The rail renaissance has arrived.
Buy a ticket
And so, the logical question follows. How is a great business, and such a large, well-followed one – with a $23 billion market cap – mispriced? Well, a few reasons: dirty ol’ coal, the lingering risk of regulation, and a market that doesn’t appreciate the potential for sustained growth.
1.) King coal: A consistent knock against CSX Corporation (NYSE:CSX) has been its exposure to coal; specifically, Appalachian Basin coal – the most costly and polluting variety. The headlines don’t distort truth. Coal, and particularly Appalachian, faces secular decline in the U.S., and with the Obama administration’s proposed introduction of carbon standards, the future decline may be accelerated.
But, as always, it’s a bit nuanced. This mind-set, well, it’s a touch myopic. More importantly, given a long-term view, it couldn’t matter less to an investment in CSX.
Foremost, coal’s not going to disappear overnight: Over 40% of our nation’s power grid depends on it. Second, even if carbon taxes limit use of Appalachian coal, CSX Corporation (NYSE:CSX) also taps the Illinois Basin, which is known for dirty but cheap coal. Power generators have increasingly opted for it. Because it’s cheap, they can justify the cost of scrubbers. I expect that to continue, for the near term. Last, while coal faces a decline stateside, it’s a growth market in Asia and Europe – on account of the relative dearth of cheap natural gas in Europe, and increasing electrification in Asia.
But, for sake of argument, assume a hypothetical worst-case scenario passes: CSX loses almost all of its coal volumes over a five-year period. That makes the shares worth $17. Not a terrifying prospect.
2.) Regulation: Railroads’ de facto monopoly status carries an implicit cost. To protect against prospective abuses, the Surface Transportation Board regulates railroads. Rail watchers have wondered whether a crackdown on price increases, limitations on investment returns, or costly safety regulations will follow.
I’d wager no, at least not for some time.
Railroads’ returns on capital aren’t astronomically high: the biggest four in the U.S. averaged 11% for the trailing-12-month period. Also remember that railroads are enormously capital intensive, spending 15%-20% of revenues on capex each year. Regulating with too heavy a hand could carry an unintended consequence – railroads in disrepair, as they would lack the profits to reinvest.
3.) Share gains: Despite share losses to rail, trucking is still big business – an estimated $300 billion, according to industry rag Transport News . In an era of elevated oil prices – a trend I expect to continue, on account of structurally higher finding costs (for oil) – I expect rail to wear truckers’ treads thin. For CSX and other rails, that’s good news.
The golden ticket
Across the long run, I project that CSX Corporation (NYSE:CSX) will grow volumes by 1%, as volume gains in other product lines will, to a large extent, be offset by declining coal volumes. I also anticipate long-run price increases in the 4%-5% range, and full-cycle operating margins in the mid-30% range – as operating leverage from pricing, population growth, and share gains contribute. For perspective, this implies a 12% terminal period return on invested capital, a relatively conservative figure, in light of CSX’s competitive advantages. On this basis, I estimate CSX shares’ worth $31.
Risks
The risks to CSX aren’t small. First, it competes with trucks for freight volumes. If, for some reason, oil prices declined below $55 per barrel on a sustained basis, then it would lose share to trucking. I doubt it’ll happen, because drilling for new oil doesn’t make sense at those prices, but it’s worth monitoring. Second, because of its large intermodal business, CSX is exposed to the health of both the U.S. and the world economy. In the long run, I think everything will be alright, but it could face a few bumps in the interim. Absent operational missteps, I’d call that a buying opportunity. Last, there’s the risk of regulation. Should regulators decide to clamp down on price increases, and limit investment returns, CSX would face trouble. For reasons mentioned above, I doubt that’ll happen.
The bottom line
I like Monopoly, and I love owning the railroads when I play. In the case of CSX Corporation (NYSE:CSX) – the promise of Monopoly meets a stock market investment. All aboard.
With 21,000 miles of track serving two-thirds of the U.S. population, CSX maintains a valuable proprietary asset. Still, this railroad will face difficult obstacles in the years ahead due to a domestic surplus of natural gas and coal’s declining popularity.
The article Why I‘m Buying CSX originally appeared on Fool.com.
Michael Olsen, CFA owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway.
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