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Despite an Improved Operating Ratio, CSX Corp Has Issues

Railroad companies have generally performed well over the past few years as the economy has expanded. This is true for one of my favorite names in the sector: CSX Corp. (NASDAQ:CSX).

I find this sector to be an attractive one to invest in because there is often very little competition from other railroads. There are just six major railroads in North America and they tend to operate in different areas. CSX operates 21,100 miles of track over 23 eastern states.

While CSX underperformed the S&P 500 in 2019 (17% gain compared to a 30% return for the index), the railroad has been the much better investment over the longer-term. CSX has generated returns of 122% over the last five years, besting the S&P 500 by 20%. CSX was also the best-performing railroad over this period of time. This growth has led to a market capitalization of more than $59 billion.

Driving returns for CSX has been an improvement in operating ratio. However, while CSX has certainly become a more efficiently run railroad, there are underlying trends that have recently turned me bearish on railroads in general - and on this name in particular.

Recent Earnings Results

CSX reported fourth quarter and full year 2019 results on Jan. 16, 2020.

Source: CSX 's Fourth Quarter Earnings Presentation, slide 5.

The company generated revenue of $2.9 billion for the quarter, which was 8% lower than the previous year and $33 million below estimates. Earnings per share of $0.99 was in line with estimates, but dropped 2% year-over-year.

For 2019, CSX's revenue was lower by 2.5% to $11.9 billion. EPS, however, was up 8.6% to $4.17.

Nearly every product category that CSX reports out saw declines in revenue during the quarter, and most had lower volume as well.

Source: CSX's Fourth Quarter Earnings Presentation, slide 6.

Foremost among headwinds for CSX was coal. Coal volumes were down 17% for the quarter while revenue decreased 22%. Revenue per unit was down 6% as well. Making matters worse is that this decrease in volumes and revenues has accelerated over the last two quarters of 2019 and doesn't appear to be abating in the near term. Lower export prices combined with a decrease in domestic volumes hit this product category hard. Coal is the second largest contributor to revenue for the company, so these decreases were quite meaningful to CSX's results. Coal has generally been a weak portion of business for other railroads as well.

Results were similar elsewhere as well. Intermodal had a 7% drop in volumes and a 9% decrease in revenue during the quarter. Volumes and revenue for Automotive were both lower by 10%. Automotive is another area that has been weak for numerous railroads over the last year due to lower production in North America. Chemical volumes were down 5% to go along with a 4% decrease in revenue. Revenue per unit for Metals were up 10%, but this only partially offset a 14% decrease in shipment volumes.

Only two products saw growth in either volumes or revenue. Agricultural & Food Products grew 2% on higher volume and revenue. Minerals had a 12% increase in volume that was partially offset by a 5% decline in revenue per unit.

One additional positive was CSX's 10% increase in free cash flow for the year. This was enough to lower the railroad's dividend payout ratio to below 24%., which is below the stock's 10-year average payout ratio of 31%. This leaves CSX plenty of room to continue growing its dividend, which it has done for 15 consecutive years. Income investors, however, may not find the current yield of 1.3% particularly attractive.

On the surface, CSX's annual revenue and EPS results were okay. The railroad had a slight decrease in revenue but high-single-digit growth in EPS. The issue is that this EPS growth was accomplished through the heavy use of share buybacks. CSX spent $3.4 billion on buybacks in 2019. This helped reduce the float significantly.

CSX had an average share count of 798 million last year. The average share count for 2018 was 861 million, meaning that the average share count for 2019 was down 7% from the previous year. Looking beyond just EPS, net income increased just 0.6% in 2019. Adjusting for the share buyback, EPS was flat on a year-over-year basis. Share buybacks successfully hid the fact that CSX was only slightly more profitable in 2019 than it was in 2018.

Buybacks by themselves are not a negative, especially if a company believes its share price to be undervalued. In the case of CSX, the buyback makes it seem that CSX had a high rate of growth despite producing less revenue. This wasn't the case though, which has given me a pause on buying CSX at the moment.

Pricey valuation

Where the railroad did shine was in its ability to become more efficient. Just a reminder, operating ratio is the percentage of revenue used for expenses, so the lower the better. CSX's operating ratio set a fourth quarter record of 60% and was a 30 basis point increase from the previous year. For the year, operating ratio improved 190 basis points to 58.4%. The gains in efficiency were made in several areas.

Source: CSX's Fourth Quarter Earnings Presentation, slide 8.

Train velocity improved 100 bps compared to the third quarter of 2019 and 230 bps compared to the fourth quarter of 2018. Car miles per day increased more than 5% sequentially. Terminal dwell improved 50 bps from the third quarter and 80 bps from the third quarter of 2018. Fourth quarter results for each of these metrics were the best they had been over the past five quarters.

On top of this, CSX had a carload trip plan performance of 82.6% for the fourth quarter. Trip plan performance measures success in meeting end-to-end customer commitments based on specific time of arrival. For context, CSX's trip plan performance for the fourth quarter of 2018 was just 67.3%. Intermodal trip plan performance went from 73.4% to 95.5% over this same period of time. Both results are a reflection of the gains made in improved operating ratio.

Clearly, CSX has made massive inroads in becoming a more efficient railroad. Improving operating metrics means fewer costs as trains spend more time moving and less time stationary.

While the efficiency of CSX is impressive, the valuation of its stock is not. The stock closed the most recent trading session at $76.40, giving the railroad a trailing price-earnings ratio of 18.3. Analysts expect CSX to earn $4.30 per share in 2020. This gives shares of CSX a forward price-earnings ratio of 17.8. The stock has five and 10-year average price-earnings ratios of 17.2 and 15.2, respectively. If shares were to revert to a multiple within this range and achieve the expected EPS for the current year, then shares would trade in a range of $65 to $74.

Final Thoughts

As stated, I am concerned about CSX. The company's revenue was lower for both the quarter and year while net income was barely above results for 2018. Several categories of shipments, such as coal, appear to be headed for more difficult times as well. Share repurchases helped prop up EPS, helping to hide the fact that the company's profits were lacking.

The railroad does have an entrenched business in the heavily populated eastern portion of the U.S. The improvements in efficiency have been excellent, but there is likely only a limited amount of costs remaining that CSX can squeeze out so the operating ratio may not move much lower than it already has.

Given all of this, I am avoiding buying CSX for the time being. I am, however, a long-term investor and do find this sector attractive, so short term issues won't have me ignore CSX completely. But I am waiting for shares to reach at least the 10-year average price-earnings ratio of 15.2 before purchasing. A share price of $65 would represent a decline of 15% from current levels, but would mean that CSX was trading at a much more reasonable level in my opinion.

What are your thoughts on CSX? Is there another railroad or transport stock you prefer? Feel free to leave a comment below.

Disclosure: I am not long CSX

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