CSX merger unlikely, but speculation continues

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  • | 12:00 p.m. October 20, 2014
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Analysts seem to agree that a buyout of Jacksonville-based CSX Corp. is unlikely because of regulatory issues, but that didn’t stop them from speculating last week.

The rumormongering started when The Wall Street Journal reported CSX rebuffed a merger proposal from Canadian Pacific Railway Ltd.

Analyst John Larkin of Stifel, for one, thinks such a merger could work.

“Canadian Pacific CEO Hunter Harrison has been vocal in the past about the efficacy of end-to-end mergers in the railroad industry, and the proposed CP-CSX merger fits the bill. Overlap is minimal, and CP could likely increase fluidity of the combined network by optimizing operations,” Larkin said in a research note.

“We also do not view CSX management’s disinclination to merge as a deal-killer. For CSX shareholders, a buyout offer might be hard to turn down. And the opportunity to have Hunter Harrison (in our view, the greatest pure railroad operator of our generation) at the helm of a new, combined railroad could be very enticing to shareholders,” he said.

However, Larkin and other analysts said they would have to wait and see what railroad regulators have to say about a potential big merger.

“While meaningful in and of itself, the key question is not whether CP and CSX will merge, instead it is whether the regulators will allow mergers between major Class 1 railroads at all,” RBC Capital Markets analyst Walter Spracklin said in a research report.

“While it can be argued that a merger could be beneficial for the two carriers in the long term, now is not the ideal time for such an effort to be launched, in our opinion, primarily because both shippers and regulators are currently disenchanted with the rail industry due to the ongoing service and capacity issues, which emerged late last year and are unlikely to abate in any material sense until mid-2015, a timeline that some shippers may still view as wishful thinking,” Cowen & Co. analyst Jason Seidl said in a research note.

“CP’s reported move to join forces with CSX will likely have the effect of exacerbating service concerns with shippers who will recall service challenges associated with past transactions, including those encountered by CSX in 1997 when it integrated parts of Conrail into its network after a fight over the acquisition of the company with Norfolk Southern Corp.,” Seidl said.

There are only seven Class 1 railroads — the largest class of railroads — operating in the U.S. and Canada, so any merger between them would have a major impact on North American rail traffic.

If regulators are open to mergers of the big railroads, Spracklin said “CP and CSX will be only one of many merger options to be considered and entertained.” His report took a look at all possibilities involving the seven companies.

“We see CSX more as a target than a potential acquirer,” he said.

Since CSX operates in the eastern half of the U.S., the most likely companies that could be interested in acquiring CSX would be western railroads Union Pacific Corp. or Burlington Northern Santa Fe Railway, Spracklin said. CSX isn’t big enough to think about acquiring either western railroad, he said.

Canadian Pacific operates across Canada and in northern U.S. markets.

The Wall Street Journal story prompted a spike in CSX’s stock price, but Larkin thinks the stock price will start to slip.

“We remain Hold-rated on both names (CSX and CP), as we believe merger hopes are unlikely to materialize—and, all else equal, share prices should likely retreat to prior levels over time,” he said.

Mixed views on CSX earnings

The merger speculation came the same week that CSX reported third-quarter earnings, and analysts had mixed views on the results.

CSX’s earnings of 51 cents a share were 6 cents higher than last year and 3 cents higher than the average forecast of analysts surveyed by Thomson Financial.

“Overall, we are impressed by CSX’s third-quarter results as the company was able to achieve strong earnings growth in a challenging operating environment,” Spracklin said.

However, Larkin sees problems ahead, because of the service issues.

“We would suggest that the earnings beat was largely a function of 7 percent year-over-year volume growth handled poorly by just 1 percent more employees who lacked sufficient locomotive power to move the increased revenue tonnage,” Larkin said.

“On the surface, the company’s favorable 220 basis point drop in the third-quarter operating ratio to 69.7 percent looks fabulous in the face of challenging congestion issues. However, trains departed on schedule only 54 percent of the time, while trains arrived on time an even more distressing 43 percent of the time,” he said.

The operating ratio – expenses divided by revenue – is a key metric of CSX’s performance.

Larkin said customers are giving CSX the benefit of the doubt now as the company works to ramp up its capacity to improve service levels, but he is not sure if customers will remain patient if the issues continue.

Other analysts are more confident about CSX, saying the service levels, which have affected the entire rail industry, will improve.

“With sub-70 ORs in two consecutive, poor-service quarters, and with service set to gradually improve and freight demand remaining robust, we have increased confidence in the company’s ability to meet or exceed its targets,” Seidl said.

Robert W. Baird analyst Benjamin Hartford said he is optimistic about CSX’s performance as it enters a “post-coal era of its life cycle,” with the company depending less on coal shipments.

“All in, we believe accelerating volume and pricing growth (and resulting operating leverage), as well as returning to and potentially surpassing recent peak service metrics, should drive return on asset improvement this cycle, supporting continued outperformance in CSX shares,” Hartford said in a research note.

Vistakon sales drop sharply

Vistakon, the Jacksonville-based contact lens subsidiary of Johnson & Johnson, reported a sharp drop in third-quarter sales, particularly in the U.S.

Johnson & Johnson’s quarterly report last week showed sales in its vision care business dropped 5.9 percent to $704 million.

That was partially due to foreign exchange fluctuations affecting international sales, but Vistakon’s U.S. sales plunged by 12.5 percent to $232 million. Overall, excluding the foreign currency impact, total sales in the quarter fell by 4.5 percent.

In its news release, Johnson & Johnson said Vistakon’s sales “were negatively impacted by competitive pricing dynamics.”

During its conference call with analysts, Chief Financial Officer Dominic Caruso was pressed for more details on the big drop in domestic sales.

“We took the opportunity to price reset some of our products in that marketplace. We have a lot of new and important innovations coming to market soon and when we noticed what was going on in the market, we wanted to price our products competitively with those in anticipation of the new products we have coming in the near future,” Caruso said.

“I would say there is a little bit of a slowdown overall in the market, but the impact you saw for our business was primarily a result of our price reset,” he said.

Aside from Vistakon, it was a pretty good quarter for Johnson & Johnson. The New Jersey-based medical products giant said total operational sales growth was 8.4 percent, excluding the divestiture of its Ortho-Clinical Diagnostics business. Total sales reached $18.5 billion.

Net income for the quarter, excluding special items, was $1.50 a share, up from $1.36 the previous year and 6 cents higher than the average forecast of analysts, according to Thomson.

Johnson & Johnson also increased its forecast for all of 2014 for the second straight quarter. After projecting earnings of $5.85 to $5.92 at the end of the second quarter, the company increased the forecast to $5.92 to $5.97 a share.

Analyst upgrades Rayonier to ‘outperform’

With timber markets showing improvement, RBC Capital Markets analyst Paul Quinn increased his rating on Jacksonville-based Rayonier Inc. from “sector perform” to “outperform.”

“At current levels, we see an attractive entry point and believe downside risks (from higher interest rates in the future and a more gradual US housing recovery) are priced in,” Quinn said in a research note.

After spinning off its performance fibers division as a separate company, Rayonier is now a timber and real estate development company. Quinn’s upgrade focused on the outlook for timber.

He said demand for timber is benefiting from the U.S. housing recovery and also demand from Asia, but he also said data from forest products information company RISI Inc. shows prices are increasing for sales of timberlands.

“Many market participants expect the increased deal flow (and high valuations) will compel TIMOs (timber investment management organizations) to finally liquidate over-mature funds. We expect Rayonier to be a beneficiary, profitably growing its timberland base through disciplined acquisitions.” Quinn said.

Quinn has a price target of $37 a share for Rayonier’s stock, which was trading at $31.74 when he issued the upgrade.

“While we have maintained our $37/share target, we note that private market timberland transaction comps would support an even higher valuation,” he said.

Analyst ups EverBank forecast

After seeing third-quarter results for some of the nation’s biggest banks last week, Sterne Agee & Leach analyst Peyton Green increased his earnings forecast for Jacksonville-based EverBank Financial Corp.

“Mortgage results from JPMorgan and Wells Fargo support our belief that EverBank will post stronger than expected EPS,” Green said in a research note.

He expects EverBank to post earnings per share of 33 cents, up from 27 cents in the third quarter of 2013 and 2 cents higher than the consensus forecast of analysts.

Green thinks that EverBank will record lower revenue from servicing mortgage loans than it did in the second quarter, but that its profitability will be higher after the company sold off its default mortgage servicing business to Green Tree Servicing LLC.

“Given the sale of the default servicing business, we believe the third quarter will be the first quarter with normal cash servicing expenses. Simply put, we believe that cash expenses will drop by a wider margin than servicing revenue,” he said.

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