Jesse Barone: Lead Analyst jbarone@theowlfund.com Ethan Friedland: Associate Analyst efriedland@theowlfund.com Joseph Heidt: Associate Analyst jheidt@theowlfund.com
COMPANY OVERVIEW
CSX Corporation is a diversified freight transportation company that provides rail-based transportation services throughout the eastern United States. CSX transports chemicals, automotive products, agriculture, forest products, metals, phosphates, fertilizers, minerals, food and consumer products, along with waste and equipment. In addition, the company uses its network of 50 terminals and 21,000 miles of rail to transport coal and provide intermodal transportation services. The companys four business segments, all based in the United States, are Total Merchandise (58.5% of FY 2013 revenue), Coal (24.1%), Intermodal (14.1%), and other services (3.3%).
INVESTMENT THESIS
CSX is currently trading at an 8.04% discount to its competitors. Investors have been devaluing CSX because of the decrease in demand for coal (Coal is 24% of revenue for CSX), and the recent dip in the companys performance metrics due to congestion of railways from substantial volume growth. CSX is seen to have two economic moats, which are barriers to entry and an expansive network of railways and terminals that cannot be replicated, giving it a competitive advantage over its competitors. Through CSXs strategic rail network, it is able to provide service to 66% of the population in the United States, and currently is in charge of 50% of rail volume on the east coast. Looking forward, investors have not accounted for the new capital expenditure projects that CSX have started in 2014, and the recently completed projects in 2014 in order to keep up with the increasing volume it is experiencing. These projects will expand its performance metrics back to normal historical levels. Investors also havent accounted for the new coal demand to be capitalized on by CSX in the Illinois Coal Basin, the United States energy boom, which has created new markets for CSX such as crude oil, liquefied petroleum gases, and frac sands, and increased regulation in the trucking industry allowing CSX to claim market share away from trucking companies. We believe the company will appreciate from its current EV/EBITDA multiple of 8.77x, to the 5 year historical spread average compared to peers of 9.69x, resulting in a price target of $36.61, and a total return of 19.34% including a dividend yield of 2.05%.
All prices current at end of previous trading sessions from date of report. Data is sourced from local exchanges via CapIQ, Bloomberg and other vendors. The William C. Dunkelberg Owl fund does and seeks to do business with companies covered in its research reports.
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Page 2 SEGMENT OVERVIEW
Total Merchandise: The merchandise business shipped nearly 2.8 million carloads and generated approximately 59% of FY 2013 revenue. Along with being CSXs largest segment (42% of FY 2013 volume), total merchandise is the most diverse segment consisting of nine sub-segments. The Merchandise segment transports chemicals, automotives, agricultural products, forest products, metals, phosphates and fertilizers, minerals, food and consumer products, as well as waste and equipment.
Chemicals The Chemicals segment made up 27% of Total Merchandise revenue and 15.8% of total revenue in FY 2013. In this segment, CSX transports plastics, plastic feedstock, plastic intermediaries, crude oil, liquefied petroleum gas (LPG), and frac sand.
Automotive The Automotive unit made up 17.3% of the Total Merchandise business and 10.1% of total revenue in FY 2013. The Automotive segment is an essential part of North American vehicle distribution, as it ships almost 1/3 of all light vehicles produced. CSX handles nearly 4 million vehicles annually through its network of 35 auto distribution centers and a fully enclosed multilevel fleet. In addition to transporting finished vehicles, CSX transports auto parts throughout the eastern United States.
Agricultural The Agricultural segment made up 14.4% of the Total Merchandise business and 8.4% of total revenue in FY 2013. The agricultural unit transports products such as grain, flour, oils, sweeteners, and ethanol. Through this business, CSX directly serves grain elevators, feed mills, grain processing facilities, bakeries, ethanol plants, and soft drink production facilities.
Coal: The Coal business shipped nearly 1.2 million carloads and generated 24% of revenue and 18% of volume in FY 2013. CSX transports domestic coal, coke and iron ore to electricity-generating power plants, steel manufacturers, and industrial plants. CSX also exports coal to deep-water port facilities. CSX is the largest coal transporter east of the Mississippi and serves more than 120 load-outs in 9 states.
Intermodal: The Intermodal business contributed 14% of revenue and 40% of volume in 2014. Intermodal transportation is using at least two modes of transportation to move freight. CSXs intermodal line of business combines long distance rail transportation with short-haul trucking. The intermodal business has 50 terminals east of the Mississippi River and uses them to transport mainly manufactured consumer goods in containers.
RISKS New Legislation or Regulatory Changes: Legislation passed by Congress or new regulations issued by federal agencies regarding pricing negotiation and constraints, climate change, emissions, capacity, and hazardous waste transportation could have a negative effect on top or bottom line growth. Declining Natural Gas Prices: As natural gas prices decrease, coal-fired power plants are being replaced by natural gas-fired power generation facilities. If natural gas prices remain low and continue to decrease, more coal-fired plants could be replaced, which would reduce CSXs domestic coal volumes and revenues. Demand Fluctuation: General domestic and global economic conditions that affect demand for the commodities and products CSX transports could adversely affect the top line. Severe Weather: Extreme weather conditions can adversely affect the companys operations and incur additional costs, negatively affecting top and bottom line growth. U.S. Energy Markets: Over the past few years, production of natural gas in the U.S. has increased dramatically, resulting in lower natural gas prices, causing a negative impact on CSX. As a result of sustained low natural gas prices, coal-fired power plants have been displaced by natural gas- fired power generation facilities.
ECONOMIC MOATS: Narrow and Stable Rail Network: CSX spans the densely populated eastern U.S., capturing about half of the rail volume in the region. CSX operates approximately 21,000 miles in rail network, which serves various population centers in 23 states east of the Mississippi River, the District of Columbia, and the Canadian provinces of Ontario and Quebec, as well as operates approximately 4,000 locomotives. Barriers to Entry: The network of rails is very unlikely to have any new main lines built especially since most regions already have two main competitors and replicating the network in place is nearly impossible.
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Page 3 CATALYSTS
New terminals/expansion of old terminals CSX in recent months has experienced a significant increase in demand for its service. With the substantial increase in demand, several performance metrics have fallen in recent quarter such as dwell time, average velocity, EBITDA margin, and profit margin. Stemming from this decline, CSX has committed to improving these metrics by creating new terminals, expanding capacity of old terminals, and improving infrastructure. During 2013 and 2014, the company has expanded terminals in Columbus, Ohio, Louisville, Kentucky, Atlanta, Georgia, and Worcester Massachusetts. An example of the benefits from this additional capex is a 50% increase in capacity at the companys terminal in Columbus, Ohio. The company expects to open new terminals in Winter Haven, Florida and Quebec, Canada during 2014. Investors and the company should start to see benefits from the 2013 projects that the company has recently completed in the second half of 2014, and should expect to see the rest of the terminals fully operational by end of 2015. Some other notable investments that are occurring is an upgrade in infrastructure in the Chicago area, specifically with the Elsdon sub- division, which will provide this area with double track miles (having a track run in each direction so trains going opposite directions arent on the same track), which will increase average train velocity and flexibility in the area to be able to divert traffic away from the more congested routes. In the River Line area, which is from New Jersey up to Boston, double track is being added to capitalize on those same benefits listed above. This specific infrastructure project is crucial because it is going to address a growing need as demand increases in one of CSXs busiest regions.
Illinois Basin Coal Shift Historically, the Appalachian region was a main supplier of coal and was a large part of CSXs coal business. However, with decreasing coal demand, the Appalachian region has not been growing in terms of coal output. The Illinois Basin has become a large hotspot for coal production to make up for the significant decline seen in the Appalachian region. Extracting coal from the Illinois Basin cost about $44 a ton, 22% cheaper than Central Appalachia and 30% cheaper than Northern Appalachia. Powder River Basin has the cheapest extraction price tag of $11 per ton. CSX is positioned to take advantage of this shift away from the Appalachian region to the new Illinois Basin region. CSX is investing in a new coal unit train processing facility that will support this growth, while also adding increased employees and infrastructure in the region. CSX is in a unique position as one of only two companies that can add the capex needed to support the growth that is having in this region.
United States Energy Boom The surge seen from the increased drilling for the extraction of oil and natural gas has created several new high growth markets and products such as crude oil, liquefied petroleum gases, and frac sands that CSX is uniquely positioned to capitalize on. Along with these markets, CSX is capable to capitalize on transporting the supplies needed for drilling for natural gas and oil. CSX is able to transport the material from the gas processing plants to the market. With these expanding markets, CSX has invested in new terminals, railcars, locomotives, and additional employees in order to meet the demand stemming from these specific markets and products.
Public-Private Partnerships and Increased Regulation CSX is joining with several government partners such as the Commonwealth of Massachusetts and the State of Florida, to increase capacity, efficiency, and safety with railroads. The reason for this is these government organizations have begun to recognize the benefits of using rail instead of trucking. Some of the benefits of using rails instead of trucks are reduced traffic, reduced pollution (rails are four times more efficient than trucks), and increased activity at U.S. ports by the use of intermodal transportation. One of the projects called National Gateway, which is a project totaling $850mm in investment from CSX and government organizations throughout the east coast, is outfitting tracks and bridges to allow double stacking of freight. This will increase the percentage of tracks outfitted for double stacking from 90% to 95%. There are several of these projects underway currently, such as creating a rail corridor parallel to interstate 70 and 76 between Washington, D.C. and northwest Ohio, replacing bridges in Maryland, and expanding the Virginia Avenue Tunnel. Along with these partnerships, the Federal Government continues to put stricter regulations on the trucking industry, which continues to increase costs for companies causing them to switch to another mode of transportation such as rail, or the use of intermodal transportation by using rail for long distances and trucking for shorter distances.
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INDUSTRY OVERVIEW
The Rail Renaissance In 1980 the Staggers Rail Act severely deregulated the railroad industry and allowed rail companies to set their own rates as long as there was competition and create service contracts. This has led to significant consolidation in the railroad industry in order to increase efficiency. The number of Class I rail companies has reduced from over 40 in 1980 to just 8 today, which CSX is one of them. Over the past five years the S&P 500 Rail Index has grown over 182%. During the recession there were as little as 80 freight cars per train. However, once demand picked up Class I railroads were able to expand their operating margins by 26.8% in 2010, just by adding more freight cars per train and having a minimal increase in operating cost. Operating cost was able to stay low since the railroads didnt need any additional engines or crews to operate the longer trains. Even as demand rose and more operating cost were incurred, it was offset by more fuel efficient locomotives, widening margins to 27.1% in 2012. The Association of American Railroads reported that fuel efficiency rose from 235 ton-miles per gallon in 1980 to 476 ton-miles in 2012. Today we are seeing a lot of these same things play out for Class I railroads. There is significant congestion and volume growth, making companies like CSX increase their capex in order to keep up with the demand and keep performance metrics at high levels.
Future Demand for Coal Future Domestic Coal Demand The Mercury and Air Toxics Standards take effect next year, and coal powered plants will need to equip their facilities with scrubbers that remove sulfur dioxide to comply with the new regulation. The Obama administration is trying to reduce carbon dioxide emissions, but still estimates the nation to burn 616 million to 636 million tons of coal in 2020. Coal current share of power generation is 41%, but is expected to fall to 33% by 2020 and 30% by 2030 under the new regulation.
Future Foreign Coal Demand Coal remains the 2nd largest energy source worldwide. Annual consumption of worldwide coal is expected to increase 1.3% per year until 2020. In the longer term, growth of coal consumption decelerates as policies and regulations encourage the use of cleaner energy sources, natural gas becomes more economically competitive as a result of shale gas development, and growth of industrial use of coal slows largely as a result of China's industrial activities. Globally, generating electricity accounts for 60% of coal consumption, followed by industrial facilities at 36%. Most countries that consume substantial amounts of coal have domestic coal resources. For that reason, the volume of world coal trade tends to be small relative to worldwide coal consumption. PEER GROUP IDENTIFICATION Union Pacific Corporation (NYSE: UNP) o Provides rail and freight transportation services for various cargo. It primarily operates on the Pacific and Gulf Coast. Canadian National Railway Company (CN: CNR) o Operates a transcontinental railway throughout Canada and parts of the United States. Also, offers logistics and supply chain expertise services. Norfolk Southern Corporation (NYSE: NSC) o Provides rail transportation in 22 states and Washington D.C. and transports overseas freights through Atlantic and Gulf Coast ports. It also operates a logistics services segment. TARGET PRICE
CSX is currently trading at an 8.04% discount relative to its competitors based on a 5 year EV/EBITDA multiple spread average. Currently, competitors are trading at an 11.57x multiple, and when multiplied by the mean factor of 0.845, gives us a target multiple of 9.69x. Using consensus NTM EBITDA estimate of $4,656.30B and a target multiple of 9.69x, we calculated an enterprise value of $45,133.89. Adding back cash of $789.00mm, subtracting debt and preferred of $9,331.00B, yielded an equity value of $36,591.89B. Dividing by total number of shares outstanding of 999.6mm, yielded a target price of $36.61, yielding a total return of 19.34% including the dividend yield of 2.05%.
Historical Average Target Price= $36.61 Historical Average Multiple = 9.69x Equity Value = $36,591.89B
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Page 5 Rail and Intermodal Traffic The Association of American Railroads reported an increase in U.S. rail traffic in August 2014, both carload and intermodal volume increasing compared with August 2013. The rail industry has played and is continuing to play a critical role in the U.S. economys resurgence. In fact, average weekly U.S. rail volume, in terms of carloads plus intermodal containers and trailers, was higher in August 2014 than in any month since October 2007, said AAR Senior Vice President John T. Gray.
Regulations Regarding the Safety and Efficiency of Railroads The U.S. Department of Transportation released the details of its comprehensive rulemaking proposal on July 23 rd 2014. The report emphasized on improving the safe transportation of large quantities of flammable materials by rail - particularly crude oil and ethanol. Specifically, within two years, it proposes the phase out of the use of older DOT 111 tank cars for the shipment of packing group I flammable liquids, including most Bakken crude oil, unless the tank cars are retrofitted to comply with new tank car design standards. The main problem with this proposal is that the production capacity for new tank cars about 35,000 cars a year and industry analysts say the railcar industry could have difficulty expanding production fast enough to accommodate the short time frames proposed by regulators for ushering out older tank cars for transporting flammable liquids. At current production rates, cars ordered today couldn't be delivered until 2016. Regulators have proposed a 2018 deadline for removing all the older, general-purpose tank cars. Outlook for Chemicals such as Crude Oil and Frac Sands The need for sand used in fracking has never been higher than it is today. Sand demand is forecasted to grow by 96% from 2013 till 2016, while capacity is only growing 76% in that time period. What this means is that the growth is being constrained by the lack of rail service available to transport the sand from areas like Pennsylvania, Minnesota, and Wisconsin. Sand prices could increase as much as 50% due to this supply side shortage.
Chemicals Petrochemicals
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FINANCIALS
Revenue
In Q2 FY 2014, CSX reported sales of $3.244B, representing an increase of 6.50% QoQ. Since 2010, sales have grown from $10.636B to $12.026B, representing a CAGR of 4.18%. From 2013 to 2016, sales are expected to grow from $12.026B to $13.749B, representing a CAGR of 4.57%. Sales are being driven by increased volume, stemming from strength in several end markets that CSX serves, such as chemicals and automotives. Intermodal transportation is set to continue to be a driver of revenue as stricter regulations come down on trucking, making companies rely on rails for longer distance shipments. Through CSXs increased spending on infrastructure and terminals, the company has been able to serve more customers through intermodal transportation, as well as steal market share away from trucking. Revenue per unit has been consistently increasing since 2009, showing greater efficiency and better pricing. In 2009, revenue per unit was $1,561, growing to $1,839 in 2013, representing a CAGR of 4.18%.
Total Merchandise Total Merchandise was 58.5% of revenue in 2013, up 4.6% from 2009. This is beneficial for CSX because total merchandise is the companys most diversified segment, consisting of nine sub-segments. By increasing total merchandises percent of total revenue, CSX becomes less reliant on one product or market, such as coal. There are four main sub-segments under total merchandise, which are chemicals (15.8% of revenue), automotive (10.1%), agricultural products (8.4%) and forest products (6.4%). The other five sub-segments are each less than 5% of revenue and in total account for 17.8% of revenue. Total merchandises revenue in 2009 was $4.875B, growing to $7.037B in 2013, representing a CAGR of 9.61%. Total revenue per unit has also been increasing since 2009, growing from $2,085 to $2,548 in 2013, representing a CAGR of 5.14%
Chemicals Chemicals represented 15.8% of revenue in 2013. This segment has seen an increase of 1.8% in terms of percent of total revenue since 2009. This is mainly derived from the United States energy market boom providing an increase in the shipping of crude oil, liquefied petroleum gas, frac sands, as well as other materials needed for the drilling of oil and natural gas. The chemicals segment has been, and is going to continue to be one of the fastest growing segments for CSX since the growth in chemicals is stemming from a decrease in coal usage and an increase in natural gas and crude oil usage. This segment is vital in counteracting the decrease in coal volume and revenue, but continuing to provide increased revenue and volume growth. We have seen this trend occur as coals percent of total revenue has decreased from 30.7% in 2010, down to 24.1% in 2013. Chemicals total revenue has grown from $1.267B in 2009 to $1.896B in 2013, representing a CAGR of 10.60%, outpacing overall revenue growth by 6.42%. Revenue per unit for this segment is the highest out of all segments for CSX, mainly because the materials for chemicals are far more dangerous than other products it transports, meaning these products carry a pricing premium compared to other less hazardous products. Revenue per unit in 2009 was $2,988 and has grown to $3,564 in 2013, representing a CAGR of 4.51%.
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Page 7 Automotive Automotive represented 10.1% of revenue in 2013. This segment has seen an increase of 2.6% in terms of percent of total revenue since 2009. This is mainly derived from the expansion of the domestic auto market as CSX ships nearly one third of all light automobiles, totaling 4 million units. Automotives total revenue has grown from $511mm in 2009, to $1.217B in 2013, representing a CAGR of 24.23%, outpacing general revenue growth by 20.05%. Automotives revenue per unit in 2009 was $2,184, and has grown to 2,817 in 2013, representing a CAGR of 6.57%.
Agricultural Products Agricultural Products represented 8.4% of revenue in 2013. This segment has seen a decrease of 2.2% in terms of percent of total revenue since 2009. This is mainly due to volatility in the harvests on a per year basis. Also, this segment is limited in its growth potential because there is only so much food that needs to be produced to serve the domestic demand. This segments revenue has grown from $960mm in 2009 to $1.013B in 2013, representing a CAGR of 1.35%, under-pacing general revenue growth by 2.83%. We do believe in the future this segment does have some room for growth as ethanol from corn becomes more widely used. Agricultural Products revenue per unit has grown from $2,243 in 2009 to $2,597 in 2013, representing a CAGR of 3.73%. The company guided that this segment in the short-term will grow as population grows, so 1-2% YoY growth.
Forest Products Forest Products represented 6.4% of revenue in 2013. This segment has seen an increase of 0.3% in terms of percent of total revenue since 2009. This segments revenue has grown from $547mm in 2009 to $775mm in 2013, representing a CAGR of 9.10%, outpacing general revenue by 4.92%. Forest Products revenue per unit has grown from $2,120 in 2009 to $2,601 in 2013, representing a CAGR of 5.24%.
Coal Coal represented 24.1% of revenue in 2013. This segment has seen a decrease of 6.1% in terms of percent of total revenue since 2009. This is due to the recent discovery of large supplies of natural gas, causing the price for natural gas to decrease dramatically. Also, coal is more of a pollutant when used compared to natural gas. The revenue in this segment bottomed out at $2.727B in 2009, and has increased to $2.895B in 2013, representing a CAGR of 1.51%, under- pacing general revenue growth by 2.67%. In that time period, coals revenue peaked in 2011 at $3.709B and proceeded to fall to $3.190B in 2012, and $2.895B in 2013. Even though coals revenue is slightly decreasing, it is good that at the same time coals percent of total revenue is also decreasing. This will enable CSX to be less reliant on coal, allowing it to be a more diversified company and not as exposed to large changes in the macro environment regarding coal. Coals revenue per unit has grown from $1,756 in 2009 to $2,423 in 2013, representing a CAGR of 8.38%.
Intermodal Intermodal represented 14.1% of revenue in 2013. This segment has seen an increase of 1.00% in terms of percent of total revenue since 2009. This is due to stricter regulations on the trucking industry making trucking companies unable to meet the growing demand that has been seen in the recent year. The revenue in this segment was $1.184B in 2009, and has increased to $1.697B in 2013, representing a CAGR of 9.47%, outpacing general revenue growth by 5.29%. Even though intermodal is seen as the smallest of the three main segments for CSX, we see this segment as being one of the biggest growth opportunities for CSX. As trucking regulations keep restricting driver availability and efficiency, intermodal will become more and more prevalent, especially in longer distance shipments. Also, with CSX upgrading and building new terminals, this will allow them to serve even more customers using intermodal transportation than ever before. With the regulations on the trucking industry, customers are finding it cheaper and cheaper to transport goods using rail, especially for longer distances. Forbes notes that transporting freight by truck is 10 times more expensive than rail. Intermodals revenue per unit has increased from $623 in 2009 to $657 in 2013, representing a CAGR of 1.34%.
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Page 8 Margins
CSX has seen significant margin expansion by growing operating margin to 28.88% in 2013 from 25.11% in 2009, EBITDA margin to 39.87% from 35.1%, and profit margin to 16.54% from 12.64%. As talked about before, CSX has faced significant railway congestion due to increased volumes. This is causing compression of margins in 2014 due to the company not being able to handle the additional volume as efficiently. However, the company is expecting to see margins expand back to 2013 levels by 2015, and then above 2013 levels in 2016. In 2016, it is projected that CSX will report operating, EBITDA, and profit margins of 30.67%, 39.87%, and 16.54% respectively. The biggest downside for this company is that its margins are lagging behind its competitors. The reason for CSXs lagging margins is because its other competitors have not been faced with the type of rail congestion that CSX has. CSX operates in highly populated and highly dense areas, such as Chicago and New York causing the company to be more prone to rail congestion than its competitors. That is why CSX is devoting itself to increasing its capex to try and lessen the impact of rail congestion in the future, and to make its railways more efficient.
Railroad Performance Metrics
There are several metrics that railroad companies use in order to judge how efficient they are acting compared to their own history and competitors. Below, are a list of metrics that CSX tracks in comparison to its competitors, and the QoQ growth or decline for Q2 FY 2014. Starting from the top, average dwell time, average velocity, on-time arrivals, and on-time originations all performed worse in 2014 compared to 2013. This stems directly from the substantial increase of 13.86% in cars online during the period. This wasnt just solely CSX, NSC and UNP also experienced the same results, but werent quite as severe as CSX because of the location of its railways. However, as you can see, CSX also experienced the greatest increase in cars online outpacing NSC by 8.62%, and UNP by 18.07%. CSX did see improvements in the quarter in its injury and accident rate. Both of these are important because a lot of concern surrounding the railroad industry is the risk of accidents and injuries associated with increasing the use of railroads compared to trucks. To show improvement QoQ with both of these metrics, despite all the growth the company has experienced is a testament to the companys safety precautions and procedures.
Earnings
CSX has a strong track record for beating earnings estimates, beating estimates 9 out of the last 10 quarters, with an average earnings surprise of 6.12%. Since 2010, CSX has been able to grow earnings at a CAGR of 10.67%. From 2013 to 2016, CSX is expected to grow earnings at a CAGR of 8.54%. The reason for this slight decline in EPS growth is due to the extreme growth seen from CSX in 2011, increasing EPS by 23.4% YoY. The slight decline in EPS growth is also due to the small YoY growth of 1.5% that is expected in 2014. After 2014, the company has provided guidance that it expects EPS growth to be in the range of low to mid double digit YoY growth. This is a testament to the company being able to capitalize on the additional capital it is setting aside for capex, and the ability to capitalize on the energy market boom seen in the US to offset the decline in the coal market. Analysts are concerned that with the declining coal industry, CSX will not be able to maintain the EPS guidance it has provided, and will have to reduce guidance to the range of mid to high single digit YoY EPS growth. However, we feel that the energy market opportunity, and the positive effects felt from the increased capex will enable CSX to meet the goal of double digit EPS growth. In 2013, CSX reported EPS of $1.83, and are projected to earn $1.86 in 2014, representing growth of 1.5% YoY. This low growth year is due mainly to the growth and congestion that the company and industry has seen, which have increased costs at a pace $10mm per month, or $120mm annually. In 2015, EPS is projected to be $2.12, representing YoY growth of 14.2%, returning EPS growth to levels that the company and analysts are more comfortable with. The accelerated growth expected in 2015 is due to the lowering of costs after the capex projects CSX is investing in now come online. In Q2 FY 2014, CSX reported EPS of $0.53, beating estimates of $0.52, representing QoQ growth of 2%.
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Page 9 Cash Flow
CSX reported CFFO of $3.3B and FCF of $954MM in 2013. In FY 2014, CFFO and FCF are projected to be $3.1B and $702.5MM respectively. The reason for the decrease in CFFO is due to the slower than usual earnings growth that the company has historically seen, and the higher costs associated with the congestion of railways, compressing margins, and deteriorating performance metrics. FCF is projected to decrease because of the ramp up of capex that is projected for 2014 of $2.4B, which represents an increase of $100MM YoY. CFFO and FCF have grown at CAGRs of 12.49% and 11.69% respectively since 2009. From 2013 to 2016 CFFO and FCF are expected to grow at CAGRs of 2.28% and 4.16% respectively. Although these CAGRs are lower than historic numbers, we think this isnt a bad thing for CSX because they are making a commitment to invest capital to increase capex to all-time high levels, which in turn should provide increased efficiency, improvement of performance metrics, and expansion of margins. All of those results will then translate into higher EPS growth moving forward, allowing the company to stay within its target of YoY double digit growth.
Capital Expenditures
In 2013, capex was $2.31B and has been increasing at a CAGR of 12.83% since 2009. In 2014, CAPEX is projected to reach its highest level ever at $2.4B. CSX is growing capital expenditures to finance capacity-related projects such as its new coal unit train processing facility in the Illinois Basin, expanding terminals in Ohio, Kentucky, Georgia, and Massachusetts, along with opening new terminals in Winter Haven, Florida and Quebec, Canada. In addition, CSX has increased capex to add double track miles in both the Chicago-based Elsdon sub-division, along with the River Line area. capex is projected to remain relatively the same in 2015 at $2.38B, but it is expected to ramp up in 2016 to $2.42B. In FY 2013, capex as a percentage of depreciation was 210%, showing that the company is not only replacing its aging equipment, but that it is adding in new terminals, expanding its fleet size, and making investments in rail expansion. For FY 2014, CAPEX as a percentage of depreciation is projected to remain above 200%, reflecting the companys persistent efforts to grow its rail and terminal network, improve quality of existing infrastructure, and bring a younger fleet of trains. In terms of ROIC/WACC, CSX has seen a steady increase from its 2010 value of 0.85 to its 2013 value of 1.18. CSXs ROIC/WACC LTM as of the beginning of September was 1.65, which is a record high and a significant increase from CSXs 2013 number of 1.18. CSX has guided that it expects capex to remain between 17 and 19% of revenue.
Debt
CSXs total debt is $9,309mm. The company has $3,156mm due in bond principle through 2020, with $627mm, $18mm and $630mm due in 2015, 2016 and 2017, respectively. The net interest expense was down to $554mm in 2013 from $561mm in 2012. Also, CSXs interest coverage ratio is 6.27x showing the companys ability to pay its interest payments. CSX has decreased their debt/equity in 2013 to 91% from 107.6% in 2012 driven by a net reduction in total debt of $277mm. CSX has a high credit rating with ratings of BBB+ at S&P.
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Page 10 FLEET AGE/SIZE CSX uses 3 main types of locomotives that make up its fleet of 4,259 locomotives: freight, switching, and auxiliary units. Freight locomotives, which account for 87% of the fleet, are the power source used to pull trains. Switching locomotives are used to sort railcars so the right railcar and train are properly connected and make up 8% of the fleet. Finally, auxiliary units make up 5% of the fleet and provide extra traction for heavy trains in hilly areas. In terms of age, CSXs fleet has remained relatively stable since 2009. Average age for freight locomotives has remained steady at 20 since 2010. Auxiliary units have dropped in age to 21 in 2013 from their all-time high of 50 in 2010. Switching locomotives have grown in average age by one year from 32 in 2010 to 33 in 2013. Management has made a concentrated effort to use capital expenditures on growing fleet size and minimizing the fleets average age, as seen by an 8% expansion in fleet size YoY since Q2 FY 2013, and 10% YoY growth since Q4 FY 2013.
SHAREHOLDER RETURNS
The company announced a $1B share repurchase program starting April 2013 spanning two years. CSX is funding the repurchasing program through excess cash and free cash flow. Since 2005, CSX has increased its quarterly dividend 12 times from $0.017 in 2005, to its current quarterly dividend yield of $0.16. The LTM dividend payout ratio is 35.21%, slightly higher than the companys target dividend payout ratio range of 30-35%. The company believes this payout ratio is justified due to strong EPS growth. CSXs dividend payout ratio has grown every year over the past 4 years from 23.8% in 2010, to its current dividend payout ratio of 35.21%. Looking ahead, the company plans to keep increasing quarterly dividend payouts due to its strong earnings growth. Dividends are projected to grow at a 10.65% CAGR over the next 3 years, with the expected 2017 quarterly dividends to be $0.22 per share.
VALUATION Undervaluation CSX is currently trading at an 8.04% discount to its competitors on a 5 year EV/EBITDA basis. There are several reasons why CSX has begun trading at a discount. The first of these reasons is due to the decrease in coal volume. Coal volume has been continuously falling due to the energy boom in the U.S., causing natural gas prices to be significantly cheaper than coal. Also, companies are now trying to be more environmentally friendly, and switching away from coal to other forms of energy such as natural gas is a way cost effective way to do this. The second reason that CSX is trading at a discount to its competitors is because of the companys declining performance metrics, such as dwell time, average train velocity, and on-time arrivals. These metrics have decreased more than peers due to CSXs rail network position and significant volume growth.
Peer Group Valuation The companies used in my relative valuation are Union Pacific Corporation (UNP), Norfolk Southern Corporation (NSC), and Canadian National Railway (CNR). All of these companies have been listed as direct competitors, transport the same kind of goods, and have the same kind of business model that CSX has. As stated before the company is trading at an 8.04% discount to its historical 5 year spread on an EV/EBITDA basis. The company is index is trading at 11.47x EV/EBITDA multiple and multiplying it by the mean factor gives us a target multiple of 9.69x. Using the 9.69x multiple and consensus NTM EBITDA of $4,656.30, we calculated an enterprise value of $45,133.89. Adding back cash of $789.00 and subtracting debt of $9,309.00 yield an equity value of $36,591.89. Dividing number of shares of 999.60, yields a target price of $36.61, giving a total return of 19.34% with a 2.05% dividend included.
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Discounted Cash Flow
Assumptions The 7 year CAGR of for sales growth of 4.5% was found using a combination of Bloomberg estimates and company guidance. The company has guided for the foreseeable future that it expects revenue to grow by mid-single digits. Sales growth is being driven by a combination of strength seen in end markets, as well as continued growth of the companys intermodal segment as more truckers continue to use intermodal as a practical and cost efficient mode of transportation. Margins are expected to slightly contract in 2014, due to the explosive increase in volume the company has experienced recently, but are expected to return to 2013 level in 2015, and exceed those levels in 2016 and beyond. Capex has been projected by the company to be between 17-18% of revenue after 2014. 2014 is slightly higher because of additional capex the company felt was needed in order to handle the growth it has seen.
WACC The WACC of 9.33% is calculated using the 5 year average weights of 71.65% for equity and 28.35% for debt. Cost of equity of 10.919% is calculated using CAPM, with a risk free rate of 2.47%, a market risk premium of 9.57%, and using a beta of 1.19. Cost of debt of .02% is calculated using the pre-tax weighted cost of ST debt total of 0.1%, ST debt rate of 0.53%, LT debt total of 0.90%, LT debt rate of 2.47%, and a tax rate of 36.35%.
WACC 9.33% EM Method EM: 7.64x $45.17 GP Method GP: 3.8% $36.45
Fall 2014
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Page 12 DISCLAIMER This report is prepared strictly for educational purposes and should not be used as an actual investment guide. The forward looking statements contained within are simply the authors opinions. The writer does not own any CSX Corp. stock. TUIA STATEMENT Established in honor of Professor William C. Dunkelberg, former Dean of the Fox School of Business, for his tireless dedication to educating students in real-world principles of economics and business, the William C. Dunkelberg (WCD) Owl Fund will ensure that future generations of students have exposure to a challenging, practical learning experience. Managed by Fox School of Business graduate and undergraduate students with oversight from its Board of Directors, the WCD Owl Funds goals are threefold: Provide students with hands-on investment management experience Enable students to work in a team-based setting in consultation with investment professionals. Connect student participants with nationally recognized money managers and financial institutions
Earnings from the fund will be reinvested net of fund expenses, which are primarily trading and auditing costs and partial scholarships for student participants.