All Aboard for Profits: What CSX Corp Tells Us about the US Economy and Global Coal Markets
First-quarter earnings season is in full swing, with about one-third of companies in the S&P 500 having reported results. About 80 percent of these firms announced earnings that trumped consensus estimates, while 73 percent beat on the top line–a reminder that cost reductions aren’t the only impetus for earnings growth.
But analyzing corporate earnings involves more than just comparing results to Wall Street’s consensus estimate or looking at a few profit and loss statements. My favorite part of earnings season isn’t the press release and regulatory filings, but the conference call and Q-and-A session. During these discussions, management teams often offer additional color on business conditions and emerging trends, details that aren’t necessarily reflected in the numbers. Given the complex interconnections of global markets, management’s comments often have implications beyond their industry or sector. Railroad operators are a case in point.
As the circulatory system of the economy, the transportation industry provides invaluable insight into the health of the broader economy. When the economy is humming, trade and manufacturing activity pick up, which translates into higher volumes of goods and commodities circulating throughout the country.
If you’re wondering why I’m writing about railroads in a service devoted to analyzing energy markets, consider this: A railroad can move a ton of freight more than 430 miles on a single gallon of diesel fuel–an impossible feat for a truck. Because of this fuel efficiency, railroads usually benefit from elevated fuel prices. More important, the vast majority of coal mined and consumed in the US rides the rails for at least part of its journey from mineshaft to power plant or steel mill. Quarterly statistics from the railroads provide insight into supply and demand conditions in the US and global coal markets.
CSX Corp (NYSE: CSX), a long-haul railroad with a network that primarily serves the eastern US, announced solid first-quarter earnings. Revenue was up 13 percent from a year ago, reflecting an uptick in volume, price increases and costs recovered through higher fuel surcharges. This pricing power stems from strong demand for rail shipping, a sign that the US economy continues to strengthen.
Over the past three months, economists have lowered their estimates of first-quarter gross domestic product (GDP). Consensus expectations for US GDP growth in the first three months of 2011 declined from to 1.8 percent from about 3 percent at the outset of the year. These downward revisions reflect several factors, including a jump in US net imports and weather-related disruptions. But that dour economic outlook contrasts with CSX Corp’s comments during the company’s conference call to discuss first-quarter earnings:
…discussions with our customers and key leading indicators suggest economic growth will continue throughout 2011 and beyond. With this as a backdrop, CSX volume growth in 2011 is expected to exceed both gross domestic product (GDP) and industrial production (IP). As such, the volume outlook is favorable across all three major markets – merchandise, intermodal, and coal. Overall core pricing gains are expected to exceed rail inflation with increases across all markets, which enables continued investment in rolling stock and infrastructure to support long-term growth.
Management was even more confident about its 2011 outlook and emphasized that the firm should be able to boost prices at a faster pace than cost inflation, which spells higher profit margins.
If management had concerns about economic growth, the company wouldn’t boost its investment in basic rail infrastructure, railcars and locomotives.
Despite CSX’s record-setting results, the stock pulled back after the company announced earnings. Profit-taking accounted for some of this correction–the stock enjoyed quite a run in the first three months of 2011–but some analysts expressed concern about the railroad’s deteriorating efficiency metrics.
Specifically, CSX’s on-time originations–a measure of the timeliness of its service–dropped to 66 percent from 69 percent in the year-ago quarter. The average velocity of cars traveling on the company’s network also fell to 20.4 miles per hour (mph) from 20.9 mph a year ago.
This concern appears overdone. Much of this poor performance occurred in the company’s merchandise unit, the business segment that transports cars, fertilizers, chemicals and similar items. A series of severe storms during the first quarter hampered the merchandise network’s efficiency, a problem that likewise affected CSX’s regional competitors.
At the same time, CSX may lack sufficient capacity to meet demand in an efficient manner. Management noted that the company brought 180 locomotives out of storage, many of which were taken out of service during the 2007-09 recession. The company has also also recalled furloughed workers and plans to hire at “a strong level” throughout the year to meet expected demand growth. None of these steps suggest the company faces a major business slowdown.
US Coal Export Boom
For energy investors, CSX’s recent conference coal offered plenty of insight into the market for US coal exports. Overall volumes of coal moved in the first quarter increased by 3 percent from a year ago, but revenue soared 19 percent, thanks to higher prices and fuel surcharges levied to offset increases in diesel prices.
Last year was a record year for coal export volumes traveling on CSX’s rail network. The company transported about 30 million tons of US coal to East Coast ports. During CSX’s conference call to discuss fourth-quarter earnings, management predicted that the firm would handle 35 to 40 million tons of export coal in 2011–another annual record.
Three months later, management upped this estimate to 40 million tons of exports. And this forecast looks conservative when you consider that the firm shipped nearly 11 million tons in the first quarter alone. With robust demand for export coal and a new rate system that will reprice on a quarterly basis, coal slated for export should be big business for CSX in 2011.
Management is working to squeeze more volume out of its existing coal transport infrastructure. For example, the firm is putting longer trains and larger coal cars into service so that it can move larger loads with a single train.
Roughly 70 percent of the coal CSX transported to ports for export was metallurgical (met) coal, the variety used in steelmaking. This mix reflects typical trends. The US has traditionally been an exporter of high-value met coal, while thermal coal output is primarily destined for domestic consumption.
Moreover, global demand for met coal is booming. Devastating floods in Australia–the source of about two-thirds of seaborne exports–disrupted the country’s coal mining and shipping operations. This shortfall sent met coal prices to the moon, and steelmakers have struggled to secure supplies. US coal producers have stepped in to fill the gap.
But CSX’s Chief Commercial Officer Clarence W. Gooden also hinted that interest in thermal coal exports has picked up:
The thermal coal market into Europe has improved in the last three months. The API-2 index [a common export thermal coal benchmark] about a week ago was up to $129 [per ton], and that’s significantly up from where it had been previously. Having said that, we got some – we have seen some slight pickup in thermal coal going to Europe. Going forward longer term, I would be hesitant to venture a guess given what the German utilities’ position have been recently on nuclear power.
Gooden’s assessment of the market for thermal coal exports gibes with comments from US coal producers over the past few quarters.
Mr. Gooden also brings up a valid point about Germany. With about 40 percent of Germany’s nuclear power capacity shut down for at least three months, the nation is seeking to boost generation capacity in any way possible. As soon as Germany shuttered its nuclear power plants, spot electricity prices jumped to 19-month highs. Meanwhile, the country’s electricity imports from the Czech Republic soared fivefold.
Over the long term, this situation is unsustainable. Germany must rely on a combination of coal- and natural gas-fired facilities to offset any nuclear power plants that it shuts down. Despite the country’s substantial investment in alternative energy, plants that burn fossil fuels remain the only viable source of baseload capacity. US producers of thermal coal could win some of this business.
In contrast, the domestic market for thermal coal remains depressed. With US natural gas prices hovering near a multiyear low, many utilities have elected to burn gas rather than coal. Stockpiles of thermal coal at electric utilities have remained at above-average levels for some time. CSX’s management noted that coal stockpiles at power companies in the Northeast are near the long-term average, while utilities in the South hold excess inventories. CSX’s forecast calls for domestic demand for thermal coal to remain soft throughout 2011.
After a big run-up in the first three months of 2011, many coal producers’ shares have pulled back in recent weeks. Based on comments from CSX’s management team, names with exposure to seaborne coal markets and growing met coal output should do well in 2011. Coal-related plays remain some of my favorite stocks in The Energy Strategist’s model Portfolios. For more information on my top picks, sign up for a free trial of The Energy Strategist.