Is this Railroad the Bargain of the Century?
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Railroads have been on a tear ever since Warren Buffett bought Burlington Northern Santa Fe during the 2009 freight recession. Railroads are notorious for trading at high multiples, so they rarely look attractive from an investment standpoint. But CSX Corporation (NYSE: CSX) is incredibly cheap if it can continue to achieve management's targets.
In addition to operating in an industry with high barriers to entry, CSX has made enormous improvements over the last decade. The two factors, combined with excellent management, make the stock look extremely cheap at a recent price under $20 per share.
Powerful Barriers to Entry
Perhaps the most attractive aspect of the railroad industry is that the nature of the assets removes competition in a given geographic location. Once right-of-way is purchased and track is laid, it is uneconomical for another railroad to come in and compete. However, railroads must compete with alternative forms of transportation, such as trucks and barges, whose rights-of-way are subsidized by governments.
CSX's competitive advantage lies in its unmatched railway across the eastern seaboard; it connects Florida with New England and everything in between. Its geographic location has positioned it to be the leading carrier of coal in North America; coal accounted for 34% of revenues in 2011. The company also has exclusive Class I access in some parts of Florida.
Huge Improvements in Operations
Although the entire industry has seen higher profitability in recent years as gasoline prices continue to rise, no Class I railroad has improved more than CSX. The company has improved its operating ratio from 86.2% in 2002 to 70.9% in 2011 (operating ratio = 1 - EBIT, so lower is better). This operating ratio is in line with Union Pacific (NYSE: UNP) and Norfolk Southern (NYSE: NSC), but neither UNP nor NSC improved nearly as much as CSX.
In addition to an improving operating margin, CSX has also steadily improved the rate at which it converts EBITDA into free cash flow.
This is a testament to management's efforts to improve efficiency. Meanwhile, Union Pacific and Canadian Pacific (NYSE: CP) are now converting a lower percentage of EBITDA into free cash flow.
Management has made a point to buy back stock over the last few years. The company has repurchased $6.8 billion in stock over the last five years (nearly 30% of shares outstanding), including $1.56 billion (6% of shares outstanding) during 2011. The company is still buying back stock.
Management has also set aggressive targets for 2015, including an operating ratio of 65%, $5.5 to $6 billion in EBIT, and $3.09 to $3.36 in earnings per share. Assuming a 10x multiple of EBIT, the 2015 price per share will be $53 to $58 per share in 2015 if management hits its target. At a recent price below $20 per share, the company has a lot of room for coming up short before the shareholders lose money.
It's always tricky to value railroads because they frequently trade at absurdly high valuations. But investors can be confident that the price of gasoline will continue to rise, which will give more business to railroads like CSX. Investors can also take solace in the relatively little competition that takes place in the vast majority of railroad operations. If the U.S. economy sees a sharp rebound any time in the next couple of years, CSX could turn out to be the bargain of the century.
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