The prospects for coal in the U.S. have suffered lately and weighed on coal mining companies such as Alpha Natural Resources (NYSE:ANR). Another fraternity wary of this trend is railroad companies. Another fraternity wary of this trend is railroad companies.
CSX Corporation (NYSE:CSX) and Norfolk Southern (NYSE:NSC) are the two such railroad companies that are marked with heavy exposure to coal frieght. CSX and NSC both derive nearly 30% value from coal freight, according to our estimates. This could, in turn, undermine a huge business segment of these companies, around which they have revolved over the years. But, it is still pretty early to be entirely bearish about coal. Alternatively, another segment intermodal freight has displayed encouraging results in the recent past and rail companies would look to cling onto this very segment to sail through this coal mess.
We have a $25 price estimate for CSX, which is around 15% above the current market price.
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Will Coal Freight Revive?
There has been turbulence in businesses associated with coal as coal has lost its vigour lately as the preferred fuel option for electicity generation in the U.S. amid rock bottom natural gas prices. However, while coal demand is subdued in the near term, it will gradually pick up.
There are two reasons why we believe this. Firstly, the utility companies are very likely to revert back to coal fired power generation from gas fired as soon as the gas prices get past coal prices on per BTU basis. Secondly, if the coal demand in U.S. remains subdued for long, the miners will streamline their businesses for exports.
Export demand has risen, previously, both in metallurgical coal as well as thermal coal. However, there lies a hindrance to the revival of domestic thermal coal demand if the U.S. Environment Protection Agency (EPA) raises the bar on carbon emissions on power plants. Considering all this, we maintain a neutral outlook for the U.S. rail carloads of coal, which entails a dip in traffic in near term before gradually increasing. We assume that CSX will be able to hold onto its current market share in coal freight market till the end of our forecast period due to high barriers to entry in the industry.
Intermodal Freight & Ethanol to drive revenues
Intermodal services enable customers to capture the combined benefits of multiple shipping modes. For example, domestic intermodal customers can enjoy the flexibility of truck pickups and deliveries, along with the pricing benefits of long-haul rail transportation. Intermodal freight displayed 3.5% growth in May and 3.6% in April, 2012 compared to respective periods last year.
CSX has spent heavily on developing assets to support its intermodal growth pursuits. The corridor projects through public-private partnerships, including the National Gateway initiative and the Massachusetts and Florida projects will enhance its capacity in intermodal freight. The Panama Canal expansion project is another project to augment CSX’s intermodal freight capacity. The recent intermodal network’s double-stack initiatives add vertical clearance to the corridors and allow containers to add on top of another thereby providing significant operating leverage and incremental capacity.
The ethanol market, on the other hand, is also expanding rapidly. Corn, which is used as an animal feed as well as an input for ethanol production, could see shipment volumes increase as the demand is expected to rise. The Energy Independence and Security Act (EISA) of 2007 mandates domestic ethanol production increase from 13 billion in 2010 to 20.5 billion gallons by 2015 and to 36 billion by 2022. This should continue to drive growth opportunities for ethanol transportation.
Easy debt availability
The liquidity of the railroad companies, on the hand, have been adequate owing to their better pricing ability and improving operating leverage. That is primarily the reason why many credit rating agencies have upgraded railroad companies despite decline in coal traffic.  Railroad business is a capital intensive business because it needs regular capital spends for state-of-art systems to maintain better efficiency in the industry. A better credit rating will help CSX fund its growth plans through loans at cheaper interest rates.
CSX’s EBITDA margin has continuously improved over the years and it stands at nearly 40%. We project the margins to improve further as utilization levels improve, rendering better operating leverage. Moreover, fuel prices also help CSX to increase profitability.
When oil prices rise, CSX’s revenues surge on increased rates and higher fuel surcharges. Moreover, a majority of traffic diverts away from trucking to railroad as it is cheaper. Oil prices are expected to rise in future, which will help CSX gain margins. However, the ability to charge a fuel surcharge could take a beating if Surface Transport Board (STB) imposes tougher regulations over it. In Jan 2011, STB held hearings to determine whether it should review the exemptions, which is expected to continue in 2012. Revoking the exemptions would potentially impact railroad pricing flexibility, posing downside to the margins.Notes: