Norfolk Southern - Why I'm Bullish

Summary:

Norfolk Southern (NYSE: NSC) is an attractive income play on the eventual U.S. economic recovery with an industry leading yield of 3.5% coupled with a competitive growth outlook, attractive valuation multiples, and a conservative balance sheet. However, I believe the share price is a little bit ahead of itself and I recommend investors initiate a half position in NSC if the stock corrects to $33, and accumulate a full position at $30.

Closing Price as of 6-18-09: $38.12

Dividend Yield: 3.5%

12-24 month Target Price: Between $49.50 and $58

Business Description:

Norfolk Southern Corp. is a Virginia based freight railroad company operating primarily in the eastern United States. NSC operates approximately 21,000 miles of railroad across 22 states comprising 2/3rds of the American population. NSC generated its 2008 operating revenues from the following traffic sources: Coal (28%), General Merchandise (52%), and Intermodal– (i.e. standardized containers that are handled and transferred between ships, trucks and rail) (19%).

NSC’s main competitor is CSX Corp (NYSE: CSX) but it also competes with other forms of freight shipping especially trucking.

Industry Note: NSC and CSX are the two overwhelmingly dominant freight shipping railroad operators in the eastern United States. Union Pacific Corp. (UNP), Burlington Northern Santa Fe Corp. (BNI), and Kansas City Southern (KSU) operate as the dominant freight shipping railroad operators in the Western United States.

Investment Thesis:

My bullish case for NSC is based on three factors:

1. The cyclical attractiveness of the railroad industry in general.
2. The secular attractiveness of railroads as a competitive alternative to trucking.
3. NSC’s industry competitive profitability, efficiency, and most importantly its dividend.

Factor 1:

Even though the economy could remain very weak for some time, transports and the railroads in particular should be one of the first groups to benefit from the eventual recovery. Indeed, the recent credit crunch and resulting economic flood have hit the railroads particularly hard. Auto sales are down 50% (decreasing automotive traffic or 8% of 2008 revenues), international trade volumes have plummeted (slashing intermodal traffic or 19% of 2008 revenues), and the unprecedented cyclical drop in electricity demand has reduced coal consumption (29% of 2008 revenues). NSC officials describe the current environment as the unforeseeable “100 year flood” which I believe to be a fair and accurate description of current conditions in the railroad industry and the economy in general.

Given that backdrop, auto sales will inevitably rebound well beyond the current sub-10 million car level if not due to anything but simple replacement demand. In addition, electricity demand simply must increase again at a minimum to accommodate population growth. Finally, economic recovery will see international trade volumes accelerate with intermodal traffic along with it, as well as a general pickup in most other cyclical commercial traffic. Thus, I expect NSC to experience a sizable pickup in overall rail shipping volumes beginning in the second half of 2010.

Factor 2:

Freight trucking carrier costs continue to rise as diesel fuel prices increase, highway congestion worsens, a chronic shortage of qualified truck drivers continues, and stricter emissions standards are implemented.

Meanwhile, the railroad industry’s renaissance coming on the back of 30 years of de-regulation and industry consolidation, has resulted in billions of public-private partnership investment in new rail capacity that offers cost effective alternatives to trucking for long-haul freight shipping. According to a U.S. Department of Transportation forecast, rail freight transportation shipping demand will increase by 88% (measured in tonnage) by 2035. That’s comparable to what was seen in the growth of annual rail freight tonnage shipped since the 1980 de-regulation.

It’s also worth noting that rail’s fuel-efficiency relative to trucking also plays well with the current administration’s emphasis on cutting carbon emissions.

Factor 3:

As shown in Table 1, all the major railroad companies have similar profitability and growth profiles.

Table 1

3/31/2009
	NSC	CSX	BNI	UNP	KSU
ROA (TTM)	6.81%	6.26%	6.49%	6.28%	4.23%
ROE (TTM)	16.41%	14.89%	17.27%	14.46%	7.85%
Operating Ratio	80.30%	76.8%	80.5%	80.3%	86.0%
P/E Forward	10.64	10.63	12.77	11.7	15.63
Yield (6-18-2009)	3.56%	2.60%	2.20%	2.10%	0.00%
Payout Ratio	30%	27%	26%	22%	0.00%
Net Debt/Cap	38%	47%	44%	33%	47%
Consensus 5yr Forward Growth	11%	9.95%	6.78%	12.30%	16.25%
PEG	0.97	1.07	1.88	0.95	0.96

What sets NSC apart is its dividend. With the highest yield (3.5%) and payout ratio of the entire industry, NSC has consistently paid a dividend for over 26 years. Over the last 12 months, NSC has increased its dividend by 17% bringing its payout ratio to a very manageable 30% on trailing earnings. Even if NSC generates just $3.05/shr in EPS in 2009 (as I am modeling), the $1.36/shr in dividends would still only be 45% of trough earnings.

Investors could be well rewarded by investing in any of the major railroad companies, however NSC’s enticing yield puts it over the top in terms of total attractiveness. In addition, NSC has a very conservative balance sheet with Net Debt to Capital of 38% (as of 3/31/2009) which is much lower than its main competitor CSX at 47% but still slightly more than Union Pacific at 33%.

Growth:

The consensus average annual growth rate in NSC EPS over the next five years is 11%. However I am modeling around 16% average annual earnings growth between year-end 2009 and year-end 2013 mainly reflecting recovery tailwinds pushing revenues and operating margins up from current trough levels.

Beyond cyclical considerations though, the railroad industry has some very bright growth prospects ahead of it in terms of capturing more of the long haul freight market. The railroad industry in partnership with various federal and state governmental agencies will be investing billions to upgrade and expand rail freight capacity in the United States. This will allow railroads to more effectively compete with trucking for long-haul freight shipping. In particular, NSC’s planned “Crescent Corridor” looks to build a 2500 mile rail network to parallel the major interstate highways running from the Northeast to the South (I-78, 81, 75, 40, 59, 85).

I believe these projects will allow NSC and the railroads in general to more effectively compete with trucking for long-haul freight shipping given that rail is the much cheaper option than trucking in most circumstances.

Legislative Risk:

The greatest risk to the railroad industry’s future is re-regulation and/or anti-trust legislation. The railroads are a natural oligopoly and are thus easy targets for charges of monopolistic pricing by rail shipping customers.

Currently, there is anti-trust legislation in Congress that if passed would effectively eviscerate the railroads by potentially causing hard-fought pricing to collapse along with returns on investment. Capital for further investment and expansion in rail capacity would evaporate. However, I believe the probability of unfriendly legislation actually passing is minimal. The railroads fit perfectly into the Obama administration’s anti-global warming agenda given their undisputable fuel efficiency and low emissions per-ton relative to trucking. It is equally important to remember the railroad’s labor unions are also united in opposition to the current anti-trust legislation, which won’t go unnoticed by the Democratically controlled Congress and a very union friendly White House.

Side-Note: Various lobbying groups representing rail freight service users contend that the railroads have little to no competition and thus no incentive to improve service at a reasonable cost. I believe this to be absurd to say the least. The railroads not only compete with themselves, but they also have to compete with other forms of freight transportation especially trucking. In addition, the railroads still don’t even meet their cost of capital (around 10%) despite sizable increases in revenues and profitability over the last few years.

Valuation:

For NSC, I have a 12-24 month price target range of between $49.50 and $58 per share. To get to these valuations, I use a multiple of 14x my EPS estimates which I view as a conservative but normalized multiple on normalized earnings.

The low end of the range reflects a multiple of 14x cycle trough 2010 EPS of $3.54/shr. The high end of the range reflects the average valuations for 2010 and post-recovery 2011 based on a 14x multiple.

Disclosure: The author does not have a position in NSC (yet).

Comments

[DmytrenkoArtem:]

posts like this looks like stock promotion :-)

Jun 19 03:52 PM

[Jim Regan:]

While I do like the rails, this analysis misses what is perhaps the most important point: location. There is a reason that I continue to reiterate UNP (and to a lesser extent, BNI) over names like Norfolk Southern... and that is that the Eastern region of the United States has been as slow as molasis with less of a sign of bottoming. UNP's CEO Jim Rogers has reiterated his belief that UNP's volume has troughed out... and they are much more efficient in maintaining workers for the eventual recovery (something NSC isn't handling as well). The west is the most dominant for the two number one cyclical and still-healthy deliverables: ag and coal. They deserve that premium spready (if not a heck of a lot more) over NSC for these reasons... so simply claiming that their valuation is better than the pack is not true.

Again, I think you did a very well and thourough job with this and I appreciate anyone who wants to pump the rails up as I think this is a terrific buy for the long run. However, please keep in mind what I have pointed out to you today as a potential hazard to your assumptions.

Regards,
-Jim Regan, BullishBankers.com

Jun 19 04:02 PM

[Trane250:]

The bean counters at NSC have done a good job at rationalizing their system and they maintain their trackage and equipment at the highest standard (unlike CSX). But they are heavily dependent on coal shipments both domestic and export. This is their big profit generator. A bet on NSC is really a bet on coal. Keep this in mind.

Jun 20 09:33 AM

[Jake Silberman:]

Since your a portfolio manager, do you publish your track record?

Jun 20 03:11 PM

[Jake2:]

Three big Red Flags: Coal, Ag (wheat stem rust, spring floods, late plantings, fertilizer cutbacks, etc., etc.), and Autos (some say the will, and some say they won't . . . . recover, that is).

Jun 20 05:32 PM

[Jake2:]

PS: A Dividend Yield of 3.5% is good, of course, but it is Total Yield which is the most important.

Jun 20 05:35 PM

[Value Inter...:]

Jake2, if an investor bought the stock when/if NSC hits 33, then the total return (including dividends) over 24 months would be between 56% and 82% assuming the stock hits my target range $49.50 to $58. I judge that as a sufficient return for the risk. You're right in that Coal, Ag and Autos are risks. But then again, I see recovery in all three. Look at coal. Shipments are down mainly because the economy has contracted so hard that electricity production has acually contracted. The first time that's ever happened. And shipments will indeed recover with the economy, cheap natural gas notwithstanding. 50% of all the electricity in the US is produced with coal fired power plants. That's not something that's going to change overnight.

Jun 21 05:42 PM

[Jake2:]

Woulda, coulda, shoulda doesn't cut it.

Jun 23 12:21 PM

[Stone Fox C...:]

Dividends are nice, but they are only one part of the equation. What about buybacks? The total net payout is more important. CSX does a decent amount of buybacks.

Jul 01 05:50 PM