Analysis: the message is one of caution as CSX cuts back on capital spending

© Wangkun Jia

US freight rail operator CSX recently reported a trading update that may have pleased some shareholders, but also pointed to a very challenging outlook and highlighted a few risks surrounding its capital allocation strategy into 2017.

A 13% drop in fourth-quarter revenue came on the back of declining fuel surcharge recoveries and lower volumes, which jointly pushed down its top line by $400m, to $2.7bn from $3.1bn a year earlier.

That fall was mitigated by cost efficiency measures – as a result, earnings per share (EPS) held up at $0.48, and were broadly in line with EPS of $0.49 in the fourth quarter of 2014.

Unfortunately, this is where the good news ends.

Management

Management sent a message of caution in a conference call with analysts on 13 January – there is no recovery around the corner in the freight industry across the Atlantic. Chief executive officer Michael Ward said that “strong pricing in quarter four” had been more than offset by weak volumes and other items.

Fourth-quarter expenses decreased, yet the drop in operating costs was not enough to shore up operating income, which dropped 12% to $791m.

CSX’s stock price has plunged almost 40% from a 52-week high of $37.6 in early May 2015, and management knows solutions are needed. It said last Monday that as it “continues to match its network resources to business demand and drive additional efficiency … it is consolidating its operations administration from ten divisions to nine and closing administrative offices at Huntington, West Virginia”.

This was unsurprising. Its operating ratio (operating costs/sales) improved 20 basis points to 71.6% in the fourth quarter, and got closer to 70% for the full year – in fact, CSX pointed out that in 2015 it recorded the “first sub-70 full-year operating ratio at 69.7%”.

That says a lot about where things are going and why consolidation in the industry might be needed if the business cycle doesn’t roar back by 2020.

CSX is a solid company that operates in a highly regulated industry, but its plan now is to cut heavy investment, while targeting an operating ratio around the “mid-60s” level over the longer term as short-term hurdles are apparent.

In fact, management indicates that negative global and industrial market trends will lead to lower EPS in 2016. The pain is being felt across a vast number of sectors, even though it was full-year coal revenues that were hit hardest, plummeting $1.4bn, down from $3.7bn to $2.3bn.

Chief financial officer Frank Lonegro noted that CSX expected volumes “to decline in the first quarter [and] the challenging freight environment to continue as the headwinds associated with coal, low commodity prices and a strong US dollar more than offset the markets that will show growth.”

The majority of its end markets remain under strain into the first quarter, although, according to CSX, the outlook is “favourable” to “neutral” for automotive, minerals, waste and equipment and intermodal.

In this context, “service measures continue to progress well as we enter 2016,” Mr Ward said – adding “Chicago operations have now been fluid for nearly 12 straight months.”

Financials

Inevitably, the spotlight now is on dividends and buybacks.

If CSX had not shrunk its average share count to 973m in the fourth quarter of 2015, from 995m in the quarter before, its EPS would have been closer to $0.47 than $0.48.

For the year ended 25 December 2015, it reported EPS of $2, which implies a 4.1% rise from $1.92 in 2014. Its EPS, however, would have been $1.96 if CSX had not reduced its average shares outstanding to 984m from 1bn.

From a cursory glance this does not appear a big change, but it is actually a pretty important detail, given that buybacks did not help CSX shore up its share price last year, when it repurchased its shares at an average price of $30.90, which represented a 35.7% premium to its closing price of $22.70 at the end of last week.

As it said in its annual results released last week, it bought back 26m shares at a cost of $804m – and that amount is barely covered by its core free cash flow. It means that CSX decided to spend $201m for each percentage point in EPS growth last year.

Meanwhile, 2015 dividends – which are financed by debt, unless we assume that debt is used to finance buybacks – grew 9.5% from $626m to $686m.

The disconnection between share price and dividend per share (DPS) has become more evident in recent months – DPS stood at $0.70 in 2015, for a trailing yield of 3%, which is well above average. If your name is on the shareholder register, here’s why you should bother.

Yield and safety

CSX is cutting core capital investment – which includes infrastructure spending on “rail safety and performance”, as well as equipment “focused on upgrading the locomotive fleet”, it said in a presentation last week.

Yet it could continue to grow its dividend at about 10% a year – just as it did in 2015 and in 2014. Its dividend cover is safe at 4.9 times, but there’s a possibility that downside risk for shareholders will stem from dividend risk if market conditions remain challenging.

On top of that, when it reported 2014 results on 14 April 2015, CSX said that its $2bn share repurchase programme was expected to be completed over the next 24 months, which means that there is still some $1.19bn to be spent by early 2017.

CSX may well decide to reduce buybacks – it’s rather implied in its 2016 EPS guidance, in my view – but that would put even more pressure on its falling stock market value, assuming its end markets do not recover.

Its cash balances stood at $628m at the end of 2015, and were only $41m lower than in 2014, so there is plenty of time to address the situation at a time when Canadian Pacific is pulling all the stops to acquire Norfolk Southern, which geographically remains its closest rival.

Yet there’s another issue that is set to become even more important these days – safety.

“Our commitment to safety defines who we are at CSX,” it says on its website.

The Wall Street Journal reported on Friday that Canadian Pacific “faces an additional obstacle in its uphill effort to combine with Norfolk Southern, as federal regulators are concerned that mergers of major freight railroads can undermine safety.”

We’ll see how this one goes.