Under its former CEO, the late Hunter Harrison, CSX (NASDAQ:CSX) fully embraced what it called precision scheduled railroading. As a result revenue rose, margins improved — and the CSX stock price shot higher. CSX shares have been the best of any railroad over the past three years, rising 134% against the Dow Jones U.S. Railroads Index’s 88% gain.
And precision scheduled railroading was a big reason why. But of late, the gains in the CSX stock price have slowed noticeably. In fact, shares are down 7% over the last year — while the railroad index has been roughly flat. There, too, PSR might be a big reason why.
After all, it does seem like the benefits have largely been achieved. But the risks from the strategy remain, while peers presumably have more room for improvement. As I wrote last month, it might seem strange that CSX has the best margins in the industry — and the lowest multiples assigned its stock. In the context of precision scheduled railroading, however, that seeming contradiction makes a lot more sense.
Are PSR Gains Already Baked Into the CSX Stock Price?
At the moment, CSX seems to be outperforming all of its railroad peers. Its 2018 operating ratio was 60.3%, the lowest among North American railroad operators. Norfolk Southern (NYSE:NSC), for instance, is hoping to get to that level — by 2021. The two Canadian majors, Canadian National Railway (NYSE:CNI) and Canadian Pacific Railway (NYSE:CP), are a full point higher.
But, again, one question is whether that’s necessarily a good thing looking forward. After all, its peers have more room for improvement and thus more room for margin expansion and earnings growth. Norfolk Southern, for instance, plans to cut its operating ratio by five points, which suggests a double-digit percentage increase in its margins.
To be sure, CSX’s improvement isn’t over. After the second quarter, the company issued guidance for an operating ratio this year that gets below 60%. But there’s simply less room for cost cuts, and for growth at this point. And perhaps more importantly, there are questions about just how far CSX has cut its operating ratio and what that might mean going forward.
Has CSX Gone Too Far?
One of the attractive aspects of the railroad business is that operators have monopolies in many aspects of their businesses. As the Jacksonville Business Journal noted in a feature on CSX last week, the majority of rail customers have no second carrier to use. Those customers in theory could use other transportation providers like FedEx (NYSE:FDX), United Parcel Service (NYSE:UPS) or trucking companies, but in many cases those options simply aren’t feasible.
In part due to that fact, railroads are regulated by the federal government. The U.S. Surface Transport Board, in particular, has authority over rate disputes. It’s already made changes that are seen as favorable to shippers. And as the Business Journal detailed last week, those shippers are increasingly frustrated with CSX and the results of precision scheduled shipping.
A May hearing saw so many complaints that a second day needed to be added. Those complaints ranged from small businesses to massive corporations, with the Journal specifically noting the complaints of Molson Coors (NYSE:TAP) and chemical giant Olin (NYSE:OLN).
And those complaints follow several service issues that arose after Harrison’s arrival. A Tennessee Pringles factory nearly went under after delays in raw material shipments. A Kellogg (NYSE:K) plant had to suspend production. Federal intervention was required to get feed to Florida dairy cows.
The Risks to CSX
These issues set up several risks. First, shippers can move to alternative methods. With a driver shortage easing, and fuel costs low, trucking has returned to being a more viable competitor.
Second, regulators can step in. Rate disputes can go shippers’ way, pressuring margins. And the Journal notes that fees have skyrocketed, growing 94% in 2017 alone. A crackdown on those fees could hit revenue — and profits — given the enormous incremental margins.
More broadly, there’s a question of just how much CSX can really wring out of PSR. It’s already helped on the margin front. The fees, ostensibly designed to motivate shipper performance by improving efficiency across the system, aren’t going to double every year. CSX notes that they represent just 3% of total revenue — but, again, they drop almost completely to the bottom line. Their impact on profit isn’t necessarily transformative, but it’s likely material.
Is 15x Forward Earnings Really Cheap?
None of these issues, on their own, can devastate CSX. Customer complaints are common in every industry. President Donald Trump’s administration, in particular, has been friendly to business. Fee revenues are a small portion of the overall top line.
But in sum, they do lead to the question of just how much growth is left. And, as the Journal notes, CSX has changed its calculations of key figures, including operating ratio. That figure now includes the impact of real estate sales, which can’t last forever. That does suggest operating ratios aren’t quite as low as they appear, which is potentially good news. But it also suggests slowing improvement going forward in a market that may be expecting steadier decreases.
If internal improvements are near an end, the case for CSX stock becomes much tougher to make. A forward price-to-earnings ratio of 15 does sound cheap — but it’s not terribly so for a company that still has cyclical exposure. Coal shipments are declining, a risk for the industry.
This is not to say that CSX stock is a short, or close. It’s still a great company in an attractive industry. But I asked last month if peers might be more attractive, and increasingly that looks like it might be the case. CSX has driven enormous gains in a short amount of time. The benefits of those improvements look priced in. The risks they’ve created might not be.
As of this writing, Vince Martin has no positions in any securities mentioned.