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What CSX's Earnings Are Saying About the Economy

By Lee Samaha - Updated Jan 21, 2020 at 9:27AM

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The industrial economy is starting 2020 in difficult shape, but railroads are improving operational performance and CSX expects improvement in the second half.

CSX's (CSX -4.27%) fourth-quarter earnings and guidance need to be put into context. It's no secret that the first quarter of the year is going to be a difficult one for the industrial sector. Railroad revenue is always correlated to growth in the overall industrial economy, and given the broad-based weakness as we begin 2020, it's hardly surprising to see CSX guide toward full-year 2020 revenue to be flat to down 2% from 2019. That said, the report/guidance wasn't that bad, and there was enough in it to make investors in the industrial and transportation sectors be positive. Let's take a closer look.

A railway track.

Image source: Getty Images.

Current trends in railroad stocks

Investors in railroad stocks already know that the railroad sector is facing a difficult year. The industrial sector is currently in contraction mode -- something you can see by the widely followed Institute for Supply Management Purchasing Managers Index survey. A reading below 50 indicates a contraction in the industrial economy.

US ISM Manufacturing PMI Chart

US ISM Manufacturing PMI data by YCharts

The broad-based weakness in the industrial economy is also reflected in the Association of American Railroads rail traffic data -- the latest data shows total rail traffic down 7.6% on a year-to-date basis -- and it's also mirrored in the 7% decline in carload volume and 8% decline in revenue reported by CSX in the fourth quarter of 2019.

CSX's underlying improvement

The headline volume and revenue numbers look bad, but then most investors were already reconciled to this for the first quarter. On closer inspection, there are actually quite a few positives to be gleaned from the report and guidance.

First, it's quite possible the first quarter of 2020 will mark a trough in the railroad sector and the industrial sector at large. Indeed, according to CSX VP of Operations Jamie Boychuk on the earnings call, the "first quarter will mark the low point from a growth perspective" and growth should improve in the back half of the year. Meanwhile, CEO Jim Foote expects "merchandise volume growth to turn positive in the second half of the year."

Moreover, management's commentary is backed by its guidance. For example, CSX exited the year with an 8% revenue decline in the fourth quarter, so a forecast for full-year 2020 decline of 0% to 2% implies a relative improvement through 2020.

Second, it's worth noting that, among the industrial and transportation sector, railroads face the specific challenge coming from the decline in the use of coal as a source of electricity generation. To put this fact into context, CFO Kevin Boone agreed with an analyst on the earnings call that ex-coal carload volumes would be up on the year. In other words, declining coal volumes are dragging down CSX's revenue.

Third, CSX continues to make progress on reducing its operating ratio (OR) -- a key measure of efficiency which divides operating costs by revenue, so a lower number is better.

Largely thanks to the adoption of Precision Scheduled Railroading (PSR), a set of railroad management principles which involve running railroads with fewer assets, all the listed Class 1 railroads have been improving their ORs -- something you can see by looking at the improvements in operating margin in recent years.

CSX Operating Margin (TTM) Chart

CSX Operating Margin (TTM) data by YCharts

For reference, CSX managed to reduce its OR to 58.4% in 2019 from 60.3% in 2020 -- a good result in a year where revenue fell 3% -- and it suggests that operating profit growth could be substantial when its end markets turn up.

What it all means for investors

On a headline basis, the numbers weren't great. That said, anyone buying into the thesis that the second half of 2020 will look more positive for the industrial sector would have received support from CSX management's commentary and outlook. In addition, the company's impressive improvement in OR and ongoing execution of PSR augurs well for future profit growth in the railroad sector. In context, it was a decent earnings report for the company and the industrial economy at large.

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