CSX worth $34, despite reliance on King Coal
With stricter environmental regulations in the U.S. and signs of a slowdown in China, coal's importance to freight carriers will likely decline.
While coal production and demand are likely to grow over the next few years, driving traffic volume for freight carriers such as CSX Corporation (CSX) and Union Pacific (UNP), there may be a long-term shift away from this reliance.
With stricter environmental regulations in the U.S. and signs of a slowdown in economic growth and infrastructural developments in China, we expect that coal's importance to freight carriers will gradually decline.
Our price estimate for CSX is $34, which is about 60% above the current market price.
Analysts have predicted a deceleration in emerging markets like Brazil, Russia, India and China (BRIC), with average economic growth estimates by the International Monetary Fund for these four nations reduced to 6.1% in 2012 compared to 9.7% in 2007.
China has recently announced plans to cut its railway construction expenditures by 42% in 2012. This report from SBS Dateline offers an overview of concerns surrounding construction and the development of "ghost cities" in China. These factors point to a slowdown in infrastructural activity and raise questions about whether China will sustain its demand for coal, which has been the greatest stimulus to producers in the U.S.
Additionally the demand for coal in Europe will probably contract as its economy struggles with debt issues.
Coal producers in the U.S. may also face competition from Australia. We think that railroads that anticipate a sustained increase in coal exports to Asia, South America and Europe may need to reconsider their strategy, as it seems that coal might not be their key to better profits in the long term.
Furthermore, recent regulations by the U.S. Environmental Protection Agency (EPA) requiring a reduction in mercury emissions from power plants will likely lead to the eventual closure of several old coal-fired plants. These new rules could cost utilities as much as $9.6 billion per year, but the EPA contends that the health benefits will outweigh the costs substantially. The agency has extended some concession to the industry by allowing companies more time to implement emission-reduction technology. These regulations are a setback to domestic demand for coal, which was already competing with low-priced natural gas used for electricity generation.
We believe that while coal may account for a significant portion of total freight carried by railroads in the next few years, this trend might not hold and other commodities such as agricultural, industrial and consumer products will likely drive the volumes and profits of railroads in the future.
You can modify the chart above to see how a reduction in the U.S. rail carloads of coal would impact our price estimate for CSX.
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