One of the leading indicators in the market is the health of the transports, especially US rail. This company is giving off every indication that the economy may be on the mend sooner than we expect, observes Taesik Yoon of Forbes Investor.

CSX (CSX) is a leading domestic railroad operator. The company provides rail, intermodal, and rail-to-truck services via 4,164 locomotives and nearly 70,400 freight cars over 21,000 miles of tracks. Its railroad infrastructure connects 23 states in the Eastern US, the District of Columbia, and the Canadian provinces of Ontario and Quebec.

The company’s services fall into several categories. The Total Merchandise category, which produced 55.6% of all revenue through the first nine months of 2012, provides freight transportation for customers in eight major market segments: agricultural products, phosphates and fertilizers, food and consumer, chemical, automotive, metals, emerging markets, and forest products.

The Coal category, which generated 27.3% of revenue, delivers coal, coke, and iron ore from coal-mining customers in the Appalachian mountain region and the Illinois Basin to electric utilities and industrial manufacturers in the Northeast and Mid-Atlantic. It also transports coal shipments for export.

Intermodal (13.8% of revenues) provides coast-to-coast intermodal transportation services through company-operated trucks, terminals, and containers. Intermodal transportation can offer significant advantages over traditional long-haul trucking by combining the cost savings of rail transport with the flexibility of short-haul trucking.

Finally, the Other category includes revenues from demurrage, switching charges, and other incidentals, which added 3.3% to the company’s top line.

Because each major US railroad operator covers a specific region with little overlap, railroaders work in cooperation with one another to complete customer orders. As such, CSX’s real competition comes from the trucking industry.

Rail tends to be slower and less flexible than trucks, but rail rates are generally lower. Better fuel efficiency also makes them more attractive in a rising fuel cost environment.

Analysis
CSX’s stock is down about 9% since it reported third-quarter results a little over a month ago (on October 16), and is down more than 15% since mid-September.

The primary concern is weaker coal volumes stemming from lower demand by electric power producers, who have excess coal inventories due to a mild winter and lower natural gas prices (which has made it an attractive alternative to coal for power generation). Indeed, fellow railroad operator Norfolk Southern cited weak coal volumes as a key reason for disappointing Q3 earnings.

While CSX’s own Q3 results fared better, domestic shipments of coal fell 29% in the quarter. This soft coal demand environment is expected to persist in Q4 and continue well into 2013. Due to the severe droughts in the Midwest earlier in the year, agricultural products volume will also remain weak in the foreseeable future. This is likely to limit revenue growth and margin expansion over the near term.

Other concerns include the moderating pace of economic recovery in the US, which could lead to slower-than-expected growth in merchandise volumes, and the negative impact of operational disruptions stemming from hurricane Sandy.

Nevertheless, there’s still a lot to like about CSX in our view. Due to the quasi-monopolistic nature of the US railroad industry (with each operator responsible for a specific region) and the high barriers to entry, the company’s operations and profit margins are more stable than those of other cyclical businesses. This limited competition has helps CSX generate fairly steady cash flow and pay a growing dividend that currently yields about 3% annually.

Thanks to the stock’s recent slide, CSX is trading at its lowest level in more than a year—at just ten times expected earnings for 2013. This is among the lowest in the railroad industry, and well below its average forward price-to-earnings multiple over the past five years. It also strongly indicates that company’s current concerns are more than priced in.

Furthermore, we have been encouraged by the steady rebound in natural gas prices since April. Indeed, gas prices are at their highest levels in over a year, and are approaching $4 per 1,000 cubic feet. A continual rise in natural gas prices should eventually result in electric power producers switching back to coal. This would lead to a faster workdown of customer coal inventories and stronger-than-expected operating results, especially in the second half of 2013.

Despite the more challenging near-term market environment, management still believes CSX can achieve its goal for an operating margin of 35% by 2015. Clearly, investors have their doubts. Quite frankly, we do too.

Fortunately, the stock’s recent sell-off implies the current bar is set much lower. Thus, we believe CSX’s share price offers a compelling entry point for those investors willing to employ a little bit of patience. The stock’s generous dividend yield also affords the benefit of getting paid while you wait.

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