Why I Went Long Norfolk Southern Corporation

Jan.22.14 | About: Norfolk Southern (NSC)

In Oct. 2012, I was on the lookout for new stocks that had yet to take full advantage of the rebounding US market that was sputtering at the time to fully start its historically strong growth engine. I wasn't at all concerned with which industry or vertical my new picks would come from, and, in fact, I selected three by the end of that month: Microsoft (NASDAQ:MSFT); Bank of New York Mellon (NYSE:BK); and, finally, Norfolk Southern Corporation (NYSE:NSC).

All of these stocks, at the time, fit my screener, especially in terms of: being former/current leaders in their respective fields; languishing with a depressed stock price relative to their 52-week high, and their historical average over the past five years; along with maintaining a low P/E relative to their peer set. Other stocks certainly fit my screener more than even these did, but the management consultant in me had learned over the years that metrics do not the company make.

Instead, I cast a wider net, pulling in some fringe stocks that I would take a look at qualitatively. Honestly, if I had stuck to my screener, I would have missed out on the above picks since each one missed on one or more of the screener's metrics. Given Norfolk Southern reports today, and has blown the lid off of earnings during its record-setting Q4 performance, one can easily expect a large jump today, which pre-market trading already has signaled (the stock is up nearly 4% as of this writing). However, I am not here to simply glow in the fact that my faith in my pick has me well-positioned in the short term. Instead, I wish to alert those who have yet to establish a position in this surging rail company that the good times are still to come.

How It All Began

Considering the rail industry in 2012 had taken a significant hit due to the advent to fracking technology--which proved disruptive to the coal industry's historic hegemony of a specific pocket within the energy sector--rail was on my radar and I really wished to gain a smart entry point with a specific company. After looking at the various North American leaders, I also decided to stick with US-based companies.

Of course, Berkshire Hathaway had purchased Burlington Northern Santa Fe, so that was an option, but much of the upside had already been priced into that company. At the time, both Union Pacific (NYSE:UNP) and Kansas City Southern (NYSE:KSU) both had, in general, more attractive earnings metrics, but this too appeared priced into their stock prices (i.e., relatively higher TTM P/E of above 15 and 20, respectively). Two others, CSX Corporation (NYSE:CSX) and Norfolk Southern, stood out as laggards with both having TTM P/E between 11 and 12.

After some investigation, the major contributor to this discounted price appeared obvious: Coal demand had significantly decreased and these two rail companies had, and still have, a high exposure to coal as a percentage of their rail shipments. In fact, given the increasing supply of natural gas at a historically low price, coal shipments appeared fated to continue dragging on these companies' revenues for the foreseeable future.

Finding the Diamond in the Rough

Instead of throwing in the towel and moving on, additional due diligence then informed me that, of course, both companies were working toward shifting their carload mix away from coal and to more profitable segments, like chemicals. This appeared promising for both, but then something very interesting struck me. Obviously both of these companies had room to run, if their respective companies could create new arbitrage opportunities.

Luckily, and I'd rather be lucky than good, not even a month before I had started my research, Norfolk Southern had just been awarded "its best-ever score in the S&P 500 Climate Change report released by the Carbon Disclosure Project." Considering I started my management consulting career during 2009, I was all too familiar with the various ways corporate America had recently been forced to focus on almost any and every way to improve profitability in the face of a failing economy that would no longer drive profitability through increased spending.

This now sounded promising.

Effectively Utilizing Unconventional Metrics

Perhaps this may appear counterintuitive, but I was more than happy to see that Norfolk Southern had achieved its highest rating ever, but, nonetheless, it hadn't hit the Carbon Footprint ball out of the ballpark just yet. Compared to CXS, Norfolk Southern had a significantly lower rating of 88 vs. CXS's 95 rating. Reading past articles and transcripts on Norfolk Southern's sustainability initiatives revealed that it was committed and determined to look at virtually any way to increase its rating, which had a ways to go until it would move from a B-rating to an A.

Now, over a year later, Norfolk Southern has continued to show promise in terms of turning a new (green) leaf. Reviewing the highlights from its recent sustainability shift highlights the many ways in which Norfolk Southern will continue to realize efficiency gains and cost-savings via this same shift.

Moving Forward

Even though its rating yet again increased this past year, Norfolk Southern still owns a B-rating and yet has work to do to finish its transformation. However, this bodes well for a continuing upwards trend in terms of sustainability initiatives increasing profitability for the foreseeable future.

With the other rail companies brandishing A-ratings as deemed by the Carbon Disclosure Project, they do not have as much room to run thanks to cost-savings via increased efficiencies. Norfolk Southern's B-rating, though not necessarily good for the environment, makes a strong case for the rail investor looking for a stock that has more upside that arguably has yet to get priced in. Most forecasting models have already accounted for the rebounding economy; most have also likely accounted for the stabilizing demand for coal; and most have certainly accounted for the upswing in profitability that many rail companies have displayed over the past few quarters as they shift to more profitable business.

However, the savvy investor will understand that sustainability has real-world impact, and not just in terms of making our planet greener. Interestingly enough, corporate sustainability can also line investor pockets with green.

Disclosure: I am long NSC, BK, MSFT, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.