CSX Corporation (NYSE:CSX) is set to release its Q3 2012 earnings on Tuesday after the market close. Railroad investors are likely to closely watch this earnings announcement since CSX competitor Norfolk Southern (NYSE:NSC) expects its profits to decrease 25% due to weakening freight demand. This has caused CSX’s stock price to remain suppressed over the last month or so, an over-reaction since weak demand is unlikely to impact CSX as much as NSC (the firm has been quick to cut costs to offset revenue declines in the past). Therefore, during this earnings release, investors should closely watch for cost cutting measures that impact CSX’s margin trends. Additionally, they should look for growth in its industrial freight segment, which is a core driver of the company’s revenues.
During the second quarter, CSX announced net earnings of $512 million versus $506 million in 2011. The growth in earnings was primarily due to an improvement in margins; revenue and freight volumes were essentially flat year over year. EBITDA margins for the second quarter were around 40% in 2012 versus 38% in 2011.
Improving Efficiency Will Improve Margins
Over the last 3-4 quarters, CSX has been posting impressive efficiency gains. It has improved on-time originations and arrivals to 90% and 80% respectively. Additionally, CSX has posted increases in average system velocity for five straight quarters, and has decreased its average system dwell time for six straight. These trends have led to a decline in the firm’s operating ratio to 68.7% in Q2 2012 versus 69.3% for in 2011. If the company is able to maintain these trends, it will be well positioned to mitigate the impact of slowing freight demand.
CSX Management Quick to Cut Fixed Costs
A reason why NSC warned investors of lower earnings during the third quarter was because the company was not quick to cut fixed costs. On the other hand, CSX management has been more active with cost cutting measures; it reduced the number of full time employees during Q2 and the number of active locomotives from 3,919 to 3,762 over the same period. We expect CSX management to continue to cut workforce and capacity during the third quarter since it recognizes that cost cutting measures will hold the key to improving the company’s profitability.
Industrial Freight Growth Key for Top-Line Growth
During the second quarter, industrial revenue growth was key in offsetting the impact of declining coal revenues. Industrial revenue was buoyed by strong automotive demand, a trend which has continued in the third quarter. We expect that this segment will continue post growth, and is likely to be the top revenue driver for the company during Q3. This is key, since industrial freight, according to our estimates, is the company’s biggest operating division, making up approximately 30% of the firm’s total value.
Overall, we do not think that CSX’s profitability will be affected to the same degree as its competitor, Norfolk Southern. CSX management has been proactive in cutting costs, which will help relieve margin pressure as freight demand decreases. Additionally, the increase in automotive demand during the quarter will mitigate a decline in coal freight revenues. During the earnings announcement, investors should watch margins and industrial freight revenues closely as they assess the long term health of the company.
We currently have a $23.55 price estimate for CSX Corporation, which is approximately 10% above the current market price.