CSX: Leading dividend growth stock for long-term investors (NASDAQ: CSX)
Time to discuss one of the few dividend growth stocks that I like, but don’t own yet. Florida-based CSX (NASDAQ:CSX) is the only US-based Class I railroad not in my portfolio and, despite its low yield, an attractive investment for long-term investors looking for a company with a broad moat. The reason why I am writing this article now is its poor performance due to general market weakness as it brings us opportunities.
I expect a significant increase in dividends this quarter
CSX is a Class I railroad based in Jacksonville, Florida which competes primarily with Norfolk Southern (NYSE: NSC) in the eastern United States. The company has a market cap of $76 billion, making it the second-largest publicly traded railroad in the United States behind Union Pacific. (NYSE:UNP).
As I briefly mentioned in the introduction, the reason I’m writing this article is the title’s poor performance. As I write this, the stock is down 9.3% year-to-date. It’s a mix of lingering uncertainties in the stock market and the stock’s quarterly earnings.
So that’s where I’ll start this article as I work towards the company’s expected dividend hike this quarter.
In its 4Q21 quarter released last week, the company reported revenue of $3.43 billion. That’s 21.2% higher than the year-ago quarter and $110 million higher than analysts expected. GAAP EPS came in at $0.42, in line with expectations.
The company’s revenue segmentation displays a few ongoing macroeconomic trends that I want to briefly highlight. One of them is coal straightening. Coal is back as 2021 saw production growth in all major economic areas of the world due to skyrocketing natural gas prices, increased demand and, therefore, the need for affordable energy sources. Coal accounted for 15% of the company’s revenue in 4Q21, with the segment growing 39%. Other segments showing economic strength also performed well, as chemicals, agriculture, minerals, forestry products, metals and fertilizers were all up.
And above all, even intermodal is on the rise, which is remarkable. Intermodal is a problem for many players due to port congestion. The company was able to offset the problems caused by trucking (and related) shortages thanks to strong demand from east coast ports. I was pleasantly surprised, to be honest, as I had a hard time estimating how bad the situation on the east coast would be. The trucking segment is new due to the acquisition of Quality Carriers on July 1, 2021.
With that in mind, the company had some “problems.” The company’s cost/income ratio increased by 310 basis points to 60.1%. Note that the operating ratio shows operating costs as a % of total revenue. In other words, the costs of operations. The higher it is, the worse it is.
The higher operating ratio is why the company was unable to beat EPS expectations despite the revenue. The company suffered cost increases due to higher inflation, labor shortages, increased demand due to higher deliveries, etc. For example, labour, which accounts for one-third of total expenses, increased by 20%. Purchased services are up 44%. Fuel costs increased by 103%.
And on top of that, the company reported that supply chain issues had impacted its operations. Only 65% of trains were on time (instead of 69%). Energy efficiency decreased by 5%, downtime hours increased by 8%, and personal injury increased by 5%.
The rising cost pressure is expected to last as analysts expect the company to post EBITDA margins close to 53% in 2022 and 2023. Still, free cash flow generation is expected to remain strong. This year, the company is looking to exceed $3.8 billion in GAAP free cash flow.
A simpler way to think of free cash flow is net income adjusted for non-cash items after capital expenditures on business services (i.e. investments in maintenance and new equipment) . Capital spending is expected to be $2 billion in 2022, slightly above analysts’ expectations and why the stock fared poorly after earnings.
Yet, that’s where the bad news ends. $3.9 billion in free cash flow expected this year is a fantastic number. That’s 5.1% of the company’s $76 billion market cap.
This is one of the highest values (see graph below) since the railways began to dramatically increase their operational efficiency after the Great Financial Crisis. It’s also important because it means investors aren’t paying too much for access to free cash flow – and that’s what (growth) dividend investing is.
For example, right now, the stock is down 1.1%. This is one of the lowest numbers ever recorded.
However, CSX has “never” been a high yielding stock for one big reason: it has the ability to dramatically increase dividends. There is no reason for investors to allow yields to reach high levels.
The 5.1% free cash flow yield I just calculated shows that there is huge room to increase dividends. And that’s what the company did. On February 10, 2021, the company increased its dividend by 7.7%. In February 2020, the dividend was increased by 8.3%. In 2019, the company increased the payout by 9.1%. In 2018, this number was 10%. In 2017, management approved an 11.1% increase.
Excess cash is almost entirely spent on share buybacks. In 2021, the company paid nearly $840 million in dividends. Still, buyouts were valued at $2.9 billion. Between 2016 and 2020, the company bought back a fifth of its outstanding shares. This results in higher earnings per share and drives up the stock price. For example, in 4Q21, earnings per share increased by 27%. Total revenue increased by 23%.
The downside is that investors don’t get a high return.
Based on everything so far, I think investors will benefit from a dividend hike of at least 10% in February.
Valuation & Outperformance
Currently, CSX has an enterprise value of approximately $14.1 billion. It is almost entirely long-term debt. Adding the market cap of $76 billion, we get an enterprise value of $90.1 billion. This is 11.9 times next year’s EBITDA of $7.6 billion (expected). It’s not cheap, but it’s also far from overvalued as the (expected) valuation has fallen back into the 5-year valuation range.
One of the reasons the stock is down is the decline in economic sentiment. CSX stock price is now up about 16% year over year. This performance is strongly correlated with forward-looking economic indicators such as the Empire State’s manufacturing index. If the US economy does indeed weaken, we could see a further 10-15% drop in the stock. This would bring the total sale to 20-30% of the stock’s all-time high.
Now, I’m not saying that’s going to happen, but it gives you an idea of what to expect when economic growth weakens and when to buy CSX if you want to wait for a bigger correction.
Apart from that, the valuation is already improving. EV/EBITDA dipped below 12x as I showed, and free cash flow yield brought it back above 5.1%.
And to give you a good reason to buy this stock despite its low yield: investors have consistently taken advantage of the outperformance. Since 2000 (the stock market bubble) the stock has consistently outperformed the S&P 500. Not a bad thing considering CSX is a “boring” railroad with very slow growth in shipments and the fact that the S&P 500 is very technological.
CSX is doing so well because it has a wide moat (few competitors), the ability to take pressure off a tight trucking industry, and it’s a major ESG (environment, social, governance) player because it’s capable of transporting goods much more efficiently than trucks.
To take with
This was the takeaway I gave readers in October of last year.
My advice is quite simple. If you are a long-term dividend (growth) investor, keep buying the stock on weakness (>10% corrections). This is when I add significant exposure to my existing trades. If you’re not long yet, you can obviously wait for a correction to occur, but it’s safer to buy now and keep adding over the long term. Especially if you expect to hold out for decades, there’s no need to wait for the perfect entry – mainly because I think the CSX rally has more upside.
As we are now in a 10% correction, it is warranted to start buying larger positions. IF (not when) performance worsens by -20% from the stock’s all-time high, that warrants even larger purchases (all within reason).
When I trade, I cut the losers and run the winners. When I’m dealing with investors focused on long-term dividend growth, I love when I can buy more in a downtrend. It gives us a better return, a better valuation, and it will have a major impact on long-term performance.
The only reason I don’t own CSX is because I own 3 other railroads. One of them (Canadian Pacific) is comparable. At least as far as its low performance is concerned. If CSX drops enough, I could invest my dividends in the company and own it after all.
(Disagree? Let me know in the comments!