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Surging Profits at This Company Bode Well for Investors

Monday - 7/15/2013, 2:54pm  ET

Warren Buffett made a fortune investing in great businesses that were unlikely to fall from glory, but that is not the only way to make money in the market. Another way to make money, perhaps even more intuitive than Buffett's method, is to buy companies that are struggling at the moment, but have enormous potential upside in the event that they turn operations around.

Such was the opportunity in shares of CSX Corp nearly a decade ago, when it traded for one-fifth the price at which it currently changes hands. The company was in terrible shape with one of the worst operating ratios in the industry, but it took several steps to correct the problem.

For one, it laid off close to 25% of its mid-level managers in an attempt to drive down labor costs. When combined with recovering rail volumes, this effort led to a substantial improvement in profitability -- rewarding the investors who predicted the margin improvement ahead of time.

Stacks up with competitors

Now that it has cut the fat out of its cost structure, CSX stacks up favorably with two of the best railroads in the industry: Union Pacific and Canadian National Railway . Union Pacific's relatively diverse cargo mix enables it to ride out cyclical downturns in other industries better than its peers. Meanwhile, Canadian National's industry-best operating ratio allows it to generate significant free cash flow even in this capital-intensive industry. But CSX's improvements in its cost structure have allowed it to generate free cash flow in line with that of its peers.

Moreover, all three railroads' profits are protected by the nature of their assets; each has a network of installed track that is impossible to replicate because virtually no rail is allowed to be built where it already exists. This gives the companies local monopolies in many cases, enabling them to earn relatively predictable profits.

However, this also exposes the railroads to the industries and local economies that use rail transport. For instance, about 10% of Union Pacific's 2012 freight revenue came from transporting automobiles; a slowdown in the industry would have a significant adverse effect on the railroad's overall revenue.

But as long as gasoline prices remain at an elevated level -- which may well be forever -- railroads will continue to benefit from increased rail volumes due to the industry's value proposition relative to the trucking industry. As a result, railroads as a group should continue getting better over time.

Valuation

CSX is no longer the broken-down company selling at a low price that it was in 2003. However, its much-improved EBITDA margin makes it a viable investment candidate.

CSX has generated close to $3 billion in pre-tax earnings over the last four quarters -- it currently trades at just 8.3 times that figure. A quick look at Canadian National's results make me believe that $3 billion could be a sustainable figure; Canadian National averaged an 11.7% pre-tax return on tangible invested assets over the last decade, and $3 billion in pre-tax earnings is less than an 11% return on CSX's tangible invested assets. Moreover, CSX has earned 10% to 11% on tangible invested assets over the last three years -- suggesting that this is not a fluke.

However, Canadian National is one of the most profitable railroads in the industry, and matching its record over the long run seems like a large assumption to make for CSX. But Union Pacific's pre-tax return on tangible invested assets has wavered between 11% and 15% over the last few years, reflecting the strong increase in freight volumes experienced throughout the industry. While certainly not the best railroad, CSX's improvements have placed it among the best. If the srongest railroads are besting 11% returns on assets, CSX can likely accomplish the same.

Bottom line

If CSX can earn $3 billion or more before taxes, the stock is cheap. However, it is important to remember that railroads' profitability has increased over the last few years due to a recovering North American economy combined with elevated gasoline prices. Although both trends seem likely to persist in the intermediate term, a reversal of these trends would harm all railroads' earning power.

Nonetheless, it is difficult to find a company trading at less than nine times pre-tax earnings in this rising market, so CSX represents an interesting investment opportunity.

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This article was originally published as Surging Profits at This Company Bode Well for Investorson Fool.com

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