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Morningstar | CSX Posts Astonishing 58.6% Operating Ratio, Unimaginable Just Two Years Ago

CSX increased second-quarter revenue 6% and reduced expenses 8% to improve its operating ratio to what’s sure to be best in class among North American railroads this quarter: a remarkable 58.6%. The prior-year period OR was 67.4% on a reported basis and 63.5% adjusted for restructuring in 2017. The rail improved second-quarter adjusted earnings per share a strong 58%. We are maintaining our wide moat rating and expect to increase our fair value estimate slightly as the company seems to be improving margins sooner than we forecast.

We think the main margin levers were continued demand for high-margin export coal, broad rate increases, decreased employee count (down 1,200 of the 2018 targeted 2,000 and down about 10% year over year), improved train velocity, lower terminal dwell time, and greater train lengths. Real estate sales added a $37 million gain in this period and strong export coal demand will not continue in perpetuity, but management speaks frankly about having room to improve its intermodal franchise, so we think the profitability improvement is not a one-off phenomenon--this marks real change at CSX. In fact, CEO Jim Foote mentioned that when he implemented precision railroading at Canadian National, intermodal profit margin was greater than the average for the overall book of business, which is surprising, given typical comments at rails that intermodal ranks below merchandise and well below coal for margin. Excluding real estate gains, the OR would have been just a hair over 60%.

Management increased its 2018 top-line guidance from up slightly to up by midsingle digits due to higher fuel prices and the expectation that export coal demand will continue through the full year. Management points out that this is a great time to be in the shipping business and suggests pricing will continue to be strong, which we think is supported by expensive rates in trucking. It’s a healthy environment in which to execute a turnaround.

The secular decline in coal demand continues. Utility coal tonnage declined even faster than we expected (3%), down 11% year over year, but export coal at 11 million tons in the period (of 25 million total coal tons) was up a sharp 39%. Even though management expects export coal in the second half to be as strong as the first, and of course this is a great business, we view export as a take-it-while-you-can-get-it opportunity versus a long-run regular annual revenue contributor.

While the OR and a number of performance metrics look positive, on-time arrivals were a still-weak 61% even though the firm is managing on-time departures quite well, at a respectable 85%. Clearly, from management's own negative comments on room for improvement in intermodal and these low scheduled arrival values, the turnaround is still a work in progress.