Railroads have been generally strong performers in the second half of 2012. Large carriers such as Union Pacific (UNP) and Kansas City Southern (KSU) have overcome underperformance in the first half of the year and have now outperformed the S&P 500 for the whole of 2012 (see chart). Sentiment has improved on the sector as 2013 looks like it will be a better year for economic growth than 2012 -- provided the fiscal cliff can be successfully navigated. In addition, auto manufacturing has remained strong, the housing market is coming back and the outlook for exports to China has improved as their economy appears ready to accelerate from recent weakness and a once-a-decade political transition.
Unfortunately, one rail stock that has not participated in this rally is CSX (CSX), which has been a laggard in my portfolio most of the year. The main driver of this underperformance is that the company gets a third of its revenues from transporting coal. This fossil fuel has been under pressure from both low natural gas prices and an increasingly hostile regulatory regime. Utility customers have accelerated their migration to natural gas as their primary fuel source over the last few years. This should continue but offset somewhat by long-term secular export demand for coal coming from Asia. That said, CSX should benefit from better economic growth in 2013 across the economy. The shares are cheap for several reasons.
- The stock sells for just over 6x operating cash flow (OCF) and has grown OCF by approximately 60% over the past three years.
- It provides a solid dividend of 2.8%.
- CSX is selling at just under 11x forward earnings and has beaten earnings estimates each of the last three quarters.
- CSX has bought back some 30% of shares outstanding over the past five years. It still has a substantial amount of buying power left under an existing purchase program as well.
- The company has used its steady cash flow to continue improving its dividend. It has more than tripled payouts over the past half-dozen years.
- It has a great footprint. CSX connects Florida with New England and everything in between. It has yet to participate to any extent in the increasing amount of the oil from the oil shale regions being transported via rail. This should change as production in its core service regions (e.g., Marcellus Shale) continue to expand.
- Finally, the company has done a marvelous job improving operating efficiency over the past decade. This ratio has come down to less than 71% at year-end 2011 from 86% in 2002. The company is targeting 65% by year-end 2015. This will have a significant positive impact to margins and the bottom line.
I expect CSX's business to improve throughout 2013. I am putting a valuation of 12x 2014's projected earnings of $2.13 per share (Credit Suisse) to be achieved at some point in 2013, or around $25 per share. This would be a 25% increase from Wednesday's closing price of $19.70 per share, in addition to a nice dividend yield while you wait.