2023-07-21 09:42:05 ET
Summary
- CSX Corporation missed Q2 earnings and revenue estimates due to headwinds in volumes and costs, impacting profitability.
- Strength in merchandise and secular trends like supply chain re-shoring provide some support.
- CSX remains committed to efficiency and cost control, and while 2023 is challenging, long-term prospects look positive with rising export demand and secular tailwinds.
Introduction
It has happened. Economic weakness has caught up with the CSX Corporation ( CSX ) . The company missed earnings and revenue estimates in the second quarter , as it is now dealing with headwinds in both volumes and costs, which is doing a number on profitability.
While analysts had expected better numbers, none of this is a big surprise, as leading economic indicators have pointed at weaker growth for a while.
Although this doesn't make the numbers any better, the company continues to see tremendous strength in merchandise and secular headwinds due to supply chain re-shoring and similar trends.
So, instead of running away from railroads, I'm more than ever embracing the mantra to buy on weakness, which is what I have been doing in the three railroads that I own.
So, let's dive into the railroads!
Why 2Q23 Was A Tough Quarter
As most readers know, railroads are one of my favorite industries to invest in. In my 22-stock portfolio, I own three railroads. I own Union Pacific ( UNP ), which gives me diversified West Coast exposure. I own Norfolk Southern ( NSC ), which has significant intermodal exposure on the East Coast, and I own Canadian Pacific Kansas City ( CP ), which connects all North American nations with significant bulk exposure.
While I have often made the case that CSX is one of the best-managed railroad companies, I don't own it because there would be too much overlap. I have East Coast and bulk exposure. Also, CP and CSX are working together in some areas.
So, that's the only reason why I don't own CSX.
On a side note, bear in mind that CSX also operates in New England. These maps haven't been updated since the acquisition of Pan Am Railways.
Wikipedia (CSX Transportation)
Having said all of this, 2Q23 wasn't such a great quarter.
In the second quarter, CSX reported $3.7 billion in revenue, which was $30 million lower than expected. GAAP EPS came in at $0.49, which was a penny below consensus estimates.
While both misses aren't a big deal, the company has missed estimates for the first time in two years.
With that in mind, let's take a step back and analyze this quarter, starting all the way at the top: volumes. After all, not only do the company's numbers and comments tell us a lot about its business, but we also learn a lot about the state of the economy.
Looking at the table below, we see that the company reported a 3% decline in volumes. Revenue growth was also down 3%.
CSX Corp. (Author Annotations)
Essentially, we're seeing a very reasonable development, which is the result of weaker economic expectations. Given the importance (and size!) of the current Class I railroads, there is no way any of these companies can escape economic trends. While secular trends like re-shoring are beneficial, they are the blood vessels of the economy, which means economic weakness translates to lower volumes.
Unfortunately, this is what economic growth expectations currently look like:
Bloomberg
One of the things that caught my eye in the most recent Bloomberg report on the ISM index was inventory levels. Companies aren't ordering much anymore to deal with (potential) demand weakness. This hurts railroads, which benefit from companies ordering more products.
“Demand remains weak, production is slowing due to lack of work, and suppliers have capacity,” Timothy Fiore, chair of the ISM Manufacturing Business Survey Committee, said in a statement.
The ISM gauge of customer stockpiles shrank at the fastest pace since October, while the index of factory inventories dropped to the lowest level since 2014.
Having said that, CSX did have an area of strength, which was not impacted by these developments. As the table above shows, merchandise was very strong, with revenue increasing by 5% in the second quarter. This growth was driven by a 3% increase in volume compared to the previous year and a 1% all-in revenue per unit increase. Improved service levels resulted in more opportunities for CSX as customers increasingly brought their business to the company's network.
Key sectors, such as automotive, minerals, and metals, performed well, with increased volumes and successful expansion of commercial relationships.
However, certain segments, like chemicals and forest products, faced challenges due to soft demand. These segments are more cyclical and benefit less from secular tailwinds.
Coal, which accounts for more than 17% of CSX's revenues - making it the most coal-focused Class I railroad - also did well.
Coal revenue decreased by 2% due to a decline of 6% in revenue per unit, driven by lower export coal benchmarks. However, there was a 4% gain in volume, supported by export growth, beneficial cycle times, and good performance at the Curtis Bay terminal, which is a Baltimore-based port mainly handling Northern Appalachian coal.
Domestic utility shipments were affected by low natural gas prices, resulting in a decline as expected. Please note that I'm bullish on natural gas, as I discuss in this article (among many others). We also see that natural gas prices are breaking out again, which could put a pricing and demand floor under thermal coal demand.
Furthermore, CSX foresees continued momentum in export markets in the second half of the year, driven by new mine capacity and opportunistic shipments into international markets.
However, the domestic business faces tougher comparisons. While international benchmark prices remain healthy, the company expects a sequential mid-teens percentage decline in third-quarter all-in coal revenue per unit.
So far, so good.
Now, let's focus on that one big segment that suffers most from consumer weakness and (consumer-focused) stores reducing inventory: intermodal.
The intermodal business segment's second-quarter revenue declined by 18% due to a 9% reduction in revenue per unit and a 10% decrease in volume.
International intermodal faced headwinds from declining imports and inventory destocking, while the domestic business showed more modest declines.
Nevertheless, CSX remains focused on its initiatives, including rail conversions and exploring new markets and lanes to position itself for truck conversion in the future.
So far, these developments are promising, as the company recently secured new customers who recognized the value of its strong service product and continues to see potential growth opportunities at inland ports.
Collaborations with other Class I partners also offer creative opportunities to attract more business to the railroads. In this case, CSX is working with CP to increase traffic in the Southeast - a measure that benefits both giants in expanding their service network close to Mexico, a country that tremendously benefits from economic re-shoring.
CSX CEO Joe Hinrichs said this deal “provides shippers with a compelling transportation option with access to markets in Texas and Mexico as well as into the heart of the thriving and dynamic U.S. Southeast.”
This new connection between CPKC and CSX will provide a new competitive option with the connection CPKC has with Norfolk Southern at Meridian, Mississippi.
As part of the deal, CPKC will acquire about 50 miles of track between Meridian, Mississippi, and Myrtlewood, Alabama, if regulators approve. CSX will take over the line it currently leases to the Meridian & Bigbee Railroad that runs east to Montgomery, Alabama.
Having said that, while these improvements are great for CSX, they do not have a major impact on current intermodal struggles, which will last until consumer sentiment improves meaningfully.
Operating Efficiencies & Expense Management
So far, we only discussed the top line of the income statement. Now, we need to discuss operating expenses, which are almost equally important - especially because we can combine this discussion with operating developments. After all, American Class I railroads had to deal with a wave of operating inefficiencies and labor issues after the pandemic.
The bad news is that while revenue declined, expenses did not decline. Expenses rose by 5% to $2.2 billion, which caused the operating ratio to increase by 450 basis points to 59.9%. Bear in mind that the operating ratio needs to be as low as possible, as it measures how efficiently a railroad operates.
CSX Corp. (Author Annotations)
The company's total second-quarter expenses increased by $105 million (5%).
While network efficiency improvements resulted in cost savings of over $20 million across labor, PS&O (Purchased Services and Outside Expenses), and rents, it was not enough to offset more than $100 million of headwinds from inflation and higher depreciation. After all, inflation is still with us despite demand weakness.
- Labor and fringe expenses increased by $57 million, driven by inflation and increased headcount.
- PS&O expense increased by $37 million due to inflation and higher repair and maintenance costs, partly offset by savings in intermodal operations and cycling of costs related to the Pan Am acquisition.
- Depreciation rose by $33 million due to last year's equipment study and a larger asset base.
- Fuel costs decreased by $134 million, mainly driven by lower fuel prices.
While operating expenses were somewhat of an issue, operating improvements continued. During the 1Q23 earnings call , the company made clear that it gained momentum with its customers thanks to improved service performance and the success of its ONE CSX efforts. The company's network operated efficiently, and initiatives combined with employees' dedication showed signs of progress.
There was also good news for shareholders.
Shareholder Returns
While CSX does have a track record of consistently rising dividends, it is known for its buybacks.
- CSX has a 1.3% dividend yield. While that isn't a high yield, it is backed by a payout ratio of just 21% and 8.5% average annual dividend growth over the past five years.
Again, dividends are a reason to buy CSX. However, buybacks are where it's at. Over the past ten years, CSX has bought back 33% of its shares, which makes it one of the most aggressive buyback companies on the market.
The bad news is that current economic tailwinds are pressuring buybacks.
In the first two quarters of this year, CSX generated $1.5 billion of free cash flow after funding infrastructure investments and strategic projects.
This is down from $1.7 billion in the prior-year period and the reason why buybacks were lowered from $2.5 billion to $1.9 billion.
While this is a temporary headwind, the company continues to manage its balance sheet very effectively, as it is expected to end this year with a 2.1x net leverage ratio. Furthermore, Moody's ( MCO ) upgraded the company's long-term local currency credit rating from A3 to A2.
Outlook & Valuation
Looking ahead, CSX reiterated its expectation that revenue ton-miles will grow in the low-single digits for the full year. The company remains pleased with the performance of its merchandise business and anticipates volumes to be supported by continued strength in automotive, minerals, and metals.
Domestic coal shipments are expected to soften due to low natural gas prices, but higher demand for export coal is projected to drive full-year coal volumes higher.
Furthermore, there are modest signs of improvement for domestic intermodal activity in the second quarter, but no near-term recovery is expected for the international business.
As a result, the company expects a decline of $300 million in supplemental revenues, mostly occurring in the second half of the year.
Additionally, lower international met coal benchmark prices will impact coal revenue per unit for the remainder of the year.
Needless to say, CSX remains committed to driving efficiency and controlling costs to offset inflationary pressures and improve service to customers, which is key, given the pressure on volumes.
Having said that, CSX dropped 5% after the earnings release. This is not yet visible in the chart below.
FINVIZ
This decline happens after shares have risen 31% from their 52-week lows, pushing the year-to-date performance to 9% (pre-earnings).
As much as I like CSX, I do not disagree with the post-earnings decline. The CSX share price has done very well despite further weakness in economic indicators. That is not sustainable. The same case can be made for the market in general, but that's a bit of a different discussion.
Having said that, 2023 is expected to see a decline in free cash flow. After 2023, free cash flow is expected to pick up again, resulting in an expected 3-year average annual FCF growth rate of 4% (including the 2023 slump).
While 2023 isn't a great year, the company is expected to maintain a 4.9% free cash flow yield, potentially rising to 6.0% in 2025. Note that I expect 2025 free cash flow to far exceed $4.0 billion if we get an economic bottom in 2024.
This also means that the company is trading at roughly 18x 2024E free cash flow. I believe this valuation is fair. The same goes for the NTM EV/EBITDA multiple of less than 11x.
The current consensus price target is $36. That's 9% above the pre-earnings stock price.
I still believe that's a fair target.
However, I do not suggest investors rush in at these prices. I aggressively bought railroads before they took off this year. I would love to see a decline to $26 in CSX before it becomes attractive.
That's where I would be a buyer. However, I'm not, as I already mentioned (I own three other railroads).
On a long-term basis, I expect CSX to outperform the market and its industrial peers.
Yes, 2023 is a tough year, but the long-term outlook remains terrific. Export demand for bulk goods like grains and coal is rising rapidly after Russia's invasion of Ukraine, re-shoring benefits remain strong, and secular tailwinds like truck-to-rail conversions will likely heat up if economic demand improves.
Takeaway
Despite CSX facing economic weakness in the second quarter and missing earnings and revenue estimates, the long-term outlook for the company remains positive.
The decline in volumes and revenue is in line with weaker economic expectations, affecting the overall industry.
However, CSX continues to show strength in its merchandise segment due to successful expansions, commercial relationships, and secular tailwinds.
While certain segments, like intermodal, faced challenges from declining imports and inventory destocking, CSX remains focused on initiatives and collaborations with partners to attract more business.
Although the current economic headwinds have affected buybacks, the company's effective balance sheet management and solid dividend track record offer reasons to consider CSX as a long-term investment option.
Overall, I expect CSX to outperform the market and its industrial peers in the long run, making it a promising prospect for investors, especially if a decline in its stock price presents an attractive buying opportunity.
For further details see:
Despite Weakness, CSX Remains One Of The Best Industrial Plays