This article is a follow-up of a series I recently published on SA to share some research I have been carrying out about North-American class 1 railroads. The series was introduced by this article: “Learning From Buffett About Investing In Railroads: The BNSF Case Study.”
I recommend reading it because it explains thoroughly what I have found out about the way Warren Buffett thinks about the railroad Berkshire Hathaway (BRK.A, BRK.B) owns. The approach I am taking to assess the company comes directly from what I am learning from Buffett and can, therefore, be a little bit different from other ways to value a company.
For those interested in reading the previous episodes, here are the links:
- Looking At Railroads As Mr. Buffett Does: Canadian National Railway (CNI)
- Looking At Railroads As Mr. Buffett Does: Canadian Pacific (CP)
- Looking At Railroads As Mr. Buffett Does: Norfolk Southern (NSC)
- Looking At Railroads As Mr. Buffett Does: CSX
- Why I Want To Buy Canadian National Railways Company
Summary of previous coverage
The most important thing that sparked my interest in railroads was reading what changed Mr. Buffett’s mind about this business. He claimed for years that capital intensive businesses should be avoided. However, he then realized that these businesses shouldn’t be shunned as long as there is a reasonable expectation of decent returns on the capital employed by the business. In the case of railroads, we are before a regulated business. So, it becomes more important to be sure that the regulator allows enough room to railroad companies to achieve a decent return.
In order to assess what kind of return a company can make, Buffett has taught us to look at four aspects: earning power, efficiency, use of capital, and shareholder return.
Mr. Buffett has also kept himself true to his investing philosophy that looks for investments with some sort of a moat and that can benefit from macrotrends at play. In particular, class 1 railroads have a moat provided by their own railway infrastructure, which is costly and difficult to replicate. As far as macrotrends go, Mr. Buffett has highlighted more than once that he sees railroads enjoying three main tailwinds against trucks:
- cost and environmental advantages over trucking
- fuel efficiency that lead to better operating costs
- increasing need for freight trains.
First of all, we saw that the company many different sources of freight revenues, with coal, chemicals and agricultural products holding the first three places among commodities. Intermodal also plays a big role.
Now, regarding the most important metrics to look at railroads that we learned from Mr. Buffett we found out that its pre-tax earnings/interest ratio was 6.2, which is in line with most of its peers.
What we found out about the company’s efficiency was partly revealed by the fact that its operating ratio in Q2 2022 was 55.4%, which is a very good number.
As per fuel efficiency, CSX scores a 0.97 US gallon per 1,000 GTMs, which is in line with its peers.
Warren Buffett has stressed it many times that a company needs to be able to earn a decent return on the capital employed. I tried to calculate the company’s ROIC and the result 15.41%, well above the current cost of capital that is around 8-9%.
CSX Earnings Report
Since I recently published an article on CSX, I won’t spend many words on the company. For those who haven’t heard of it, it is enough to say that it is a class-1 railway company that operates mainly east of the Appalachians (though it stretches west to the Mississippi) and serves a territory where about two-thirds of Americans live. Its main competitor is Norfolk Southern.
Now, without further ado, let’s look at the results CSX reported for the past quarter. Here are the main highlights the company reported.
As we can see, revenue reached $3.90 billion which means that it increased 18% YoY. This was partly due to better pricing and party to the new and higher fuel surcharges. The company also reported a 2% increase in volumes, and an increase in storage and other revenues.
When we look at the operating income we see that CSX reached $1.58 billion a 10% increase YoY. However, due to additional labor and fringe expense related to tentative union agreements, the operating ratio, a very important metric for railroad companies, increased to 59.5% against the very good 56.4% of the same quarter in the prior year. We will get to this in a moment.
We then see that the diluted EPS of $0.52 increased 21% from $0.43 Q3 2021.
The picture shows a positive momentum for the company that seems to go on.
If we factor in that we are seeing some macrotrends that are leading to making the U.S. once again a manufacturing hub and a commodity exporter for the Western world, we have some big tailwinds for railroads in general and, in particular, for one such as CSX that has geographical exposure to many ports on the East coast where most of the traffic between the countries of the West takes place.
This was outlined by Joe Hinrichs, the incoming president and CEO, during the last earnings call:
Manufacturing investment in the United States is accelerating. We have great advantages in this market, and our customers should have every reason to ship more by CSX rail, but we have to focus our efforts to make this happen.
I think part of this trend can be understood by looking at the chart below, that shows the quarterly revenue mix with the YoY increases/decreases.
As we can see, everything is up, with automotive gaining traction as semiconductors bottlenecks are easing and car deliveries are increasing. With many automakers that have a backlog of at least 9 months, I am expecting CSX to post strong automotive numbers for the next three quarters.
Finally, we saw that in Q2, one of the way to offset fuel costs was to reduce train speed. During Q3 this trend has reversed and we see that not only train velocity is improving but also all the other main performance metrics are moving in the right direction, showing that CSX is once again walking the right path of improving its efficiency.
Key Buffett metrics
Let’s look at the earning power. It is important because it shows how much a company earns against its interest requirements. In other words, it shows if a company is able to pay its interests in any economic conditions. It is calculated as pre-tax earnings over interest. We have seen that the ratio was 6.2. If we look at the TTM, the ratio is now at 8, which makes the company even more solid before its creditors. I think investors can rightfully be satisfied with this noteworthy improvement.
Fuel efficiency, however, decreased and the company is now at 0.99 US gallons of fuel consumed per 1,000 GTMs. One may argue that this is linked with increased train velocity, but if we look at what I outlined about Canadian National we see that it can be possible to achieve both higher speed and better fuel efficiency. So, on this point, CSX underperforms its best peers.
Regarding the important ROIC, CSX does not disclose its ROIC. However, I calculated it using the formula (NOPAT/invested capital) and I got a 15.4%. With the TTM data now available I have a ROIC that decreased to 10.7%. However, it is still above the current cost of capital so I think it is acceptable.
In any case, I think it is clear now why in the title I stated that traditional metrics diverge from the ones Mr. Buffett uses. While I think the company is doing fine, I can’t say that, according to what I have learned from Mr. Buffett, it is improving its key metrics. This is an interesting case where if we look at a report with a different perspective from revenues, margins and EPS we may come across a picture that is a bit different from what we would think at first glance.
As I already said, I like CSX and I have it on my watchlist. The company confirmed its guidance so I didn’t revise the discounted cash flow model I shared in my previous article. However, since then, when I rated the stock a buy, the price has increased 14% in a month, also thanks to the recent rally we saw. Since in my bear case the upside I had was only 5%, I am changing my rating to a momentary hold because I think we are close to a peak for the near term. With a Quant Rating on Valuation of D-, it is possible to go long a stock only if there are very good reasons to pay such a premium. While I think CSX is better than Norfolk Southern at the moment, I see that according to some of the metrics I am getting used to look at the company’s performance went down a bit while its price went up. This make me stay on the sidelines, waiting for better opportunities while monitoring closely a company I would like to own.