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CSX Apr 16

CSX Apr 16

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CSX Apr 16
CSX Apr 16

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CSX Corp
 CSXAnalysis
Analyst Note
 | 16 Apr 2014 | Keith Schoonmaker, CFA,Director
CSX’ first-quarter operating earnings declined 16%even though the rail improved overall volume 3%,and the operating ratio fell 520 basis points, to75.5% due in large part to winter storms. All therails, indeed, all transports, faced bitter, debilitat-ing conditions this year. FedEx CEO Fred Smithcalled this the toughest winter in which his firmhas ever operated, but we consider weather to bea regular variable in this outdoor enterprise, andare not concerned with one quarter’s worth ofcosts to thaw switches, clear tracks, and run short-er trains. We maintain our wide economic moatrating and our fair value estimate.Despite headwinds from volumes of export coalsignificantly lower than during the past couple ofhigh years, management expects modest full-yearearnings growth in 2014 due to strong merchand-ise and intermodal, and even improving domesticcoal. A bit further forward, management expectsto delivery double-digit growth in 2015 and bey-ond, and to sustain a mid-60% operating ratio (OR)long term.CSX estimates weather increased expenses $0.06per share and constrained revenue by $0.02-$0.03per share, thus the reported $0.40 EPS would havebeen $0.08-$0.09 higher were it not for the harshconditions. Winter's impact is visible through theoperating lens as well: On-time originations andarrivals slid from 91% and 85% in the year-agoperiod to 63% and 51%, respectively. Offsettingthis, a lower tax rate in Indiana benefited thequarter by $0.02 per share.Total coal carloads declined just 1% from the pri-or-year period, as domestic utility improved 9%.Cold weather demanded some additional coal forheating power generation, but the increase wasalso from a competitive win at a utility. Export me-tallurgical and thermal coal declined 11% and19%. We project continuing declines in total coalvolume will be partially offset by long-run growthin intermodal. Iin this quarter, CSX grew intermod-al units and revenue ton-miles 5% and 7%, re-spectively.
Investment Thesis
 | 21 Feb 2014 | Keith Schoonmaker,CFA, Director
CSX's margin gains during the past decade arenothing short of astounding. The firm lagged itspeers after the rail renaissance began in 2004, butsurprisingly strong profitability during the reces-sion marked the end of its perceived second-classstatus. Historically, CSX's closest comparativepeer, Norfolk Southern, earned at least 5 percent-age points better annual margin, but CSX achievedrecord improvements in operating ratio (operatingexpenses/revenue) during 2009-12 and more thanclosed the performance gap. The Eastern railroadstarted its margin improvement trajectory duringthe early days of the modern railroad renaissanceand advanced its OR to around 71% (29% EBITmargin) during 2010-13 from more than 90% in2003. Management's high-60s OR target by 2015seems attainable to us, for we believe much-im-proved profitability is here to stay at CSX.However, given CSX's coal-rich mix (31.6% of con-solidated 2011 revenue, down to 24.1% in 2013),the rail will continue to be hard hit by plungingcoal demand during the next several years; wethink CSX can size its network to match demand.Case in point: While coal volume declined a steep16% in 2012, CSX slightly bettered its prior-yearOR. Autos and intermodal growth, plus continuedOR improvement, should help salvage earningsdespite coal losses.CSX's competitive advantagesare inseparable from the geography of its track. ItsEastern U.S. network stretches a bit farther in lat-itude than that of competitor Norfolk Southern,reaching into Florida and New England. The loca-tion of all its assets enables CSX to attract a di-verse mix of commodities. CSX made meteoric pro-gress in its operations during the past decade, im-proving safety, shortening terminal dwell time, andincreasing on-time arrivals. In almost every meas-ure of operating performance, CSX moved theneedle significantly. Along with better-run opera-tions, the company materially improved its pricing,expanding consolidated yield at a 6% compoundannual rate since 2004. Given this progress,there's now less room for improvement, but we ex-pect pricing power to persevere in excess of 2%-3% annual railroad cost inflation.
Economic Moat
TM
 | 21 Feb 2014
CSX's wide economic moat is based on cost ad-vantages and efficient scale. While barges, ships,aircraft, and trucks also haul freight, railroads arethe low-cost option by far where no waterwayconnects the origin and destination, especially forfreight with low value per unit weight. Moreover,railroads claim quadruple the fuel efficiency oftrucking per ton-mile of freight, and due to greaterrailcar capacity and train length make more effect-ive use of manpower despite the need for trainyard personnel. Even for goods that can be shippedby truck, we estimate railroads charge 10%-30%less than truckers to transport containers on thesame lane. The network of track and assets ClassI rails have in place is impossible to replicate. CSXspans the densely populated Eastern U.S., captur-ing about half of the rail volume in the region. Itsrights of way and installed track form a nearly im-penetrable barrier to entry. We think there will beno new railroads built, although line extensions byexisting railroads (including restoring abandonedlines) may take place in select areas as the eco-nomy recovers. Efficient scale followed industryconsolidation escalated by the 1980 Staggers Actthat permitted extensive rail line sales, abandon-ment, and combination. North America had morethan 40 Class I rails in 1980; today, there are justeight (a Class I generates at least $452.7 million of2012 operating revenue; six are publicly traded).Staggers also allowed private contracts and ratesetting. On all but the busiest lanes (likeWyoming’s coal-rich Powder River Basin), gener-ally a single railroad serves an end-of-the-lineshipper, and only two railroads operate in most re-gions in North America. Indeed, we opine that ab-sent government intervention, the rational numberof competitors on the continent would be two, viaadditional consolidation, since in most regionscustomers already have only two capable pro-viders. The steep barrier to entry formed by the
Release date 04-17-2014
©2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. Theinformation contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
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Page 1 of 33Release date 04-17-2014
©2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. Theinformation contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
 ß
®
Page 1 of 33
 
CSX Corp
 CSXAnalysis
need to obtain contiguous rights of way on whichto lay continuously welded steel rail spanning onethird of a huge continent fends off would-beentrants. Railroads may build spurs or restoreabandoned lines, but we anticipate that becauseof massive barriers to entry, no new main lineswill be built.No doubt barriers to entry are power-ful for railroads, but running a railroad requiresmassive reinvestment. CSX's still-sizable annualcapital expenditures typically amount to 16%-20%of revenue. While the rails don't outearn their costof capital by much, our wide moat rating stemsfrom our confidence that rails will leverage costand efficient scale competitive advantages to gen-erate positive economic profits for the benefit ofshare owners with near certainty 10 years fromnow, and more likely than not 20 years from now;by our methodology, this defines a wide economicmoat.
Valuation
 | 16 Apr 2014
Our fair value estimate for CSX is $31 per share.We model CSX's top line to increase only 1%-2%in 2014, based on our projections of volume andyield improvement in each reported commodity.We project carloads to be about flat to the prioryear, with growth in chemicals (8%, boosted bycrude), forest products (2% on housing recovery,offset by paper weakness), autos (1% on agedfleet replacement producing a growing SAAR), andintermodal (4% as domestic volume continues totake share from trucking). We model utility coaltonnage to increase 2% (first quarter was up 9%,and management expects 2014 to increase over2013) and export coal to contract 20% to 35 mil-lion tons in 2014 (per management guidance),leading to about a 5% drop in total coal volumethis year. By the end of our five-year discreteStage 1 projection period, we estimate that totalvolume will expand 1% per year despite furthercoal contraction, as population growth, auto recov-ery, homebuilding recovery, and intermodal sharegains fuel continued modest volume demand. Wealso model most rates to improve around 4% an-nually--slightly in excess of inflation. In coal,however, we model a slight decline in 2014 ratesas we believe export coal will need to be priced tomove in a demanding (read: supercheap prices) in-ternational market, and we believe the competingmode of trucking can constrain intermodal yieldexpansion to about 1%-3% per year.We forecastan operating ratio of 71.5% in 2014--a slight de-terioration from 70.6% in 2012 and 71.1% in 2013as the rail continues to adjust to dynamic coal de-mand and as the firm suffered an extremely harshfirst quarter (75.5% OR). By 2017, however, wethink the rail can achieve a 67% OR. In April 2013,management reviewed with the board the prior ORtarget of 65% by 2015, which was set before thefirm felt the full brunt of coal-to-gas utility switch-ing; the current target is a mid-60s OR long-term.We anticipate no degradation in the rail's ability tocontrol most of its costs over the long run (evenfuel is mostly covered by surcharges, albeit with adelay that can constrain quarterly earnings). Ourvaluation is constrained by the heavy cash deman-ded for reinvestment in the railroad: We projectthat about 18% of revenue will be spent annuallyon capital investment, including the unfunded butmandated positive train control implementationduring the next few years.
Risk
 | 21 Feb 2014
CSX is exposed to the health of the U.S. economyand to both domestic utility and international me-tallurgical and steam coal demand. Low naturalgas prices and increased Environmental ProtectionAgency regulations have put a material portion ofthe domestic utility coal franchise at risk of disap-pearing, and export coal demand is lower than inpast years as a result of less steelmaking in Asia.The rail is relying on its intermodal franchise to ex-pand volume. The firm has improved rapidly, andwe no longer believe it has greater operating riskthan other railroads. Outside of normal operations,CSX has assets in locations susceptible to hur-ricane damage, but natural disaster risk is inevit-able in railroading, given its outdoor nature andexpanse. Threat of increased regulation ebbedsomewhat because the 2010 election resulted in aRepublican-controlled House, but regulation canconstrain rail profitability in more modes thansimply price controls. For example, the FederalRailroad Administration estimates the 2008 legalmandate to install positive train control systems(by 2015) will cost the Class I railroads north of$13 billion to implement and maintain for the next20 years; CSX estimates it will spend $300 millionon PTC during 2014 out of $2.3 billion in total cap-ital expenditures, and $0.5 billion more on PTC inthe future. The Association of American Railroadsclaims PTC will prevent few accidents and providelittle economic return to shareholders. We con-sider legislators lacking long-term or broad nation-al freight transportation perspective to be one ofthe greatest risks railroads face.
Management
 | 17 Jan 2014
Since Michael Ward took the reins as chairman,president, and CEO in January 2003, CSX has gen-erated truly impressive results. This success wasachieved during a period when all railroads real-ized excellent performance, but we believe Wardhas accomplished a lot, particularly in driving oper-ating ratio improvement. Railroads pay executivesuites well, and CSX is no exception. Ward's $8.1million in total 2012 compensation included $1.1million in salary, $6.1 million in stock awards, and$0.8 million in nonequity incentive plan compensa-tion. Current COO Oscar Munoz served as CFOfrom 2003 to 2012, during CSX's tremendous mar-gin improvement. Solid leadership in operationshas been instrumental in CSX's success. Beforethe 2004 arrival of Tony Ingram, CSX had 10 COOsin the prior decade. Ingram retired in 2009; beforehis stability, each new COO's changing initiativesand operating philosophies made CSX's failure torun as well as other railroads no surprise. CSXpaid Munoz $3.7 million in total during 2012, andbeyond Ward and Munoz, paid total compensationbetween $2.0 million and $3.8 million to four addi-tional named executive officers. Big picture, weconsider CSX to be a prudent steward of share-holder capital as a result of continued investmentin maintaining the rail network and growing inter-modal capacity, as well as the return of cash toshareholders via an increasing dividend (doubledfrom 2008 to 2012) and sizable share repurchases
Release date 04-17-2014
©2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. Theinformation contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
 ß
®
Page 2 of 33Release date 04-17-2014
©2014 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. Data as originally reported. Theinformation contained herein is not represented or warranted to be accurate, correct, complete, or timely. This report is for information purposes only, and should not be considered a solicitation to buy or sell any security.Redistribution is prohibited without written permission. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.
 ß
®
Page 2 of 33

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