3 Problems That Aren't Going Away

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Anyone who has read much of my posts over the last year or so knows that I like railroad stocks. The industry gives investors a great way to keep up with multiple areas of the economy. The companies themselves seem poised to grow earnings as the economy recovers as well. I've made the argument that Union Pacific (NYSE: UNP) is the leader in the industry, but up until recently I've considered CSX (NYSE: CSX) and Norfolk Southern (NYSE: NSC) to be nearly interchangeable. However, CSX's last earnings report is causing me to rethink this comparison. The company has several problems that aren't easy to fix, and it's becoming apparent that these challenges are here to stay.

An Economic Forecast In An Earnings Report
CSX is a stock I've followed for many years. My family has multiple generations that have worked for the railroad, and I've often used CSX's earnings reports as a cheat sheet to see how different industries are doing. Railroads transport both raw materials and finished goods. There is a good chance that volume growth in a particular industry is tied to better performance in the future for that industry's main players. 

For instance, the fact that CSX saw a 15% volume increase in their automotive shipments should be good news for companies like Ford and GM. Since Union Pacific saw a 14% increase in automotive volumes, and Norfolk Southern said automotive volumes were up, this is a huge tip that there is strong demand for vehicles. On the flip side, the fact that coal volumes were down 18% at CSX, 23% at Norfolk Southern, and 7% at Union Pacific, can't be good news for investors in the coal industry. If you want to know what's happening with the economy, pick up a railroad earnings report. However, this information is freely available to anyone, and not a good enough reason to buy shares.

Like A Domino Effect
CSX has three issues that are built upon one another. The first issue is the company is too reliant on coal shipments, which is leading to cash flow challenges. In fact, CSX's percentage of coal volumes is higher than either of their main competitors. Coal volumes represented 25.90% of CSX's total shipments, versus 24.48% at Norfolk Southern and 20.08% at Union Pacific. The 18% decline in coal shipments thus hurts CSX more than their competition. Though the company's EPS was flat, their operating cash flow declined over 15% on a year-over-year basis. Compared to a 5.02% decline at Norfolk Southern, and a 4.9% increase at Union Pacific, this problem almost jumps off the page. 

The second domino to fall is the fact that the company's free cash flow payout ratio has risen to dangerous levels. Most investors like to see a free cash flow payout ratio of no more than 70%. In the current quarter, CSX's payout ratio was 92.23%. By comparison, Norfolk Southern's ratio was 75.73%, and Union Pacific reported a ratio of just 47.30%.

When a company has lower operating cash flow, and a high payout ratio, something has to give. In CSX's case, what has occurred is their balance sheet is weaker than their competition. The company's debt-to-equity ratio is now 1.01. Looking at Norfolk Southern at 0.86 and Union Pacific at 0.44, CSX is again operating at a disadvantage.

In the industry, there is really no question that Union Pacific is the leader. The company outperforms its competition in nearly every area. Investors who have been hanging onto CSX shares should seriously consider switching tracks. Though analysts are calling for over 12% EPS growth from CSX in the next few years, I'm beginning to wonder if this will occur. The continued softness in the coal industry doesn't appear to going away. I might have suggested that CSX and Norfolk Southern were interchangeable in the past, but based on the current quarter that thesis is breaking down. Norfolk Southern has a higher yield, is less reliant on coal, and reported a much smaller decline in operating cash flow. Unless CSX can improve its cash flow and decrease its reliance on coal, the company will continue to be the caboose in this three train race.

MHenage has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus