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CSX Corporation (CSX), the Florida-based rail-based freight transport company, reported flat revenue for Q3 on Oct. 16. However, it generated strong free cash flow (FCF) for the quarter, with significantly higher FCF margins.
As a result, CSX stock looks cheap to value investors with analysts' price targets 20% higher. Shorting out-of-the-money (OTM) put options is also a good play here.
CSX Corp was down 5% on Thursday, Oct. 17, trading at $33.40 in midday markets. This is off from its recent peak of $35.50 on Oct. 15.
That presents an opportunity for investors who want to get in cheap on this stock. As I will show below, one way to make a lower buy-in price is by selling short OTM put options in nearby expiry periods.
Strong Free Cash Flow
CSX reported that its freight volume rose 3% YoY and revenue was up 1%. Moreover, earnings per share (EPS) was up +12.2% ($0.46 vs. $0.41) from the prior year Q3.
The company reported a mixed outlook, partly because of the two monstrous hurricanes recently. In addition, it generated lower nine-months free cash flow compared to last year - i.e., $2.218 billion vs. $2.519 billion last year over 9 months (i.e.,
However, its Q3 FCF was significantly higher on a sequential quarterly basis. The market may have missed this since CSX didn't highlight it. For example, in Q2 its 6 months FCF was $1.15 billion. That implies the Q3 FCF was $1.068 billion (i.e., $2.218b Q3 YTD FCF - $1.15b Q2 YTD).
That means that its Q3 FCF was almost equal to the first 6 months (i.e., $1.068b/$1.15b = 93%). Moreover, it also implies that the Q3 FCF margin rose significantly.
For example, revenue in the first 9 months was $11.0 billion. So, the $2.218b in FCF represents 20% of sales. But sales in Q3 were $3.619 billion, so the $1.068b in FCF represents a much higher 29.5% FCF margin. Moreover, its operating cash flow margin was very high as well at 46.6% (i.e., $3.859b-2.173b, or $1.686b, and $1.686b/$3.619b in Q3 sales = 46.59%).
Projecting FCF based on Margins
Moreover, CSX management said during the earnings call that it expects capex spending will be $2.5 billion in 2024. Compared to $1.691 billion (see table above) so far this year, Q4 capex will be just $809 million (i.e., $2.5b-$1.691b), or 22.3% of projected sales of $3.63 billion in Q4.
As a result, if the company's operating cash flow margin stays flat (i.e., at 46.6% - see above), it could generate $883 million in FCF during Q4. That represents a FCF margin of 24.3%.
This allows us to project its FCF next year. For example, next year analysts are forecasting that sales will rise 3.6% from $14.69 billion projected for 2024 to $15.22 billion. As a result, if FCF margins average 24.3% next year, it could make $3.7 billion in FCF (i.e., 0.243 x $15.22b in 2025 sales).
This has huge implications for CSX's valuation. One way to value the stock is to use an FCF yield metric.
Target Prices for CSX Stock
For example, let's assume that the market gives the stock a 4.3% FCF yield (i.e., FCF/market cap). Why that metric? For one, this is a way to estimate how the market would value the stock assuming it theoretically paid out 100% of its free cash flow in dividends.
Here is how I estimated 4.3% as a FCF yield metric. The dividend yield today is 1.35%. But dividends paid year-to-date of $700 million represent just 31.5% of its $2.218 billion in free cash flow for the 9 months to Sept. 30.
In other words, paying out 100% of this FCF would theoretically raise the yield by 3.17x since the inverse of 31.5% is 3.17 (i.e. 1/0.315 = 3.17x). So, multiplying the 1.35% dividend yield today would result in a 4.3% FCF yield (i.e., 1.35% x 3.17 = 4.28%), if 100% of FCF were to be paid out in dividends.
This is useful since we can use that measure to value CXS stock. For example, let's take our forecast of $3.7 billion in FCF and divide it by 4.3%, the market cap will be $86 billion (i.e., $3.7b/0.037 = $86b).
Since CSX's market cap today is $64.85 billion, this implies the stock could rise by one-third (i.e., $86b/$64.85b-1 = +32.6%). In other words, CSX stock is worth 32.6% more or $44.29 per share.
Analysts tend to agree that CSX is too cheap. For example, the average price target from 27 analysts surveyed by Yahoo! Finance is $39.60 and $39.57 at Barchart.
Moreover, AnaChart reports that 20 analysts who've recently published targets on CSX stock have an average price target of $40.40 per share, or +20.9% higher.
One way to set a lower buy-in target price and also receive extra income is to sell short out-of-the-money (OTM) put options in nearby expiry periods.
Shorting OTM Puts
For example, look at the Nov. 22 expiration period, a little over one month from now. On Thursday, Oct. 17, the $32.00 strike price put options have a price of 40 cents.
That represents a short-put yield of 1.25% for a strike price that is over 4% below the trading price of $33.41 today.
In other words, investors who secure $3,200 in cash or buying power with their brokerage firm (i.e., $32.00 x 100 shares per put contract), can immediately receive $40.00 (i.e., $0.40 x 100) after entering a trade to “Sell to Open” 1 put contract at this strike price.
The worst that can happen, if CSX falls to $32.00 or lower on or before Nov. 22, is that the account will be assigned to buy 100 shares at $32.00. That will use the $3,200 already secured as collateral with the brokerage firm.
But the downside is somewhat limited since the breakeven price is $32.00-$0.40 already received, or $31.60. That is 5.4% below today's price.
Moreover, given the higher price targets over the next year, this may be a good buy-in price. In addition, investors can then sell more OTM puts or even covered calls against these new shares.
The bottom line is that investors may see CSX as undervalued here, given its strong FCF margins. Shorting OTM puts is a way to play this to set a lower buy-in target as well as to make extra income.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
