): 20.04 trailing P/E, 16.52 forward P/E
- Union Pacific (NYSE:UNP): 21.01 trailing P/E, 16.79 forward P/E
High operating margins and a strong economy have allowed these old-line companies to achieve fairly high valuations. But with a 10-year long bull market due for a correction, is it smart to get into CSX stock today? Despite a maxed out valuation, thanks to smart capital allocation, the company could continue to drive returns to shareholders.
Disciplined Capital Allocation a Strong Catalyst for CSX Stock Price
While CSX’s valuation appears stretched, its disciplined capital allocation continues to be a strong catalyst. Based on statements from the investor presentation mentioned earlier, the company practices asset efficiency when it comes to capital expenditures.
The company’s focus is on identifying capital investments that generate sufficient returns, as well as right-sizing their locomotive and car fleet. This has paid off, as CSX is able to move almost all of their net income down to the free cash flow line.
In 2018, the company reported a 97% conversion of net income to FCF. Management believes they can move this further, with a projected 2019 FCF conversion ratio of 99%.
This means more money for buybacks. The company bought back $5.4 billion worth of shares in 2018, and has approved a buyback program for $5 billion more in 2019.
While the dividend yield is not high (1.22%), CSX has increased its dividend about 10% per year for the past decade. A low yield may reduce interest from income investors, but the share buyback strategy is a smart way to deliver value to shareholders.
Share buybacks are a more tax efficient means to return capital. They also boost the company’s earnings-per-share, a benefit for the CSX stock price.
Bottom Line: Do Not Expect CSX Stock to Outperform
CSX has seen a tremendous run in the past ten years. Shares have risen from ~$11/share in July 2009 to nearly $80 per share today. But with the U.S. economy cooling down, CSX’s valuation continuing to be higher-than-normal, and conservative growth prospects, it is unlikely investors will see similar returns going forward.
But for a long-term investor, the stock may be a buy. The company’s strong FCF conversion ratio enable it to continue an aggressive buyback strategy. Coupled with continued dividend growth, and the stock may provide sufficient returns. But as a short-term investment? Look elsewhere.
As of this writing, Thomas Niel did not hold a position in any of the aforementioned securities.
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