We increased our CSX (CSX) fair value estimate to $48 from $41 per share based on our increased confidence that Hunter Harrison will be named CEO this year, and that he will improve CSX's operating ratio faster than we previously projected. Our conviction increased due to SEC filings late last week that reveal CSX board’s concern over Harrison’s compensation and the number of board seats activist investor Mantle Ridge would fill. Absent are stated opposition to Harrison and a defense of incumbent leadership or the status quo operating plan. CSX CEO Michael Ward, 69, is long-tenured, having lead CSX since 2003. The 2015 departure of its then COO and CEO successor Oscar Munoz to head United Airlines left CSX without a clear heir, thus we believe there is less objection from a board backing its chosen player.
We awarded Harrison Morningstar’s 2013 CEO of the Year award for turning around three railroads during his career. Under his leadership Canadian Pacific improved its OR from 81.3% in 2011 (the year before his arrival) to 58.6% in 2016—nearly 23 percentage points of improvement. Were we charged with stewardship of a railroad’s operations, we’d turn to this proven catalyst. Harrison’s playbook at CP was the same as at CN: He implemented precision railroading and quickly right-sized all the assets, including human resources, real estate, sorting yards, motive power, and rolling stock.
We previously projected improvement to a 65% OR by 2020, but now assume 60% by 2021 by reducing labor, materials, and equipment costs. Assuming greater profit from fewer assets, we also increased our projected return on new invested capital from 15% to 18%. We incorporate no federal tax rate reductions because uncertainty on accelerated depreciation and interest deductability cloud the net benefit (if any) for railroads, given their high capital spending requirements and interest payments. Also, a reduced tax shield in calculating the cost of capital is a powerful lever in our DCF model.
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