Norfolk Southern: After A Very Strong 2013, Is This Railroad A Buy?

Apr.22.14 | About: Norfolk Southern (NSC)

Summary

As coal demand eases where is management finding revenue?

After a strong price increase how do the valuations look?

With the decline in coal, how are Norfolk Southern's fundamentals holding up?

Over the past year, Norfolk Southern (NYSE:NSC) stock price has had a very solid run. Over the past twelve months, the stock increased from ~$65.00 to the current price of $96.27. As this has been a strong increase, this poses the question, at this point in the market, is Norfolk Southern a buy?

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NSC data by YCharts

About Norfolk Southern

Norfolk Southern Corporation is engaged in the rail transportation of raw materials, intermediate products, and finished goods primarily in the Southeast, East, and Midwest and, via interchange with rail carriers, to and from the rest of the United States.

In the evaluation below, we will be able to see how Norfolk Southern has fared over the past four years regarding its profitability, debt and capital, and operating efficiency. Based on this information, we will look for strengths and weaknesses in the company's fundamentals. This should give us an understanding of how the company has fared over the past few years and will give us an idea of what to expect in the future.

Profitability

Profitability is a class of financial metrics used to assess a business' ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section, we will look at four tests of profitability. They are: net income, operating cash flow, return on assets and quality of earnings. From these four metrics, we will establish if the company is making money and gauge the quality of the reported profits.

  • Net income 2010 = $1.496 billion
  • Net income 2011 = $1.916 billion
  • Net income 2012 = $1.749 billion
  • Net income 2013 = $1.910 billion

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NSC Net Income (Annual) data by YCharts

Much like Norfolk's competitor CSX Corp. (NASDAQ:CSX) the declining use of coal has limited the bottom line growth for the companies. Over the past four years Norfolk Southern's net profits have increased from $1.496 billion in 2010, to $1.910 billion in 2013, which represents a 27.67% increase but over the past three years growth has been relatively flat.

  • Operating income 2010 = $2.676 billion
  • Operating income 2011 = $3.213 billion
  • Operating income 2012 = $3.124 billion
  • Operating income 2013 = $3.257 billion

Operating income is the cash generated from the operations of a company, generally defined as revenue less all operating expenses, but calculated through a series of adjustments to net income.

Over the past four years, NSC's operating income has increased from $2.676 billion to $3.257 billion in 2013. This represents an increase of 21.71%.

Operating Ratio

A ratio that shows the efficiency of a company's management by comparing operating expenses to net sales.

1 - (Operating Expenses / Revenue)

  • Operating Income

    • Operating Expenses 2011 = $7.954 billion
    • Operating Expenses 2012 = $7.915 billion
    • Operating Expenses 2013 = $7.983 billion
  • Total Revenue

    • Revenue 2011 = $11.172 billion
    • Revenue 2012 = $11.040 billion.
    • Revenue 2013 = $11.245 billion.
  • Operating Ratio

    • Operating Ratio 2011 = 71.29%
    • Operating Ratio 2012 = 71.7%.
    • Operating Ratio 2013 = 71.0%

When looking at NSC's operating ratio, you can see that ratio has remained relatively flat over the past three years.

ROE - Return on Equity

As shareholders' equity is measured as a firm's total assets minus its total liabilities, ROE reveals the amount of net income returned as a percentage of shareholders' equity. The return on equity measures a company's profitability by revealing how much profit it generates with the amount shareholders have invested.

Net Income / Shareholders' Equity

  • 2010 - $1.496 billion / $10.669 billion = 14.02%
  • 2011 - $1.916 billion / $9.911 billion = 19.33%
  • 2012 - $1.749 billion / $9.760 billion = 17.92%
  • 2013 - $1.910 billion / $11.289 billion = 16.92%

Over the past four years, the ROE has increased. As the ROE has increased past four years, this reveals that Norfolk has generated around more profit compared to the amount that shareholders have invested.

Debt And Capital

The Debt and Capital section establishes if the company is sinking into debt or digging its way out. It will also determine if the company is growing organically or raising cash by selling off stock.

Total Liabilities To Total Assets, Or TL/A ratio

TL/A ratio is a metric used to measure a company's financial risk by determining how much of the company's assets have been financed by debt.

  • Total assets

    • Total assets 2010 = $28.199 billion
    • Total assets 2011 = $28.538 billion.
    • Total assets 2012 = $30.342 billion.
    • Total assets 2013 = $32.483 billion.
    • Equals an increase of $4.284 billion
  • Total liabilities

    • Total liabilities 2010 = $17.530 billion
    • Total liabilities 2011 = $18.627 billion
    • Total liabilities 2012 = $20.582 billion
    • Total liabilities 2013 = $21.194 billion
    • Equals an increase of $3.664 billion

Over the past four years, Norfolk Southern's total assets have increased by $4.284 billion, while the total liabilities have increased by $3.664 billion. This indicates that the company's assets have increased more than the liabilities thus adding shareholder value.

Working Capital

Working Capital is a general and quick measure of liquidity of a firm. It represents the margin of safety or cushion available to the creditors. It is an index of the firm's financial stability. It is also an index of technical solvency and an index of the strength of working capital.

Current Ratio = Current assets / Current liabilities

  • Current assets

    • Current assets 2010 = $2.471 billion
    • Current assets 2011 = $1.751 billion
    • Current assets 2012 = $2.242 billion
    • Current assets 2013 = $3.075 billion
  • Current liabilities

    • Current liabilities 2010 = $2.082 billion
    • Current liabilities 2011 = $1.701 billion
    • Current liabilities 2012 = $2.081 billion
    • Current liabilities 2013 = $2.305 billion
  • Current ratio 2010 = 1.19
  • Current ratio 2011 = 1.03
  • Current ratio 2012 = 1.08
  • Current ratio 2013 = 1.33

Over the past four of years, Norfolk's current ratio has increased from 1.19 to 1.33. As the current ratio is currently above 1, this indicates that Norfolk would be able to pay off its obligations if they came due at this point.

Common Shares Outstanding

  • 2010 shares outstanding = 367 million.
  • 2011 shares outstanding = 346 million.
  • 2012 shares outstanding = 321 million
  • 2014 shares outstanding = 309 million

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NSC Shares Outstanding data by YCharts

Driven by Norfolk's share buyback program, the amount of shares outstanding has decreased over the past four years. The company has decreased the shares from 367 million to 309 million.

Operating Efficiency

Operating Efficiency is a market condition that exists when participants can execute transactions and receive services at a price that equates fairly to the actual costs required to provide them. An operationally efficient market allows investors to make transactions that move the market further toward the overall goal of prudent capital allocation without being chiseled down by excessive frictional costs, which would reduce the risk/reward profile of the transaction.

Gross Margin: Gross Income/Sales

The Gross Profit Margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).

  • Gross margin 2010 = $6.203 million / $9.516 billion = 65.17%.
  • Gross margin 2011 = $7.049 billion / $11.172 billion = 64.00%.
  • Gross margin 2012 = $7.000 billion / $11.040 billion = 63.41%.
  • Gross margin 2013 = $8.804 billion / $11.245 billion = 74.46%.

In 2013 Norfolk's gross margin increased significantly. The ratio increased from 63.41% in 2012 to 74.46% in 2013.

Asset Turnover

The formula for the asset turnover ratio evaluates how well a company is utilizing its assets to produce revenue. The numerator of the asset turnover ratio formula shows revenue found on a company's income statement and the denominator shows total assets, which are found on a company's balance sheet. Total assets should be averaged over the period of time that is being evaluated.

  • Revenue growth

    • Revenue 2010 = $9.516 billion
    • Revenue 2011 = $11.172 billion
    • Revenue 2012 = $11.040 billion
    • Revenue 2013 = $11.245 billion
    • Equals an increase of 18.17%.
  • Total Asset growth

    • Total assets 2010 = $28.199 billion
    • Total assets 2011 = $28.538 billion.
    • Total assets 2012 = $30.342 billion.
    • Total assets 2013 = $32.483 billion.
    • Equals an increase of 15.19%.

Over the past four years, the revenue growth has increased by 18.17% while the assets have increased by 15.19%. This is an indication that the company from a percentage point of view has been more efficient at generating revenue.

Based on the information above, we can see that Norfolk Southern has produced good results from a fundamental point of view. Revenues over the past four years have increased by 18.17%, while the shares outstanding have been reduced by 15.80%. The company's revenues have increased more than the assets, indicating the company is more efficient at generating revenue with its assets. Another strong indicator of efficiency is the gross margin had a strong increase in 2013.

The Decline in Coal

Much like the other railroads Union Pacific (NYSE:UNP) and CSX, Norfolk Southern must deal with the declining use of coal. In the United States, coal consumption is expected to remain below the 2010 level for the foreseeable future and over the next few years is expected to be flat. So even though there are spikes in coal use and shipping the overall trend is not up.

In 2013, Norfolk's coal shipping revenue was 11.67% lower than in 2012. In 2012, Norfolk's coal shipping revenue declined 16.74% compared to 2011. Over the past couple of years, revenue from coal shipping has declined from $3.458 billion in 2011 to $2.543 billion in 2013. The reduction in coal shipping equates to a decline of ~26.46%. So, even though coal shipping is on the decline, Norfolk's overall revenues and earnings have remained flat over the same period so management is finding other ways to support earnings.

As the U.S. economy is slowly recovering, Norfolk has other avenues that are "picking up the slack" regarding revenue. Leading the way in growth is chemical shipping. Volume growth in this area is being driven by an increase in energy-related shipments that included
crude oil, liquefied petroleum gas ("LPG") and frac sand. In 2013, chemical shipping increased by 13.63% to $1.667 billion. This equates to ~14.82% of the company's total revenue. This is up from 2012 numbers as in 2012 chemical shipping equated to ~13.29% of Norfolk's total revenue.

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Looking forward, as the U.S. slowly recovers from the 2008/2009 economic lows, I expect revenue from the chemicals and Construction to lead Norfolk Southern's revenue growth over the next couple of years.

Valuations

In the section below, I will use a couple of different methods to find a valuation of the stock price. In this section, I will use the Discounted Cash Flow valuation model and EV/EBITDA ratios to estimate the current value and target price for each share.

I believe using the Discounted Cash Flow valuation model for Norfolk Southern to be fair, because DCF analysis can help one see where the company's value is coming from and can generate an opinion based on that.

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Even though there are variations in calculating this formula, this model is based off of a terminal value of $41.289 billion and a WACC of 6.13%. The terminal value of $41.289B is based off of the company trading at an industry average of 9.88x EBITDA. Using this valuation, I have concluded Norfolk Southern's value to be ~$99.64 per share.

EV/EBITDA = Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization

In the next section, I will use the EBITDA to calculate the EV/EBITDA. The adjusted EBITDA takes into account foreign exchange and share-based payment expenses. The EV/EBITDA ratio is one of the most commonly used valuation metrics, as EBITDA is commonly used as a proxy for cash flow available to the firm.

Enterprise Value or EV = Market Capitalization + Total Debt - Cash and Cash Equivalents.

  • EV - 29.500 billion + $9.448 billion - $1.443 billion = $37.505 billion
  • EV = $37.505 billion
  • EBITDA = 4.179 billion
  • EV/EBITDA = 8.97

As the Railroad sector often trades in the 9.88x trading range, an EV/EBITDA ratio of 8.97 supports the DCF valuation by indicating at current levels the stock is currently undervalued.

As the DCF and the EV/EBITDA both indicate that Norfolk Southern is slightly undervalued at this point in the market, what does a future target price look like? Using the EV/EBITDA ratio along with calculating future EBITDA, cash and debt we should get a 2015 target price.

2015 Target Price

  • Estimated Net debt = $10.27 billion
  • Estimated cash and cash equivalents = $1.5 billion (~same)
  • Estimated future EBITDA (2015) $4.471 billion
  • EV/EBITDA = 9.88 (industry average)
  • Shares Outstanding = 308 million
  • 2015 equity value = 9.88 x $4.471 billion = $44.17 billion
  • Equity Value - net debt + cash = Enterprise Value = $35.40 billion
  • EV / Shares outstanding = $35.40 billion / 308 million
  • Target Price of = $114.93 per share

Based on the EV/EBITDA formula to find a target price, I have calculated a target price in 2015 of $114.93 per share.

As of April 21st, Norfolk Southern's stock was trading at $96.27 - Using the Discount Cash Flow Formula, this indicates the stock is trading below its fair value of $99.64 by 3.5%.

In calculating a target price for 2015 using the EV/EBITDA formula ratio, this indicates a valuation $114.93 per share or potential upside of 19.38%.

Strategy

At this point in the market, I would not be surprised if there was a 5%-10% correction over the next few months. If such a correction were to occur, this could present an excellent opportunity to add positions in a company with excellent growth prospects. Currently, I believe there is further upside to equity markets as major world economies are either recovering or on the verge of recovering. As interest rates continue to remain near zero, this should favor equities.

Conclusion

Over the past year, Norfolk Southern's stock price has increased by ~48.1%. This has been an excellent run, but creating concerns looking forward is the long-term outlook for coal and equating that concern to future earnings. Having stated that, Norfolk Southern's management is relying on a strong increase in Chemical shipping to make up for the lost revenue in coal use.

Driven by the slowly expanding economy and a strong management team that is adapting to an ever-changing economic landscape, Norfolk Southern is a strong long-term candidate for your portfolio. At current levels using the Discounted Cash Flow Formula, I have calculated that Norfolk Southern is currently undervalued by ~3.5%. For the reasons stated above, I believe 2014 and 2015 will be strong years for the company and have calculated a target price for 2015 at ~$114.93.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.