Railroads, robber barons of yore, and Monopoly (the board game) evoke several likenesses: of wealth earned via nepotistic monopolies, fat men smoking cigars lit with $100 bills, and the Wild West variety of frontier capitalism. And while oddly romantic, it just wasn't true – 10 years ago, the railroad business more closely resembled the ragtag vagabonds that hitched a ride. Inefficient operations, infrastructure in disrepair, and unconsolidated end markets coupled to high reinvestment needs dogged railroads' returns for decades.
But the past decade's "Rail Renaissance" ushered a convergence between Monopoly and reality. After a rash of merger activity, roughly 90% of the nation's freight moves across four railroads' tracks. What seemed unfathomable a decade ago is now fact: Railroads are primed to earn high returns on invested capital, gain share from trucking, and sustainably increase prices.
That's why I'm buying CSX (NASDAQ:CSX) – the freight railroad servicing almost the entire East Coast – for my Real Money Portfolio. Misplaced concerns over declining coal volumes, which represented 27% of CSX's revenues last year, and a market that doesn't appreciate the fundamental quality of its business, afford investors CSX shares at a mere 13 times earnings. Hop aboard.
The real-life monopoly
Originally born of the B&O Railroad in 1827, also a railroad in Monopoly (the board game), CSX currently operates a 21,000-mile track network, serving 23 states east of the Mississippi. Demographically speaking, it ranks among the most attractively positioned railroads, accessing the most populous regions in the United States – New York City, Chicago, DC, Atlanta, and Boston to a name few. In the year past, its most significant products (by revenue) were coal, chemicals, cars, and intermodal (moving containers or semi trailers).
As other Class I railroads, CSX benefits from formidable competitive advantages. Because the cost of duplicating CSX's track network numbers untold billions, and obtaining rights of way harder than pushing a needle up stairs, would-be competitors face almost prohibitive barriers to entry. Likewise, because it owns a huge, geographically concentrated track network, it benefits from significant network effects: An incremental mile of track, or an additional carload, can add outsized value to the bottom line.
In the past decade, railroads have, increasingly, employed technology and operational know-how to their advantage: packing cars full on both legs of a trip, double-stacking them, and running longer trains. This, tied to oil's move north of $80 per barrel – a circumstance unlikely to change – has afforded rail a tremendous cost advantage to trucking. By Burlington Northern Santa Fe's math, rail is three times more fuel efficient than truck. Incumbent competitive advantages in hand, it's provided a license for Class I rails to increase prices at a 4%-5% clip. The numbers speak volumes: Operating margins at Berkshire Hathaway's (NYSE:BRK.B) Burlington Northern Sante Fe, Union Pacific (NYSE:UNP), Norfolk Southern (NYSE:NSC), and CSX have improved by more than 10 percentage points. That's not a typo.
The rail renaissance has arrived.
Buy a ticket
And so, the logical question follows. How is a great business, and such a large, well-followed one – with a $23 billion market cap – mispriced? Well, a few reasons: dirty ol' coal, the lingering risk of regulation, and a market that doesn't appreciate the potential for sustained growth.
1.) King coal: A consistent knock against CSX has been its exposure to coal; specifically, Appalachian Basin coal – the most costly and polluting variety. The headlines don't distort truth. Coal, and particularly Appalachian, faces secular decline in the U.S., and with the Obama administration's proposed introduction of carbon standards, the future decline may be accelerated.
But, as always, it's a bit nuanced. This mind-set, well, it's a touch myopic. More importantly, given a long-term view, it couldn't matter less to an investment in CSX.
Foremost, coal's not going to disappear overnight: Over 40% of our nation's power grid depends on it. Second, even if carbon taxes limit use of Appalachian coal, CSX also taps the Illinois Basin, which is known for dirty but cheap coal. Power generators have increasingly opted for it. Because it's cheap, they can justify the cost of scrubbers. I expect that to continue, for the near term. Last, while coal faces a decline stateside, it's a growth market in Asia and Europe – on account of the relative dearth of cheap natural gas in Europe, and increasing electrification in Asia.
But, for sake of argument, assume a hypothetical worst-case scenario passes: CSX loses almost all of its coal volumes over a five-year period. That makes the shares worth $17. Not a terrifying prospect.
2.) Regulation: Railroads' de facto monopoly status carries an implicit cost. To protect against prospective abuses, the Surface Transportation Board regulates railroads. Rail watchers have wondered whether a crackdown on price increases, limitations on investment returns, or costly safety regulations will follow.
I'd wager no, at least not for some time.
Railroads' returns on capital aren't astronomically high: the biggest four in the U.S. averaged 11% for the trailing-12-month period. Also remember that railroads are enormously capital intensive, spending 15%-20% of revenues on capex each year. Regulating with too heavy a hand could carry an unintended consequence – railroads in disrepair, as they would lack the profits to reinvest.
3.) Share gains: Despite share losses to rail, trucking is still big business – an estimated $300 billion, according to industry rag Transport News. In an era of elevated oil prices – a trend I expect to continue, on account of structurally higher finding costs (for oil) – I expect rail to wear truckers' treads thin. For CSX and other rails, that's good news.
The golden ticket
Across the long run, I project that CSX will grow volumes by 1%, as volume gains in other product lines will, to a large extent, be offset by declining coal volumes. I also anticipate long-run price increases in the 4%-5% range, and full-cycle operating margins in the mid-30% range – as operating leverage from pricing, population growth, and share gains contribute. For perspective, this implies a 12% terminal period return on invested capital, a relatively conservative figure, in light of CSX's competitive advantages. On this basis, I estimate CSX shares' worth $31.
The risks to CSX aren't small. First, it competes with trucks for freight volumes. If, for some reason, oil prices declined below $55 per barrel on a sustained basis, then it would lose share to trucking. I doubt it'll happen, because drilling for new oil doesn't make sense at those prices, but it's worth monitoring. Second, because of its large intermodal business, CSX is exposed to the health of both the U.S. and the world economy. In the long run, I think everything will be alright, but it could face a few bumps in the interim. Absent operational missteps, I'd call that a buying opportunity. Last, there's the risk of regulation. Should regulators decide to clamp down on price increases, and limit investment returns, CSX would face trouble. For reasons mentioned above, I doubt that'll happen.
The bottom line
I like Monopoly, and I love owning the railroads when I play. In the case of CSX – the promise of Monopoly meets a stock market investment. All aboard.