Is CSX Gaining Momentum or About to Derail?

In the three-train race for the best railroad in the country, CSX (NYSE: CSX  ) has been gaining ground on category leader Union Pacific (NYSE: UNP  ) . The good news is that the company is still improving its operations. The bad news is that there are still challenges to overcome if it hopes to become the best in the industry.

Improving in key metrics
CSX and its peers report two primary numbers to record the efficiency of their operations. The first is quarterly train speed, which is important in the railroad business because the faster the trains get to their destinations, the more efficient the company. The second number these companies use is dwell time to record how long their cars sit in the yard. Of course, the longer railcars sit in the yard, the less efficient the operation is.

One way to determine the most efficient operator is the one with the best ratio of train speed to dwell time. The higher the ratio, the more efficient the operator. Look at how the big three railroads perform on these measures:

Name

Quarterly Train Speed

Dwell Time
(hours)

Ratio of Train Speed to Dwell Time

CSX 

23.0 mph

21.9

105%

Norfolk Southern (NYSE: NSC  )

23.8 mph

21.0

113%

Union Pacific 

25.7 mph

26.6

96.6%

Source: SEC filings.

While CSX has the second-best ratio, the company was the only one of the big three to report an improvement in train speed on an annual basis between the second quarter of 2012 and the second quarter of 2013. When it comes to dwell time, CSX reported a near 6% improvement, which was better than Union Pacific's decline of 4%, but not as good as the 10% decline at Norfolk Southern. The bottom line is, CSX is getting better but isn't in the top spot yet.

Three challenges are derailing the company's momentum
One of the issues that is holding back CSX is also hurting Norfolk Southern. Both companies reported declines in coal revenue. Luckily for CSX investors, the company's 6% year-over-year decline was nothing relative to the 17% annual decline at Norfolk Southern.

If Union Pacific was hurting from a coal revenue decline as well, we could write this off as an industry problem. However, Union Pacific reported a 12% increase in coal revenue, which calls into question the idea that this is an industry problem and suggests that maybe this is more of an east coast issue.

The second challenge facing CSX investors is that the company is retiring shares at a slower pace than its competition. From June 2012 to June 2013, CSX was the only railroad of the big three to retire less than 2% of its diluted shares. With Union Pacific and Norfolk Southern retiring relatively more shares, CSX investors are getting the short end of this stick.

The third issue that CSX needs to find a way to solve is that the company is using more of its core free cash flow (net income + depreciation – capital expenditures) on dividend payments. Using core free cash flow gives investors a clearer picture of a company's cash situation as it strips away non-cash items. Using this metric, CSX used just over 65% of its core free cash flow on dividend payments in the first six months of this year.

While Norfolk Southern used just under 65%, Union Pacific's free cash flow payout ratio came in below 54%. Between CSX retiring fewer shares and using more free cash flow on dividends, the company's investors are being shorted from both sides.

Getting back on track
If CSX hopes to be the best in the industry, the company needs to continue improving its train speed and dwell time. The railroad is doing better than Norfolk Southern when it comes to weak coal demand, but can't seem to catch up to Union Pacific's performance.

Between middle-of-the-road efficiency and midline performance in the all-important coal business, investors aren't getting the best performance in the industry. It shouldn't be a surprise that CSX may not have the cash to retire shares and cover its dividend as well as its competition.

If CSX can continue posting improvements in train speed and dwell time, the company's cash flow could improve as well. Better cash flow could mean better share retirements and a better payout ratio. Though investors will have to be patient, CSX is making strides in improving its core operations. With the company reporting earnings soon, investors should watch train speed and dwell time to see if this railroad is getting back on track or if investors' returns could be derailed.

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