Is CSX Sounding The Horn On The U.S. Credit Cycle? by Kirk Moore, Columbia Management

  • CSX is one of the first old-line industrial companies to embark on a share buyback program funded from borrowing rather than free cash flow generation.
  • Increasing leverage while top-line growth is anemic could signal that a new stage of the U.S. credit cycle has begun.
  • While CSX’s actions are a warning signal, the crossing gates are not closed on U.S. credit.

Earlier this month, CSX Corporation (CSX) released its first quarter 2015 earnings, highlighting double-digit growth in operating income (+14%), net earnings (+11%) and EPS (+13%). The earnings performance was generated entirely by controlling costs, as revenue was unchanged at $3 billion. This is notable operating performance by CSX for which the management team should be commended.

At the same time, CSX management announced an increase in their share buyback program to $1 billion/year from $0.5 billion/year. While the impact of this increase on credit metrics (leverage increases modestly from 1.8x to 2.1x over the next 24 months) is certainly manageable, the change in financial policy is a reason to pause. When the company constructed its prior buyback policy, it was structured to be funded from free cash flow generation. The program announced in the first quarter earnings release requires borrowing to be completed. CSX is one of the first old-line industrial companies to embark on this strategy. Increasing leverage while top-line growth is anemic could signal that a new stage of the U.S. credit cycle has begun.

The classic credit cycle follows the four stages of recovery, expansion, downturn and repair. Following the 2008/2009 financial crisis, U.S. investment grade corporations were in the repair stage from 2009 to 2011. Using the change in leverage in the chart below as a proxy, high-quality corporate America reduced leverage by over a quarter turn.

Exhibit 1: U.S. IG revenue growth

CSX Corporation

Source:  Columbia Threadneedle estimates

After 2011, investment grade industrial borrowers started to let their debt levels trend back to 2.0x. We generally believe that companies at these debt levels have an adequate capital structure that balances shareholders and debtholders, suggesting that the credit cycle is in the middle of the expansion stage. As the expansion stage progresses, asset prices begin to get bid up by easy access to credit. While the Federal Reserve has provided easy access to capital for industrial America, credit has not been widely utilized to bid up asset prices, including entire companies through leveraged M&A or share prices through leveraged buybacks.

The chart below highlights average revenue growth for U.S. investment grade issuers. After the acceleration in growth witnessed post-2009, revenue growth has been flat to a modest trend downward. We expect this trend to continue into 2016. As top-line growth wanes and expense reduction opportunities disappear, more U.S. corporations might adopt CSX’s financial policies to maintain or improve their share prices, potentially signaling an approach to the end of the expansion stage.

Exhibit 2: Leverage separated

CSX Corporation

Source:  Columbia Threadneedle estimates

If aggregate leverage were to increase into the 2.25x range and the Fed’s efforts to revitalize growth were unsuccessful, the credit cycle in the U.S. could be heading for a downturn.

While CSX’s actions are a warning signal, the crossing gates are not closed on U.S. credit. Balance sheets are healthy while free cash flow and earnings growth are solid. Since 2010, operating margins have been a steady 20%. And if the Fed’s efforts result in economic growth, corporate America has tremendous operating leverage following six years of thoughtful expense reduction. The warning horn may be out there, but it is still distant.