CSX - CSX Stock: Earnings Risks And The Road To Elevated Long-Term Gains

2024-01-19 07:30:00 ET

Summary

• CSX Corporation navigates economic uncertainties with a focus on intermodal growth, strategic industrial development, and adapting to market shifts.
• As CSX approaches earnings, the company faces short-term risks but showcases resilience, positioning itself as a potential buying opportunity on a correction.
• CSX's proactive approach to truck-to-rail conversion, intermodal growth, and pricing challenges underscores its long-term commitment and resilience in a cyclical market.

Introduction

It's time to talk about one of my favorite topics: Class I railroads.

In this case, we'll discuss CSX Corporation ( CSX ) , which is one of my favorite dividend growth stocks on the market - across all industries.

As I often mention in my articles, the only reason why I do not own CSX stock is the fact that I already own three other Class I railroads.

• I own Norfolk Southern ( NSC ), which has a duopoly with CSX in the eastern part of the United States. Unlike CSX, Norfolk has a strong focus on intermodal (consumer goods).
• I also own Union Pacific ( UNP ), America's largest independent railroad, which covers the western part of the United States.
• CSX is known for high-margin merchandise and bulk goods. I have exposure to these products through Union Pacific and Canadian Pacific Kansas City ( CP ), which connects all three North American Nations.

In other words, I have all bases covered.

That said, I have also often said that I believe that CSX is one of the best railroads. Given challenges in consumer markets and derailment issues, CSX seems to be the better pick than my investment in NSC.

Over the past three years, NSC shares have lost 5.1%, including dividends. The S&P 500 (SP500) has returned 14.7%. CSX investors enjoyed a total return exceeding 30%!

Shares are up 8% since my November 29 article , when I focused on the company's qualities as a dividend growth compounder.

Not only has CSX management figured out how to quickly rebuild service levels after the pandemic had done a number on customer satisfaction, but it also benefits from bulk and merchandise benefits that allow it to offset weakness in other areas.

With all of this in mind, on January 24, CSX is scheduled to report its earnings after the market closes.

In this article, I will examine the latest developments and evaluate the company's risk/reward as fascinating changes unfold.

So, let's get right to it!

We Need To Talk About The Risk/Reward

Everything is always about the risk/reward, which is why it is so important to understand why certain things have happened going into earnings and what it means going forward.

Hence, the most important thing I wanted to discuss in this article is the development of macroeconomic expectations.

As most of my readers might recall, I often use leading indicators like the ISM Manufacturing Index. This index tends to follow regional surveys that are released ahead of the ISM Index.

When it comes to regional surveys, I prefer the Empire State (New York) and Philadelphia Fed surveys. When combined (I'm using the average), they often paint a clear picture of the cyclical economy.

As we can see in the chart below, regional surveys tell us that the recovery of the past few months was not sustainable!

We can see that this is also increasingly reflected in earnings revisions.

The chart below shows the Citigroup Earnings Revisions Index. What we see is that since September, analysts have started to issue more downgrades than upgrades.

To put it differently, the bar has been lowered quite a bit.

Investors are closely monitoring the early stages of the earnings season to assess how companies have dealt with high interest rates and to gauge the health of US consumers. About 8% of S&P 500 companies have reported so far, with the majority of these firms surprising positively, according to data compiled by Bloomberg Intelligence. - Bloomberg .

While I'm not going to scare anyone and make the case for a full-blown recession, let me show you why this bothers me a bit.

Railroads are cyclical. When adding their size (CSX covers the entire east of the U.S.), we're dealing with companies whose valuation reflects investors' economic expectations.

That's why I built the chart below.

The chart above compares the aforementioned Philly Fed/Empire State manufacturing average to the distance (in %) CSX shares are trading below their all-time high.

As we can see, the lower the economic growth expectations, the lower the CSX stock price.

• Currently, CSX trades just 6% below its all-time high.
• Mathematically speaking, CSX should trade roughly 23% below its all-time high (purely based on the relationship between the two lines in the chart above).

In other words, this shows that pressure on CSX is mounting as it heads into its earnings.

However, does this mean CSX is toast? Is this an easy short?

Absolutely not.

Why CSX Is Doing So Well

When I was a more active trader, I frequently shorted stocks.

However, since I decided to focus on dividends (growth), I stopped shorting stocks.

I cannot even remember the last time I went short.

Besides my strategy of buying great companies and holding them long term, I avoid shorting due to the high risks involved.

Although economic growth has been poor for a while (in cyclical industries), CSX has been doing well.

For example, while Q3 2023 saw 19% lower earnings on 8% lower revenues, it could have been much worse if it weren't for tailwinds like 9% growth in coal volumes and flat merchandise volumes.

Although I will not make the case that CSX should continue to diverge from leading economic indicators, the company is still benefiting from a number of tailwinds.

For example, during the Q4 2023 Stephens Investment Conference , the company noted that one of the key growth opportunities for CSX lies in the ongoing trend of truck-to-rail conversions.

The company sees the significance of providing superior service to customers, which can catalyze a shift from truck transportation to more cost-effective and environmentally friendly rail options.

Supported by its efforts to improve service quality, CSX is poised to capture a considerable market share in this segment, potentially (read: very likely) contributing to increased revenues and operational efficiency.

Furthermore, industrial development projects emerge as another noteworthy growth driver for CSX. The company is actively engaging with the opportunities presented by the establishment of new manufacturing plants and facilities across its service territory.

This proactive approach aligns with the broader trend of economic expansion, enabling CSX to tap into increased demand for freight transportation services.

To summarize this, CSX is one of the main beneficiaries of economic re-shoring.

As we can see below, manufacturing construction spending is now at $210 billion on an annualized basis, which is unlike anything we have ever seen in the United States.

These numbers include the construction of new factories that will need rail transportation, benefitting CSX and its peers.

Going back to the Stephens conference, the intermodal growth strategy was a key point of discussion.

Although intermodal accounts for just 14% of its revenue, the company emphasized its willingness to try new approaches and strategies, citing the need to incorporate various initiatives to foster mid- to long-term growth.

While pursuing larger chunks of business, CSX also recognized the importance of experimenting with different strategies to explore opportunities and remain competitive.

I believe that the aforementioned truck-to-rail conversion can turn CSX into a bigger intermodal player, although the focus will remain on merchandise and bulk.

That said, the company also highlighted the importance of achieving pricing at or above inflation for long-term success.

Despite acknowledging the challenges in pricing conversations, the company expressed confidence in sustaining a winning equation that involves pricing at or above inflation.

Yes. I mean I think the acceleration in price is all relative to where inflation is, right, so at 5%, 6%, 7% inflation, if we're getting pricing at or above that, the absolute percentage of pricing that we're getting might be higher. But if you look at that gap relative to inflation, we should be able to manage that very nicely next year. - CSX at the Stephens Investment Conference.

So, what does this mean going forward?

CSX Stock Valuation & Q4 2023 Earnings

As I briefly mentioned, CSX reports its earnings on January 24 after the market closes.

Analysts are looking for $0.44 in EPS , which is based on eight estimates. Over the past four weeks, the company has received two upgrades and three downgrades.

In Q4 2022, the company reported $0.49 in EPS, which means analysts expect an 11% decline.

Over the past two years, the company has either hit or beaten estimates 83% of the time.

Personally, I have no clue if the company will beat earnings or not. It's more often than not a wild guess.

Sure, history suggests the company will beat earnings expectations. However, it doesn't really matter if EPS comes in a few pennies below or above estimates.

What matters is the outlook. Will the company mention positive pricing power during the earnings call? Will it issue good volume guidance, or will it have to acknowledge a weakening economy?

I look very much forward to the earnings call and believe that CSX could move sideways for a while, with elevated downside risks until economic growth improves.

Hence, if I were looking to buy CSX stock, I would wait for a correction.

This is also reflected in its valuation.

Using the data in the chart below:

• CSX is trading at a blended P/E ratio of 18.7x.
• Its long-term normalized valuation is 17.2x.
• This year (2024), EPS is expected to grow by 9%, followed by 11% growth in 2025 and 6% in 2026.
• Based on these numbers, the stock has an implied annual return potential of 7.1% through 2026. Since 2003, it has returned 16.3% per year!

With all of this in mind, I believe the company could see some earnings downgrades until economic growth bottoms.

Fourth quarter 2023 earnings will shed some light on the company's own assessment.

Nonetheless, I remain very bullish on CSX's long-term future. However, I need to make the case that a correction is very likely unless economic growth bottoms in the next three months.

If CSX drops, I consider it to be a fantastic buying opportunity.

Given my long-term view, I decided to keep a Buy rating. However, it comes with an asterisk, as I recommend buying on a potential correction.

Takeaway

As we approach CSX's earnings report, I believe caution is warranted.

While CSX faces mounting pressure with economic uncertainties and a cyclical industry, the company shows resilience and strategic foresight.

The truck-to-rail conversion and focus on intermodal growth position CSX as a key player in a changing landscape.

Meanwhile, the proactive approach towards industrial development aligns with economic expansion trends.

Additionally, despite challenges in pricing conversations, CSX remains confident in sustaining success, which is reflected in analyst estimates.

I maintain a Buy rating for CSX Corporation stock, but believe we could get correction opportunities in the months ahead, potentially triggered by its earnings.

For further details see: