CSX’s Focus On Improving Pricing And Service Metrics Will Drive Its Operating Ratio

CSX Corporation’s (NYSE: CSX) third quarter operating ratio improved 2.2%, to reach 69.7%, due to the higher growth in revenue compared to operating expenses. ^[1] Despite improvements in operating ratio this quarter, CSX’s operating ratio for nine-months ended September 26, 2014 remained 100 basis points higher than the previous year’s operating ratio for the same period. In order to tie-out with last year’s operating ratio, CSX needs to aim for an operating ratio of 70.2% in the fourth quarter. It seems unlikely that CSX will be able to achieve that target given the expected increase in costs associated with high volume for the fourth quarter and the sluggish pace of CSX’s revenue per unit.

However, in the year 2015, we expect to see significant improvement in the railroad’s operating ratio given the increase in pricing and efforts being put into improving service metrics. This may help CSX achieve its target of a high 60’s operating ratio by 2015.

Improvements in operating ratio will not only help CSX in increasing its profits and earnings per share share, but will also help give it a competitive edge over its primary rival, Norfolk Southern (NYSE:NSC), whose operating ratio for the nine months ended September 2014 was 210 basis points lower than that of CSX.

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Reviewing the third quarter operating expenses

CSX’s third quarter operating expenses increased 4.6%, with only fuel expenses moving in a favorable direction. ^[1] Fuel expenses declined $14 million due to higher fuel surcharges as a result of the two month lag effect over the U.S. on-highway diesel prices. Since the U.S. on-highway diesel price has been declining steadily from $4.00 in March to $3.79 in September, ^[2] the two month lag resulted in higher fuel surcharges.

All other expenses such as Labor & Fringe, Materials, Supplies & Others, Depreciation, and Equipment and Other Rents increased due to volume increase and inflation. These expenses are expected to increase in the coming quarters driven by the same factors. CSX’s Labor & Fringe expenses will be higher in the coming quarters since it has started managing its locomotive maintenance force in-house. However, this will be offset by a corresponding decrease in Materials, Supplies & Others expense.

Repricing of 2015 contracts will help drive revenues

One of the ways CSX can improve its operating ratio is to increase its top line. In an effort to do so, CSX has been renewing its contracts for 2015 with particular focus on repricing. According to CSX, there has been a ‘significant improvement’ in pricing, which will be “much more robust” than the last three or four years. ^[3] In 2013, CSX’s core pricing grew 1.3%, driving a 2.3% increase in revenue. CSX has renewed 50% of its contracts that were due to be renewed for 2015.

The repricing will have a direct impact on CSX’s revenue per unit, which has remained flat since 2013 primarily due to the impact of weak demand for coal. Though domestic coal demand has shown improvement, driving growth in CSX’s coal shipments, a weakness in U.S. export coal continues to temper CSX’s coal revenue per unit, offsetting the revenue per unit growth in other commodities. Export coal is likely to remain a challenge for the U.S. and railroads, given the recent announcement of China imposing tariffs on imported coal. ^[4] However, CSX still remains optimistic of double digit earnings growth given its robust pricing increase for 2015.

Locomotive purchase and repairs should help improve service metrics

CSX’s service metrics had been severely tempered by  the harsh weather witnessed in the beginning of 2014. Of late, service metrics have also been under pressure due to the large volume of shipments. Service metrics such as on-time originations and arrivals, terminal dwell and network velocity not only help drive customer satisfaction but also impact CSX’s operating costs. Though there has been some improvement in the last quarter, these service metrics still remain far from their peak numbers.

In order to handle the rapidly increasing volumes, CSX has planned to increase the size of its locomotive fleet. In the third quarter, CSX signed an agreement to purchase 300 locomotives, of which 100 will be delivered in the first half of 2015 and then another 100 in the second half. ^[3] CSX will be repairing around 100-150 locomotives which are currently not under use and adding them to its fleet by the first half of 2015. According to CSX, the overall locomotive additions should help drive recovery in its service metrics and also support the growing volumes. If CSX is able to manage its volumes efficiently by expanding its locomotive fleet, its operating costs should see some declines, which in turn could help lower its operating ratio.

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1. CSX’s Q3 2014 Financial Report, www.csx.com [↩] [↩]
2. U.S. No 2 Diesel Retail Prices, www.eia.gov [↩]
3. CSX’s (CSX) CEO Clarence Gooden on Q3 2014 Results – Earnings Call Transcript, October 15, 2014, www.seekingalpha.com [↩] [↩]
4. China’s Coal Tariff Prolongs the Pain, October 10, 2014, onlinw.wsj.com [↩]