CSX Railroad Has Left the Station

 | Oct 13, 2017 | 5:35 PM EDT
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Stock quotes in this article:

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The railroad sector has been a hot one thus far in 2017.

Three of the The "Big Four" U.S railroad stocks -- Norfolk Southern (NS) (+21.8%), Union Pacific (UNP) (+8.3%) and Kansas City Southern (KSU) (22.8%) -- have posted solid gains and the fourth, CSX (CSX) , has posted a scorching 47.3% gain.

Burlington Northern Santa Fe is, of course, owned by Berkshire Hathaway (BRK.A) and it is unwise to exclude behemoth Canadian National Railway (CNI) and its $60 billion market cap (+20% this year) and Canadian Pacific Railway (CP) and its $25 billion market cap (+18% this year) from any analysis of railroad stocks. So, even without the ability to invest directly in BNSF, this is a very large, liquid group, and certainly an important economic bellwether.

Railroads have been a prime example of Trump Jump plays, and the fundamental picture has indeed improved in 2017:

  1. According to the American Association of Railroads, total combined U.S. traffic for the first 39 weeks of 2017 was 20,539,212 carloads and intermodal units, an increase of 3.6 percent compared to last year.
  2. Drilling further into the intermodal business, the Intermodal Association of North America reports that total intermodal volumes gained 4.5 percent in Q2, the strongest growth in nearly three years. International once again was the primary driver, rising 5.6 percent; domestic containers and trailer volumes increased 3.2 percent and 3.9 percent respectively.

Real Money's editors tasked me specifically with analyzing CSX ahead of earnings next week. According to Zacks, CSX is estimated to earn $2.23 in 2017 and $2.70 in 2018. CSX management's most recent guidance range for 2017 EPS was $2.17-$2.26, so the street is already near the high end of that range. Consensus calls for CSX to report $0.52 in EPS for the third quarter versus the $0.48 EPS recorded in the third quarter of 2016. I wouldn't expect CSX's management to drill down deeply into guidance on next week's call because management is hosting a two-day analyst meeting on October 29th and 30th. Those meetings are generally the venue for deep analysis of projections.

Also, CSX's second quarter presentation included this language about upcoming third quarter results: "Transition issues in Q3 impact operating ratio and EPS expectations." So, that's the equivalent of the CFO calling sell-side analysts (I was one for 11 years) and saying "hey, the quarter's going to be a little messy." Managing expectations is crucial, but lowering the bar is generally done for fundamental reasons, not just to get some talking head on CNBC to yell "beat" when earnings results are reported.

So, CSX shareholders are facing a crossroads. The time to buy a railroad stock is when economic growth is about to accelerate, but now that acceleration is already well underway. CSX's forward P/E of 19.6x represents a premium to the S&P 500 and a premium to the 18.8x forward multiple currently being accorded to Norfolk Southern. Also, the dividend yield of 1.5% is not attractive relative to the market and management seems more focused on buybacks, as the company's repurchase authorization was increased in July.

So, I am not buying CSX shares ahead of earnings. I believe the acceleration in US economic growth has already been priced into the shares, and they are certainly not cheap. I wouldn't be in a rush to sell them, either, and I believe management has put in place important measures to improve CSX's operating ratio, which has largely been flat for the past five years.

It's a good company, but that doesn't mean on any given day it's a good stock to buy. Let's let things cool off in this red-hot sector, and look to hop back on the trains if there is a meaningful sectoral pullback.

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