Wednesday, January 23, 2013

U.S. Railroad Earnings

Norfolk Southern (CSX) and CSX Corporation (CSX) reported earnings yesterday.

Both companies have been hurt lately by weak coal shipments.
(CSX saw volumes reduced by 19% versus the same quarter a year ago while Norfolk Southern had volumes drop by 13% versus the same quarter one year ago.)

The railroad business is, of course, rather cyclical. Railroads, by their nature, are capital-intensive and economically sensitive. Not often a great combination but, in their current form, the pricing power that U.S. railroads now have has made quite a big difference to their core economics.

Still, they'd have to be a whole lot less inherently capital intensive to be properly described as great businesses.

Stepping back a bit both of these railroads have had decent improvements to profitability over the past five years:*

CSX
2007 Earnings: $ 1.34 Billion**
2012 Earnings: $ 1.86 Billion
% Increase: 39%

Norfolk Southern
2007 Earnings: $ 1.46 Billion
2012 Earnings: $ 1.75 Billion
% Increase: 20%

Hardly spectacular but solid nonetheless. Year-over-year performance looks less impressive. Roughly flat in the case of CSX and down somewhat for Norfolk Southern.

Here's how the 2007 versus 2012 numbers look on a per share basis:

CSX
2007 EPS: $ 1.00
2012 EPS: $ 1.79
% Increase: 79%

Norfolk Southern
2007 EPS: $ 3.68
2012 EPS: $ 5.37
% Increase: 46%

A persistent buyback executed reasonably well (i.e. shares bought back were generally not expensive though when truly cheap during the crisis no buying was done) is behind the difference between earnings and EPS. CSX bought back ~19% of their shares outstanding over the past five years. Norfolk Southern bought back ~18% of their shares outstanding over those same five years.

Both have increased debt levels. Give or take, this level of borrowing seems consistent with and comfortably within their capacity to earn.

In addition, both companies have consistently increased the size of their dividends over the past five years (currently 2.7% for CSX and 3.0% for Norfolk Southern at yesterday's close).

In 2009, not surprisingly considering their cyclical nature, both of these railroad businesses had reduced full year earnings yet remained quite profitable. If nothing else, that time frame was a pretty good test of their resilience.

At that time, their stocks certainly dropped far more in percentage terms than the earnings power did. Back then, they became proper bargains compared to their per share intrinsic value and how that value was likely to increase over time.

What matters to an investor is not a snapshot of current earnings or historic earnings performance, but what it (and other things) reveals about longer run earnings power. Whether and how much per share intrinsic value is likely to continue increasing. That's rarely an easy thing to judge correctly and certainly not for something as economically sensitive as a railroad business.

For long-term investors, a temporary reduction in earnings isn't a problem. Good businesses often get more valuable during an economic downturn even if the near-term stock price action and temporarily reduced earning power seem to contradict that reality. Some prospects for the U.S. railroads might have been temporarily interrupted by the financial crisis but, otherwise, these businesses have done just fine. Here's a subset of a Warren Buffett quote I used in the prior post that seems relevant here:

"The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase - irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings..." - Warren Buffett in the 1992 Berkshire Hathaway (BRKaShareholder Letter

So some volatility in the earnings stream doesn't necessarily reduce value though it can lead to mistakes in the judgment of value. With added volatility, an investor might incorrectly consider a certain level of earnings as being indicative of normalized earnings. The greater the cyclicality, the bigger the possible misjudgment.

As always, I have no opinion or idea what any stock will do in the near-term or even longer but -- for my money -- neither of these stocks are selling at a big enough discount to my (necessarily imprecise) estimate of their intrinsic value to buy.

Shareholders with long run effects in mind (not traders) are better off with a stock staying cheap as long as the business continues increasing per share intrinsic value. That way the buybacks will be more effective and more shares can be accumulated from time to time at a nice discount to value.

Maybe -- and I certainly hope so -- shares of these will become cheap enough to buy again and they'll stay that way for a long time while the businesses continue to solidly increase per share earning power.

For the long-term investor, as explained by Buffett here, a lower stock price combined with increasing (again, even if volatile) earnings performance over time is a good thing.

This may or may not be intuitive but it's worth taking some time to appreciate.

Simple, yes, but the long run significance is not always obvious. It can reduce risk and increase returns.
(I don't expect that many traders -- or anyone who tries to profit from price action in time frames of less than five years -- will find this of any interest at all.)

Investing often involves lots of waiting for the right price, a bunch of time and energy spent figuring out what's an understandable and attractive business, then buying decisively when occasionally (sometimes rarely) cheap.

Often, that happens when economic storm clouds are front and center.
(Either company specific or something on a broader scale like the financial crisis.)

It was not difficult to see that shares of many good businesses in 2008 and 2009 (and later) were selling at huge discounts to value.

Those with enough justified confidence (I say justified since overconfidence will inevitably destroy investor returns) in their judgment of value had less trouble buying what they like then ignoring the rather ugly price action. The wrong kind of temperament, and a variety of cognitive biases, often lead to big mistakes. That includes not buying what (or enough of what) should be bought when very cheap because of real, even quite serious, near-term difficulties. When psychological factors have brought down the prices of marketable securities, but the long run prospects of the businesses themselves remain sound.

In the short run, psychology will be the driver of price action. In the long run, fundamental business economics will win.

Buying in an environment like now might feel less risky but it's not. That doesn't mean stocks won't go up from here. That doesn't mean there are no individual bargains. That also doesn't mean an investor needs to sell something (that's become somewhat expensive or, at least, is difficult to buy) they intend to own long-term that was initially bought with proper margin of safety. It does mean the investor is generally taking more risk these days when buying a shares of an attractive business. What has little risk at one price becomes increasingly risky at higher prices.
(By risk I mean the increasing possibility of permanent capital loss, not temporary paper losses, and certainly not beta.)

The time to do the bulk of the buying what you understand well is when headlines and market psychology are awful. That's when the shares of a business with durable advantages are more likely to be plainly cheap.

Adam

2007 - CSX Earnings
2012 - CSX Earnings
2007 - Norfolk Southern Earnings
2012 - Norfolk Southern Earnings

Long position in NSC established at much lower than recent market prices.

* As far as the other large U.S. railroads, Union Pacific (UNP) reports tomorrow and BNSF Railway results are reported with the rest of Berkshire's results.
** There's $ 110 million (roughly 8 cents per share) of earnings in the 2007 numbers from discontinued operations.
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