Norfolk Southern: Railroads May Struggle to Maintain Strong Performance

 |  Includes: FCL, NSC, VSUNQ
by: Dmitriy V

The next industry to get hit is railroads -- unlike financials, this will not happen overnight. Until now, equity value of railroad operators has, for the most part, been preserved. However, current railroad valuations are not factoring in the impact of lower commodity prices and a hobbled manufacturing industry.

Take Norfolk Southern, Corp. (NYSE:NSC) as an example. NSC's stock has more than tripled in the five year period from September 2003 to September 2008. The price increase can be easily attributed to manufacturing growth, a weaker dollar, an ethanol boom, and attractive coal prices. Total railway operating revenues increased 81% from quarter ending September 2003 to September 2008. Revenue from coal increased from $372 million to $876 million in the same time period, as did the total ratio of revenue derived from coal shipments. In 2003 coal accounted for approximately 23.3% of operating revenue but in 2008 coal made up 30.3% of total operating revenue.

There is a growing concern that given current economic conditions, companies such as NSC face a trifecta of negative pressures.

First, the stronger dollar compounded by the weaker domestic manufacturing demand will cause continued weakness in railroad shipments.

Second, an overall decline in the price of oil is not only an indicator of lower demand for the commodity but is also correlated to demand for rail. In other words, if people are driving less and trucks are hauling less, then it is likely that rail is being used somewhat less too. More importantly, weaker oil becomes a renewed competitor to railroads. If oil breaks $50, many of the current incentives to use rail will, if not disappear, at the very least be far less attractive.

Third, political implications of a Democratic controlled government will harm rail's overall profits. While an Obama administration may be more amiable to ethanol, and ethanol has been an increasing source of revenue for companies like NSC, Verasun's (VSE) recent bankruptcy demonstrates that ethanol is not an economically feasible business model, especially with the collapse in oil prices. Consequently, even if ethanol shipments may increase moderately over the next few years following further government backing, it will not make-up for the significant short fall in other shipment traffic.

Other profit segments may also get cut off at the feat - the Obama camp has explicated its distaste for the coal industry. Senator Biden said "No coal plants here in America" and according to a statement made to the San Francisco Chronicle, President-elect Obama appears to have no qualms about bankrupting coal fired power plants. Point being that any significant regulatory shifts related to emission caps will certainly hinder coal plants and coal shipments will slow.

Given NSC's increased reliance on coal for revenue it is not unfeasible that its total operating revenue will decrease substantially in the next year or two. If coal producing companies are leading indicators, then look no further than Foundation Coal Holdings, Inc. (NYSE:FCL). FCL, which was trading at $89 earlier this year, then hit a 52 week low of $13.30 on October 28, 2008 after very disappointing results.

NSC's current P/E is in the 13-14 range, but economic and political forces indicate that rail growth will likely be hindered, and the P/E will adjust higher, and the stock price lower, as a result. This revenue-destroying pattern may hit other railroad companies in much the same way. Of course, all of this is strongly correlated to current economic conditions and may change given a surprise stimulus package or dramatic changes in the valuation of the dollar.

Disclosure: none