CSX – mature, defensible, but with structural drivers

Forget tulips. One of the largest speculative bubbles in history occurred in Britain during the 1840s. In terms of scale, railway investment represented about half of the total investment in the economy in the middle of the decade, equivalent to a staggering 7 per cent of gross domestic product.

Investors piled in as railway stocks could be purchased with as little as a 10 per cent deposit. Buying on the margin has never had a happy history, but, after fortunes had been lost on the subsequent calls, the country was at least left with a network that drove economic growth for decades to come.

Across the pond, it was JP Morgan that financed the rapid development of railroad networks in the late 19th century. The great man’s enthusiasm is shared by Warren Buffett. Berkshire Hathaway holds a large position in Burlington Northern Santa Fe, the operator of the largest railroad network in North America. Others have followed suit. From 2006, Microsoft co-founder Bill Gates gradually became the biggest shareholder in Canadian National Railway through Cascade Investment. Even activist investor Bill Ackman has been getting in on the act. Shares in Canadian Pacific Railway (US:CP) now account for a significant slice of Pershing Square Capital Management’s equity portfolio.

But in the information age, why would investors with this kind of financial clout choose to invest in a mature, seemingly low-growth industry? Well, for starters, railway companies can maintain a competitive edge simply because of the barriers to entry, ergo the regulatory complexity and capital required to build a rival network – once these costs are sunk, they’re well and truly sunk.

Over the past few decades, the sector has consolidated to the point where only a handful of networks are in place in the US. So it would be fair to suggest that rail companies benefit from a wide moat. Even the low-growth narrative seems somewhat dubious when you consider that the Association of American Railroads predicts a 30 per cent increase in US freight movements by 2040. As things stand, freight railroads account for roughly 40 per cent of US long-distance freight volume, and 30 per cent of the nation’s exports.

One of the attractively rated companies within our US screen, CSX Corp (US:CSX) is well-placed to benefit from the expected growth in US freight volumes. One of the five leading North American rail operators, the Florida-based group’s network covers around 21,000 miles and stretches across 23 states, providing access to dozens of intermodal terminals that serve multiple modes of transportation such as trains, trucks, and ships with the aid of the global positioning system – an old industry meets the new.

CSX transports everything from agricultural produce to metals. Railroad freight is a good economic barometer of cyclical changes, so performance in 2022 has mirrored deteriorating economic conditions and softening consumer activity. The company’s shares have lost nearly a quarter of their value since the five-year high watermark recorded in the first week of January, yet the group’s recent third-quarter update provides cause for optimism.

Revenue reached $3.90bn (£3.39bn) for the quarter, an increase of 18 per cent year on year. The group registered net earnings of $1.11bn, up from $968mn in the same period last year. And despite the financial burden linked to ongoing union disputes, the operating ratio – operating expenses as a percentage of revenue – came in at a lowly 59.5 per cent. Five years ago, the rate stood at 67.4 per cent.

There are obvious macroeconomic headwinds around the corner, but analysts at RBC point to the potential for better-than-expected growth in auto volumes next year as supply constraints dwindle. CSX has also been expanding its workforce, which analysts think is feeding through to service improvements that will also prove supportive.

Even though inflation has been the chief economic bugbear in 2022, CSX should be able to maintain some top-line growth by expanding its average revenue per carload. Price pressures have also resulted in some shippers turning to low-cost alternatives. CSX management makes the point that, on average, freight railroads are three to four times more fuel efficient than trucks and produce 75 per cent less greenhouse gas emissions. That helps to explain why some environmentalists believe railroads will play a critical role in moving climate objectives forward. But it’s ironic that despite CSX’s green credentials, quarterly returns have been underpinned by increased coal volumes in response to the energy crisis.

Given the capital intensity of the business, a net debt ratio equivalent to 118 per cent of shareholders' funds is not surprising, and S&P gives the company a BBB+ (stable) credit rating. An enterprise/cash profit ratio of 10.6 sits well below the S&P 500 average, while the group’s free cash flow yield has expanded from 5.5 to 6.3 per cent over the past five years. The RBC analysts note CSX has begun trading at a discount to peers – a development it finds “puzzling”.

CSX isn’t about to set the world on fire, but the railroad sector offers better growth prospects than many investors would imagine. This quality stock affords a margin of safety and falls under what Buffett would probably characterise as a “set-it-and-forget-it investment”.