March 7th 2012
CSX:                                      $20.25
Market Cap:                       $21.4 Billion
Dividend Yield:                  2.37%
P/B:                                       2.5
2011 Net Income:            $1.822 Billion
2011 Free Cash Flow:      $1,396 Billion
Company Overview:  CSX is one of the largest North American railroad companies controlling 21,000 miles of track, predominantly on the eastern United States.  CSX hauls shipments of coal products (32% of consolidated revenue), chemicals (14%), intermodal traffic (12%), and a diverse mix of other merchandise.  CSX serves major population centers in 23 states east of the Mississippi River, the District of Columbia and the Canadian provinces of Ontario and Quebec.  It has access to over 70 ocean, river and lake port terminals along the Atlantic and Gulf Coasts, the Mississippi River, the Great Lakes and the St. Lawrence Seaway.  CSX operates more than 4,000 locomotives, of which over 95% are owned by the company.  CSX like other railroad operators has seen substantial growth in earnings and free cash flow over the last five years through more efficient operations.
Investment Thesis:  CSX has gone from being one of the chronic underachievers in the railroad space, to a top competitor.  Nowhere is this more evident than in the improvement that they have shown in their operating ratio, which has fallen from 90% in 2003, to a much more comfortable 71%.  Management under the leadership of Michael Ward, is laser focused on continuously improving the business, and their goal is to reduce the operating ratio to 65% which would imply a 35% EBIT margin.
Railroads are by far and away the most efficient and cost effective method for long haul shipments, as they can move an enormous amount of goods while burning substantially less fuel than large haul trucks.  It is estimated that trucks carry 70 percent of all freight in the United States, but according to the EPA their greenhouse emissions are five times higher than freight transportation. The Association of American Railroads estimates that on average, a freight train can move 1 ton of freight about 484 miles on just one gallon of fuel.  Improvements in technology continue to widen this gap in freight’s favor. According to Matt Rose, CEO of Burlington Northern Santa Fe, long-haul trains are three times more fuel efficient than trucks, so with oil prices hovering over $100 there is little doubt that trains will continue to gobble up share in the shipping industry.
CSX has improved their return on invested capital from 1.82% in 2003 to 10.4% in 2011.  This is immensely important because one of the main negatives of the railroad industry is the capital intensive nature of the business.  CSX like other railroads, will often spend up to 20% of revenue on capital expenditures, and free cash flow just about always lags net income.   At T&T Capital Management we believe that CSX has a wide moat due to their irreplaceable tracks on the east coast.  Therefore we believe that they should be able to continue to earn more than their cost of capital on future investments.
CSX yields 2.37%, and we would expect that dividend to continue to grow over the next 3-5 years along with earnings.  CSX’s heavy reliance on coal and ethanol is a little bit of a concern with the abundance of North American natural gas reshaping the energy industry, but we still expect loads and pricing to continue to improve throughout the decade.   Currently coal accounts for 32% of revenue, which is second to the merchandise business that accounts for 54% of revenue and 41% of volume.  The merchandise business should improve along with the economy as it consists of materials like crushed stone, sand, gravel, fertilizer, food, consumer goods, etc.   We also really like the intermodal business which is in direct competition with the trucking industry, and we believe that both exports and imports will be growing over time to the benefit of CSX. At less than 10 times forward earnings CSX is not absurdly cheap, but we feel that the stock should trade at about 14 times our 2012 $2.00 a share EPS estimate, which would imply a $28.00 price target.  Downside is limited due to the stability of the business, and the dividend yield is quite a bit better than 10 year treasuries.  CSX should grow revenue at a slightly higher rate than GDP for the forseeable future, so when you start with an earnings yield around 10%, earnings growth should be very rewarding even under the assumption that the earnings multiple does not expand.
In 2011, CSX repurchased a total of $1.6 billion in common stock, and has $734 million remaining under their new $2 billion program.  At the current price that the stock is trading at, we believe that share buybacks are extremely beneficial to shareholders.  The company does carry about $8.7 billion in long term debt but they improved their coverage ratios exponentially over the last few years, giving us confidence that their financial condition will remain strong.