Like the rest of the railroad sector and market at large, investors in CSX (CSX) have not been able to escape the current woes. While lower fuel costs arguably provide a benefit, the plunge in demand in combination with the big operating leverage (many fixed costs, mostly depreciation of course) results in steep earnings declines.

After trading at a high of $80 ahead of the crisis, shares dipped to the 40s and have now recovered to about $60 per share. With the first-quarter earnings just being released, it is time to review the investment thesis after the company has seen structural improvements in recent years.

The Base Case

CSX reported its annual results on January 16, 2020, and an increased focus on margins by the company reveals that it was really managed for the benefit of maximizing margins, and not necessarily growth.

CSX reported 2019 revenues of $11.94 billion, a 3% fall for the entire year with fourth-quarter sales down 8%. Revenues for the year fell 4%, with pricing/mix impact having a net positive impact of 2%, as both numbers do not add up due to rounding.

The business has organized its activities around four major segments, of which the largest merchandise segment is split up across multiple sub-units. Merchandise revenues rose a percent to $7.6 billion as strength in agricultural markets, minerals and forest products was offset by modest weakness in automotive, fertilizers and metals & equipment. The other segments reported all declines in sales on the back of weaker revenues with coal revenues down 8% to $2.1 billion, intermodal revenues down 9% to $1.8 billion, and other revenues down 11% to just over half a billion.

The impact of continued net investments into the business (as depreciation terms are very long of course) resulted in the company typically spending more in capital expenses than depreciation expenses. Depreciation charges rose a percent, offset by a 4% cut in labor, 9% reduction in materials, and 13% reduction in fuel. With depreciation charges running at just above $1.3 billion, net capital investments are very limited with net capital spending seen at $1.4 billion for the year 2019.

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Amidst all of this the company reported a 2% increase in operating earnings to nearly $5.0 billion, as the operating ratio improved further to 58.4%. This modest growth was offset by slightly higher interest expenses, with net earnings up a percent to $3.33 billion. Thanks to sizable share repurchases, earnings per share were up 9% to $4.17.

With shares peaking at $80, earnings multiples seemed relatively reasonable at 19 times, although the underlying trends were not very strong, certainly not in terms of volumes and certainly not given the declines seen in the fourth quarter.

The Recent Numbers

Towards the end of April, CSX reported its first-quarter results, and while revenues and profits were down, that is not necessarily a contradiction compared to the fourth-quarter 2019 developments.

Revenues for the first quarter fell 5% to $2.86 billion with volumes down just a percent due to the secular headwind in coal and accelerated declines in automotive, offset by a relatively resilient performance across the other segments.

With costs down 7% amidst real efficiency gains in labor and lower fuel prices, operating profits fell 3% to $1.18 billion. These slightly lower earnings, some higher interest costs and a slightly higher tax rate resulted in net earnings being down 8% to $770 million, as share repurchases halted the decline in earnings per share to 2%, with earnings coming at exactly a dollar per share.

At this rate, the company could still earn $4 per share, yet the real issue is of course that no large impact was seen in the first quarter from the current crisis and the question is how much of an impact we could see.

The company ended the quarter with $2.5 billion in cash and investments, as $16.7 billion in debt results in a net debt load of $14.2 billion. Based on last year’s EBIT number of $5 billion and EBITDA of $6.4 billion, leverage ratios seemed reasonable at 2.3 times.

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So What Can The P&L Look Like?

Assuming a 10% decline in GDP which could easily happen on an annualised basis and assuming some price deflation, I could easily envision a scenario in which revenues would fall by 20%, indicating that the business would lose $2.5 billion in annual revenues.

There is some silver lining as the fuel bill totaled nearly a billion last year and this might easily be cut in half. Materials and labor costs surpassed more than $4 billion as well, as 15% cost savings in this area should save another $600 million. This means that in a bad case the deterioration in operating earnings amounts to $1.5 billion in such a scenario. That would still allow for net earnings of around $2 billion, or around $2.50 per share. Hence, when shares traded in the high 40s recently, multiples were similar despite the arguably great pressure on earnings, as leverage and liquidity seem very manageable.

Trading at $61 at the moment, multiples have risen towards 25 times assuming the earnings number above is reasonably correct, following a roughly 40% fall in earnings per share. Assuming earnings realistically come in between $2.50 amidst very challenging conditions now and $4 per share in good times, the current level at $60 reflects a market multiple around 18-19 times based on the average of the two. The balancing act remains very tricky with investors weighing the impact of the economic uncertainty with that of historically low interest rates.

Concluding Thoughts

In July of last year, I wondered if the company was pushing efficiency perhaps a bit too much, already noting that the company was underperforming in terms of volume trends, something which continued throughout the remainder of 2019 with CSX posting declines while peers were showing better numbers.

The aggressive measures being taken in recent years in an effort to boost efficiency might have resulted in too strong pricing, creating a tough operating space to grow volumes. This observation remains and is a key reason why I am approaching this railroad with some caution vs. peers on top of the usual concerns.

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Furthermore, weekly railroad data suggests volume declines in their 20s in the first weeks of April, making the realistic scenario outlined above perhaps not just realistic, but even aggressive as the situation and economic fallout are really severe. The 20% volume declines could hold up for a few more weeks in this status quo, as the question is if things will really improve when the lock-up ends, or if the economic deterioration hurts volumes even more.

Factoring everything, I like the valuation reset as I believe that railroads probably will do reasonably fine this downturn, operating under the mantra that business is bad, yet should gradually start to improve a bit in the months to come. The real issue is that valuations are not dirt cheap as the railroad sector has benefited from a re-rating of the performance amidst continued declines in operating ratios, as CSX has squeezed all the margin gains already.

I would require a special discount vs. some other railroads before getting really excited. At $60, I see appeal increasing, but not enough to start buying shares here.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.