Eric Kobayashi-Solomon: Hi. I'm Eric Kobayashi-Solomon, Co-Editor of Morningstar's OptionInvestor. Today it's my great pleasure to welcome Keith Schoonmaker, who's Senior Equity Analyst in-charge of transportation stocks.
Keith, thanks for coming.
Keith Schoonmaker: Thanks for having me, Eric.
Kobayashi-Solomon: Just recently I did an option strategy on one of the stocks that you cover, CSX, a rail company. And one of the first things that really appealed to me about this is the nature of rails themselves. Can you talk a little bit about the competitive advantage of a rail?
Schoonmaker: Sure, I'd be glad to. Well, as we think about railroads in North America, there are only seven railroads now. Following the passage of 1980 Staggers Act, we went from about 40 railroads through mergers and acquisitions consolidated down to about seven now.
There are only two basically in each geographic region. CSX competes with Norfolk Southern.
Kobayashi-Solomon: And that's along the east, east coast side.
Schoonmaker: In the Eastern region, correct.
Kobayashi-Solomon: Florida to Canada.
Schoonmaker: Right. And we would say, there's these competitive advantages of just a colossal barriers to entry. It's going to be very, very difficult to build any new railroads.
Kobayashi-Solomon: Basically if a competitor wanted to go he'd have to buy real estate all the way up and down the East Coast, right?
Schoonmaker: It would be virtually impossible to erect a new network, very high expensive erecting yourselves, do a network like this.
Kobayashi-Solomon: Sure. Now let's turn a little bit to CSX. The thing that really interested me in CSX is that it seems like a turnaround story. From what you're saying before CSX wasn't a great operator. It seems to be operating better now. Can you tell me a little bit about that?
Schoonmaker: Sure. Since what we call the railroad renaissance began in about 2004, all of the rails improved their performance tremendously. However, CSX was a bit of a laggard compared to Norfolk Southern and some others. It had a lot of turnover in the Chief Operating Officer role and until Tony Ingram came in about 2004 and had a vision for what the railroad could be five years from now. Without so much turnover in their Chief Operating Officer role, CSX has made tremendous progress in their operations.
In fact, last year, Eric, when volume slumped about 15%, CSX still produced its own record operating ratio. This is basically a measure of profitability, costs over revenue.
Kobayashi-Solomon: Operating ratio, basically we want it to be as small as possible.
Schoonmaker: Correct, it's operating expenses over revenue, so smaller is better. One minus operating ratio is margin. So smaller is going to be more profitable railroad.
Kobayashi-Solomon: And even with the volumes really declining with the economic environment not being so great in 2009, even in the face of that they were more profitable.
Schoonmaker: Yeah, it was shocking to see it, Eric. You think of this industry as being an old, stodgy industry, fully unionized, highly asset intensive, perhaps the most asset intensive of any industry we can think of.
Kobayashi-Solomon: Heavy metal, right.
Schoonmaker: Lots of heavy metal, demand is very high, reinvestment every year about 15% to 17% of its revenue is reinvested in its network every year, so…
Kobayashi-Solomon: And even in the face of that, they're able to kind of improve their efficiency.
Schoonmaker: Right, improved efficiency, but higher profitability, strong cash flow just really surprisingly good results from CSX during this period. It's really conversion on the high performance of some of its peers.
Kobayashi-Solomon: That's terrific. Okay. So now I think I really understand this bull case. Let's talk for a minute about the bearish sources of uncertainty. Right now, the stock is trading for about $50. I think, your fair value estimate is…
Schoonmaker: Our fair value is $67, which push the stock in about a 4 star range for the equity.
Kobayashi-Solomon: Okay. So, the equity is at 4 stars, but actually what we did was receive some premium for selling the downside, so we're actually getting an effective buy prices of your 5 star price.
Schoonmaker: Sure. Let me tell you about what I see the downside here, Eric, what the risks are. I see some uncertainty concerning demand and some uncertainty concerning the risk of reregulation. CSX is more exposed as a percentage of total revenue to coal than any other rail. It derives 30% of its revenue from coal. This is both steam coal for utilities and metallurgical coal.
Schoonmaker: Industrial production was weak last year, so we saw tremendous inventory build at the utilities. Now they are taking less coal through the first and second quarter than they would have had they not built such a tremendous inventory last year when IP was so soft.
Kobayashi-Solomon: So basically the utilities are holding a bunch of coal so not as much needs to be put on the rails?
Schoonmaker: Sure, and we probably should put it in the past tense, because now we're approaching a level where we're seeing increases in demand for coal on a weekly basis.
Kobayashi-Solomon: That's good news.
Schoonmaker: It is. It is good news for the rails. The other risk I see Eric is the risk of reregulation. This can take several forms. The two principal forms are safety bills. Industry had a big Positive Train Control Mandate. This is an unfunded mandate from the federal government that's going to cause rails, the seven Class I rails to spend in excess of $10 billion over the next 5 to 10 years.
Kobayashi-Solomon: But this news has been in the market for a while.
Schoonmaker: It has.
Kobayashi-Solomon: It's probably priced in, right?
Schoonmaker: It has. It was in response to a tragic commuter train accident a couple of years ago, but it's been priced into the market, we would say for a year or so now since it was passed. The other risk is this reauthorization of the Surface Transportation Board, and this is a potential constraint on pricing. It also has some antitrust provisions in the bill. At this point however, we think there's still a lot of uncertainty, and that's what's causing the stock price to be suppressed a little bit.
Kobayashi-Solomon: And it doesn't seem like the railroads are really gouging their customers anyway, right?
Schoonmaker: Well, in my opinion they are not, Eric. I can only look at the average. I don't know the individual customer contracts. We can see what typically customers pay in each of the major commodity classes. And we also know that, as a whole, for all rail consumers, they are paying about half of the real rates that they paid in 1980.
Schoonmaker: I'd like to pay half of what I paid in 1980 for just about anything these days. So, I guess, we view the downside is somewhat limited, and we think that there is some uncertainty because of potential lower demand, but more so this uncertainty surrounding the reregulation of the industry.
Long run, it's probably true that cooler heads prevail, and we'd see Congress act with more encouragement towards the railroads.
Kobayashi-Solomon: It seems it's a green way to transport things. I mean, this is one of the things that I really liked about it. It seems like the downside is overpriced.
Schoonmaker: Well, you say green, it's also the most fuel efficient, four times more fuel efficient than trucking per ton mile.
It's certainly lower emissions. It's a better use of manpower, only two men to drive the locomotive and additional people to load, but much more manpower efficient compared to trucking, and much less wear and tear on the public assets, the roads, since the railways are purchasing their own roads.
Kobayashi-Solomon: Private assets, sure.
Kobayashi-Solomon: Well, Keith, thanks very much for coming in and for the great explanation.
Schoonmaker: My pleasure.
Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website where we have many more investing ideas based on Morningstar's fundamental research.