CSX Corp (CSX): Rails still red hot ~ market folly

Saturday, April 19, 2008

CSX Corp (CSX): Rails still red hot

CSX: Buy, Target Price: $64, Time Frame: 6 months

Typically I don't like to recommend names that are just hitting 52 week highs because they usually pull back and consolidate after their big run. However, in CSX's case, the industry is simply seeing too much strength and thus the name should have continued momentum. It took out my last price target of $51 in no time. After re-evaluating things, its still a strong play. If you thought that in a 'weak US environment' that the rails would succumb to poor performance, then think again. If you've noticed the earnings reports from all the major US rails recently, you'd notice a distinct pattern: they're all beating estimates. No matter what kind of economy we are in, CSX keeps on chugging. CSX provides rail, intermodal, and rail-to-truck services in the railroad industry. As oil prices sky higher every day, planes and 18 wheelers are looking more expensive and less attractive to transport items with. Therefore, look to the rails. As the media has hyped the last few months or so, Warren Buffett has taken a large position in the railroads recently, and rightly so. He was a little early to the railroad party, as he experienced some downside in the late summer, but nevertheless it was the right call. And, in this recent downturn, Buffett has again added to his rails position, signaling his strong belief in the core business. Rails will be a solid form of transportation whether we continue to see great global growth or whether we experience a recession. How is this possible though? Rails can sustain current profitability in a recession? Well, yes they can and its because of two things: agriculture and coal. Prices of coal and ag related commodities have skyrocketed. Thus, these products are in high demand and need to be transported constantly. These two commodities are seemingly recession proof as well, as record earnings from Potash, Mosaic and others indicate. So, even if a recession is among us or headed our way, the rails will still profit. And, as CSX's most recent earnings indicate, the rails see continued strength due to commodities demand.

Fundamentals: With a trailing PE of 19 and a forward PE of 14.5, CSX shows its increasingly rich valuation due to share price appreciation. But, this move is a fundamental move and thus allows CSX to trade at a higher multiple. Its PEG of 1.01 is decent but nothing spectacular either. Its price to sales ratio of 2.4 indicates that it is undervalued, as any PS ratio under 5 deems this. Also, its price to book of only 2.8 shows that CSX is indeed undervalued by this metric as well. Buffett likes to see PB ratios of as close to 1 as possible, and CSX is right there. The rails core business is also strong with solid operating margins of 22.2% and a return on equity of 13.9%. This ROE is slightly low when compared to Buffett's typical standard, but he makes an exception seeing as all the rails have typically lower ROE. So, as you can see, it has some decent valuation (rising multiples due to industry strength) and is even deemed undervalued by certain metrics. CSX will continue to grow and beat estimates as long as the commodity race continues. Agriculture's secular growth is a key component of CSX's ability to withstand any recessionary pressures. And, we all know this secular growth will continue as commodities demand and prices sky higher every month.

Taking a look at a 1 year chart of CSX reveals a strong uptrend with noticeable dips for buying opportunities. If you don't want to hold this one long term, you could technically flip it each time it hits the dips, as the trend is very distinct. Be warned that there might be some near term downside, but it should be limited. After all, consolidation after big moves is necessary and healthy. As mentioned earlier, the rails are being fueled by strong commodity demand and are constantly transporting agricultural products. Strong fundamental strength here is why the chart looks so bullish.

Institutional Ownership: I've been following hedge fund activity as you can really see what sectors prominent funds are heavily weighted in. I could take all the research I do on all my stocks combined and it would still be less than what some of these funds do with their research and trading teams for this one stock alone. So, why not take their lead as an indicator of where to head. After all, if you follow the prominent hedge funds (ones that return greater than 30%) you are in good hands. So, hedge funds are currently heavily weighted in rails. Like I said earlier, Buffett got into rails early, and I think even some of the hedge funds are piggybacking Buffett's idea for longterm value. So, prominent hedge funds are heavily invested in rails and in particular in UNP, and more importantly, CSX. Taking a look reveals that Atticus Capital and Tudor Investments are two majority owners of CSX. In fact, CSX makes up 4% of Atticus' portfolio. And that actually says a lot, as hedge funds hold so many different positions at any given time. They are betting big time on long term growth for CSX. Also, Carl Icahn's fund Icahn Management and Daniel Loeb's fund, Third Point are big holders of CSX. In fact, BOTH recently upped their ownership to 2.9 million shares and 2.0 million shares respectively. Both increased their positions by at least 300,000 shares each. There are many other hedge fund holders of CSX which shows an overwhelming majority, and I have only chosen to highlight the most prominent names in the space. Point is, big hedge funds are throwing big money into CSX for the long term based on its cheap valuation and their bullish outlook on the transports and particularly the rails. It should also be noted that activists Icahn and Loeb (just mentioned above) who own large stakes in CSX are calling for a split up of the company in order to extract most value. Basically, think MO (Altria) and apply it to the rails. Altria spun off Kraft foods first, and then recently just announced they plan to spin off Philip Morris International as well in order to enhance shareholder value. The same technique can be applied to CSX as Icahn's and Loeb's research points to a stronger valuation for CSX if it is broken up. So, look for that catalyst to move the stock sometime within the next year as well. Rumors are already surfacing that Icahn and Loeb have begun their activist quest. So, there you have it. CSX and the rails in general are being picked up left and right by institutional and hedge fund money.

I'm not going to cut and paste the recent earnings numbers because they're readily available on Yahoo/Google finance. If you pay any attention at all to this sector you know that it is seeing underlying strength and that's all there is to it. There are simply way too many reasons to own the railroad sector, and CSX in particular. The stock is pegged for future growth. CSX benefits from any future rise in oil prices as other forms of transportation become extremely expensive. Also, the rails will continue to drive profits from transporting the heavily desired agricultural goods. Warren Buffett staked himself in the rails earlier last summer ahead of the crowd, and numerous prominent hedge funds also have taken large positions in CSX. Buffett even added to his rails position in BNI again over this most recent sell-off. Lastly, activist investors amongst those hedge funds will also look to split up CSX to extract the most shareholder value possible. Look for CSX and the rails in general to see continued slow and steady growth. The secular growth from agriculture and other commodities is simply too great to be ignored. While we may be in a recession, you can still find solid places to put your money to work: secular bull markets. And, the rails are in one with their strong tie to commodities.

CSX: Buy, Target Price: $64, Time Frame: 6 months