CSX Initiating Coverage Report

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<ul><li><p>8/11/2019 CSX Initiating Coverage Report</p><p> 1/12</p><p> INITIATING COVERAGE REPORT William C. Dunkelberg Owl FundSeptember, 10th2014</p><p>Jesse Barone: Lead Analyst</p><p>barone@theowlfund.com</p><p>Ethan Friedland: Associate Analy</p><p>efriedland@theowlfund.com</p><p>Joseph Heidt: Associate Analystheidt@theowlfund.com</p><p>COMPANY OVERVIEW</p><p>CSX Corporation is a diversified freight transportationcompany that provides rail-based transportation servicesthroughout the eastern United States. CSX transportschemicals, automotive products, agriculture, forest products,metals, phosphates, fertilizers, minerals, food and consumerproducts, along with waste and equipment. In addition, thecompany uses its network of 50 terminals and 21,000 miles ofrail to transport coal and provide intermodal transportation</p><p>services. The companys four business segments, all based inthe United States, are TotalMerchandise (58.5% of FY2013 revenue), Coal (24.1%),Intermodal (14.1%), and otherservices (3.3%).</p><p>INVESTMENT THESIS</p><p>CSX is currently trading at an8.04% discount to itscompetitors. Investors have been devaluing CSX because ofthe decrease in demand for coal (Coal is 24% of revenue forCSX), and the recent dip in the companys performance metrics</p><p>due to congestion of railways from substantial volume growth.CSX is seen to have two economic moats, which are barriers toentry and an expansive network of railways and terminals thatcannot be replicated, giving it a competitive advantage over itscompetitors. Through CSXs strategic rail network,it is able toprovide service to 66% of the population in the United States,and currently is in charge of 50% of rail volume on the eastcoast. Looking forward, investors have not accounted for thenew capital expenditure projects that CSX have started in 2014,and the recently completed projects in 2014 in order to keep upwith the increasing volume it is experiencing. These projectswill expand its performance metrics back to normal historicallevels. Investors also havent accounted for the new coaldemand to be capitalized on by CSX in the Illinois Coal Basin,the United States energy boom, which has created new marketsfor CSX such as crude oil, liquefied petroleum gases, and fracsands, and increased regulation in the trucking industryallowing CSX to claim market share away from truckingcompanies. We believe the company will appreciate from itscurrent EV/EBITDA multiple of 8.77x, to the 5 year historicalspread average compared to peers of 9.69x, resulting in a pricetarget of $36.61, and a total return of 19.34% including adividend yield of 2.05%.</p><p>Indust</p><p>rials:Railroad</p><p>CSX Corp.Exchange:NYSE Ticker:CSX Target Price:$36.61</p><p>Sector Outperform</p><p>Recommendation: BUY</p><p>Key Statistics:Price $31.49 52 Week Low $</p><p>Return 19.34% 52 Week High $</p><p>Shares O/S (mm) 999.6 Yield 2</p><p>Market Cap (mm) $31,476 Enterprise Value $</p><p>1 Year Price Graph</p><p>Earnings History:Quarters EPS Rev. YoY Pric</p><p>3Q13 $0.460 3.63% -0.804Q13 $0.420 4.73% -6.811Q14 $0.400 1.65% -1.772Q14 $0.530 6.50% 0.13%</p><p>Earnings Projections:Year Q1 Q2 Q3 Q4 </p><p>2012 $0.41 $0.48 $0.44 $0.39 </p><p>2013 $0.45 $0.52 $0.46 $0.42 </p><p>2014(Q3,4E) $0.40 $0.53 $0.46 $0.48 </p><p>2015e $0.45 $0.60 $0.53 $0.53 </p><p>All prices current at end of previous trading sessions f</p><p>date of report. Data is sourced from local exchanges </p><p>CapIQ, Bloomberg and other vendors. The William C.</p><p>Dunkelberg Owl fund does and seeks to do business w</p><p>companies covered in its research reports.</p></li><li><p>8/11/2019 CSX Initiating Coverage Report</p><p> 2/12</p><p> Fall 2014</p><p>T h e W i l l i a m C . D u n k e l b e r g O w l F u n d Page</p><p>SEGMENT OVERVIEW</p><p>Total Merchandise:The merchandisebusiness shipped nearly2.8 million carloads andgenerated approximately</p><p>59% of FY 2013revenue. Along withbeing CSXs largestsegment (42% of FY2013 volume), totalmerchandise is the mostdiverse segment consisting of nine sub-segments. The Merchandisesegment transports chemicals, automotives, agricultural products, forestproducts, metals, phosphates and fertilizers, minerals, food and consumerproducts, as well as waste and equipment.</p><p>Chemicals</p><p>The Chemicals segment made up 27% of Total Merchandise revenue and15.8% of total revenue in FY 2013. In this segment, CSX transports</p><p>plastics, plastic feedstock, plastic intermediaries, crude oil, liquefiedpetroleum gas (LPG), and frac sand. </p><p>Automotive</p><p>The Automotive unit made up 17.3% of the Total Merchandise businessand 10.1% of total revenue in FY 2013. The Automotive segment is anessential part of North American vehicle distribution, as it ships almost1/3 of all light vehicles produced. CSX handles nearly 4 million vehiclesannually through its network of 35 auto distribution centers and a fullyenclosed multilevel fleet. In addition to transporting finished vehicles,CSX transports auto parts throughout the eastern United States.</p><p>Agricultural</p><p>The Agricultural segment made up 14.4% of the Total Merchandisebusiness and 8.4% of total revenue in FY 2013. The agricultural unittransports products such as grain, flour, oils, sweeteners, and ethanol.Through this business, CSX directly serves grain elevators, feed mills,grain processing facilities, bakeries, ethanol plants, and soft drinkproduction facilities.</p><p>Coal:The Coal business shipped nearly 1.2 million carloads and generated 24%of revenue and 18% of volume in FY 2013. CSX transports domestic coal,coke and iron ore to electricity-generating power plants, steelmanufacturers, and industrial plants. CSX also exports coal to deep-waterport facilities. CSX is the largest coal transporter east of the Mississippiand serves more than 120 load-outs in 9 states.</p><p>Intermodal:The Intermodal business contributed 14% of revenue and 40% of volumein 2014. Intermodal transportation is using at least two modes oftransportation to move freight. CSXs intermodal line of businesscombines long distance rail transportation with short-haul trucking. Theintermodal business has 50 terminals east of the Mississippi River and usesthem to transport mainly manufactured consumer goods in containers.</p><p>RISKS</p><p>New Legislation or RegulatoryChanges: Legislation passed by Congressor new regulations issued by federalagencies regarding pricing negotiation and</p><p>constraints, climate change, emissions,capacity, and hazardous wastetransportation could have a negative effecon top or bottom line growth.</p><p>Declining Natural Gas Prices:Asnatural gas prices decrease, coal-firedpower plants are being replaced by naturagas-fired power generation facilities. Ifnatural gas prices remain low and continuto decrease, more coal-fired plants couldbe replaced, which would reduce CSXsdomestic coal volumes and revenues.</p><p> Demand Fluctuation: General domestic</p><p>and global economic conditions thataffect demand for the commodities andproducts CSX transports could adverselyaffect the top line.</p><p> Severe Weather: Extreme weatherconditions can adversely affect thecompanys operations and incur additionacosts, negatively affecting top and bottomline growth.</p><p>U.S. Energy Markets: Over the past fewyears, production of natural gas in the U.Shas increased dramatically, resulting inlower natural gas prices, causing a negativ</p><p>impact on CSX. As a result of sustainedlow natural gas prices, coal-fired powerplants have been displaced by natural gas-fired power generation facilities.</p><p>ECONOMIC MOATS: Narrow and</p><p>Stable Rail Network: CSX spans the densely</p><p>populated eastern U.S., capturing abouthalf of the rail volume in the region. CSXoperates approximately 21,000 miles in rainetwork, which serves various populationcenters in 23 states east of the Mississippi</p><p>River, the District of Columbia, and theCanadian provinces of Ontario andQuebec, as well as operates approximately4,000 locomotives.</p><p> Barriers to Entry:The network of rails ivery unlikely to have any new main linesbuilt especially since most regions alreadyhave two main competitors and replicatinthe network in place is nearly impossible.</p></li><li><p>8/11/2019 CSX Initiating Coverage Report</p><p> 3/12</p><p> Fall 2014</p><p>T h e W i l l i a m C . D u n k e l b e r g O w l F u n d Page</p><p>CATALYSTS</p><p>New terminals/expansion of old terminalsCSX in recent months has experienced a significant increase in demand for itsservice. With the substantial increase in demand, several performance metricshave fallen in recent quarter such as dwell time, average velocity, EBITDAmargin, and profit margin. Stemming from this decline, CSX has committed to</p><p>improving these metrics by creating new terminals, expanding capacity of oldterminals, and improving infrastructure. During 2013 and 2014, the company hasexpanded terminals in Columbus, Ohio, Louisville, Kentucky, Atlanta, Georgia,and Worcester Massachusetts. An example of the benefits from this additionalcapex is a 50% increase in capacity at the companys terminal in Columbus, Ohio.The company expects to open new terminals in Winter Haven, Florida andQuebec, Canada during 2014. Investors and the company should start to seebenefits from the 2013 projects that the company has recently completed in thesecond half of 2014, and should expect to see the rest of the terminals fullyoperational by end of 2015. Some other notable investments that are occurring isan upgrade in infrastructure in the Chicago area, specifically with the Elsdon sub-division, which will provide this area with double track miles (having a track runin each direction so trains going opposite directions arent on the same track), which will increase average train velocityand flexibility in the area to be able to divert traffic away from the more congested routes. In the River Line area, whichis from New Jersey up to Boston, double track is being added to capitalize on those same benefits listed above. Thisspecific infrastructure project is crucial because it is going to address a growing need as demand increases in one ofCSXs busiest regions.</p><p>Illinois Basin Coal Shift</p><p>Historically, the Appalachian region was a main supplier of coal and was a large part of CSXs coal business. However,with decreasing coal demand, the Appalachian region has not been growing in terms of coal output. The Illinois Basinhas become a large hotspot for coal production to make up for the significant decline seen in the Appalachian region.Extracting coal from the Illinois Basin cost about $44 a ton, 22% cheaper than Central Appalachia and 30% cheaperthan Northern Appalachia. Powder River Basin has the cheapest extraction price tag of $11 per ton. CSX is positionedto take advantage of this shift away from the Appalachian region to the new Illinois Basin region. CSX is investing in anew coal unit train processing facility that will support this growth, while also adding increased employees andinfrastructure in the region. CSX is in a unique position as one of only two companies that can add the capex needed to</p><p>support the growth that is having in this region.</p><p>United States Energy Boom</p><p>The surge seen from the increased drilling for the extraction of oil and natural gas has created several new high growthmarkets and products such as crude oil, liquefied petroleum gases, and frac sands that CSX is uniquely positioned tocapitalize on. Along with these markets, CSX is capable to capitalize on transporting the supplies needed for drilling fornatural gas and oil. CSX is able to transport the material from the gas processing plants to the market. With theseexpanding markets, CSX has invested in new terminals, railcars, locomotives, and additional employees in order to meetthe demand stemming from these specific markets and products.</p><p>Public-Private Partnerships and Increased RegulationCSX is joining with several government partners such as the Commonwealth of Massachusetts and the State of Florida,to increase capacity, efficiency, and safety with railroads. The reason for this is these government organizations havebegun to recognize the benefits of using rail instead of trucking. Some of the benefits of using rails instead of trucks are</p><p>reduced traffic, reduced pollution (rails are four times more efficient than trucks), and increased activity at U.S. ports bythe use of intermodal transportation. One of the projects called National Gateway, which is a project totaling $850mmin investment from CSX and government organizations throughout the east coast, is outfitting tracks and bridges toallow double stacking of freight. This will increase the percentage of tracks outfitted for double stacking from 90% to95%. There are several of these projects underway currently, such as creating a rail corridor parallel to interstate 70 and76 between Washington, D.C. and northwest Ohio, replacing bridges in Maryland, and expanding the Virginia AvenueTunnel. Along with these partnerships, the Federal Government continues to put stricter regulations on the truckingindustry, which continues to increase costs for companies causing them to switch to another mode of transportationsuch as rail, or the use of intermodal transportation by using rail for long distances and trucking for shorter distances.</p></li><li><p>8/11/2019 CSX Initiating Coverage Report</p><p> 4/12</p><p> Fall 2014</p><p>T h e W i l l i a m C . D u n k e l b e r g O w l F u n d Page</p><p>INDUSTRY OVERVIEW</p><p>The Rail Renaissance</p><p>In 1980 the Staggers Rail Act severely deregulated the railroad industry and allowed rail companies to set their own ratesas long as there was competition and create service contracts. This has led to significant consolidation in the railroadindustry in order to increase efficiency. The number of Class I rail companies has reduced from over 40 in 1980 to just 8today, which CSX is one of them. Over the past five years the S&amp;P 500 Rail Index has grown over 182%. During therecession there were as little as 80 freight cars per train. However, once demand picked up Class I railroads were able toexpand their operating margins by 26.8% in 2010, just by adding more freight cars per train and having a minimalincrease in operating cost. Operating cost was able to stay low since the railroads didnt need any additional engines orcrews to operate the longer trains. Even as demand rose and more operating cost were incurred, it was offset by morefuel efficient locomotives, widening margins to 27.1% in 2012. The Association of American Railroads reported that fuelefficiency rose from 235 ton-miles per gallon in 1980 to 476 ton-miles in 2012. Today we are seeing a lot of these samethings play out for Class I railroads. There is significant congestion and volume growth, making companies like CSX</p><p>increase their capex in order to keep up with the demand and keep performance metrics at high levels.</p><p>Future Demand for CoalFuture Domestic Coal DemandThe Mercury and Air Toxics Standards take effectnext year, and coal powered plants will need to equiptheir facilities with scrubbers that remove sulfurdioxide to comply with the new regulation. TheObama administration is trying to reduce carbondioxide emissions, but still estimates the nation toburn 616 million to 636 million tons of coal in 2020.Coal current share of power generation is 41%, but isexpected to fall to 33% by 2020 and 30% by 2030under the new regulation.</p><p>Future Foreig...</p></li></ul>