- We think the railroads have strong business models.
- Railroads such as Norfolk Southern are exposed to CAPP coal and are at a disadvantage long term, in our view.
- We like Union Pacific the most out of the railroad industry.
It's hard not to like the railroad industry. North American railroads operate as an oligopoly, benefit from substantial barriers to entry, and boast significant pricing power. Free cash flow generation trends are strong at the largest operators--Union Pacific (NYSE:UNP) and Canadian National (NYSE:CNI)--but industry-wide free cash flow margins (free cash flow divided by revenue) average in the mid-single-digits as elevated maintenance capital costs weigh on conversion rates.
Canadian National and Union Pacific are currently the most efficient operators (as measured by their respective operating ratios), while Genessee & Wyoming (NYSE:GWR) and Canadian Pacific (NYSE:CP) trail the pack. Coal is the single most important commodity to the railroads, accounting for more than 20% of class I railroad freight revenue. Though US coal volumes should advance over the long haul (thanks in part to the availability of low-cost, low-sulfur Powder River Basin--PRB--coal), we expect natural gas to continue to grow its portion of US electric power generation market in coming years.
CSX (NYSE:CSX) and Norfolk Southern (NYSE:NSC) are most exposed to a decline in US coal-fired power plant retirements (and higher-cost Central Appalachian--CAPP--coal), given their rail networks in the eastern US. We expect the pace of dividend growth at these two firms to face pressure in coming years on the basis of their poor Valuentum Dividend Cushion scores and weakening free cash flow conversion rates.
We're staying far away from the domestic coal mining industry, especially the most heavily-levered producers: Arch Coal (NYSE:ACI), and Walter Energy (NYSE:WLT). Economic and political pressures are making coal a less-viable thermal (electricity) option in the US, while heightening competition and myriad risks are making the US export market for metallurgical coal (steel) less attractive. US coal exports account for only about 10% of US coal production, so thermal coal consumption trends in the US remain paramount. We're also staying away from FreightCar America (NASDAQ:RAIL) where 90%+ of the railcars the firm delivers each year are used to haul coal.
Shale-oil related energy transportation demand in the Bakken, Eagle Ford, and Niobrara should help offset declining coal carload shipments, as will improvements in the domestic housing and auto markets in coming periods. We point to Mexico as a growth opportunity for both Union Pacific and Kansas City Southern (NYSE:KSU).
Each railroad has its own unique strengths and weaknesses, but Union Pacific seems to have the most things going for it. We expect the firm's operating ratio to be among the best in the group by the end of this decade, and we like its exposure to growth in Mexico as well as future export expansion on the West Coast. The firm is levered to coal, though we note its mix is more of the PRB variety, which should continue to take share from CAPP coal in the domestic market. The firm also boasts a strong Valuentum Dividend Cushion score and a decent annual yield.
Canadian National is a close second. The firm has the strongest free cash flow margin and operating ratio and boasts a solid Valuentum Dividend Cushion score. Its exposure to declining coal shipment volumes is the lowest in the group.
Kansas City Southern is our favorite acquisition candidate, given its position in Mexico, where rail carloads are advancing at a much faster pace than in the US. The firm owns the most direct rail passageway between Mexico City and Laredo, Texas, where more than half of all rail and truck traffic between the US and Mexico cross the border. We think either an eastern US railroad, CSX or Norfolk Southern (given long-term pressures with respect to declining US coal volumes), or Union Pacific (given its strategic interchange points on the US-Mexico border) may be a potential suitor. Burlington Northern Santa Fe (NYSE:BRK.A) may be interested in expanding its rail network into Mexico as well. In any case, a proposed transaction would face significant regulatory scrutiny.
If investors need exposure to coal directly (which we do not prefer), Cloud Peak (NYSE:CLD) offers the least-risky proposition given its capital structure and pure-play position in the Powder River Basin. No firm in either the railroad industry or coal mining group registers a 9 or higher on our Valuentum Buying Index at the time of this writing. Our best ideas are always included in the portfolio of our Best Ideas Newsletter.
With all of that said, let's profile Norfolk Southern's valuation in this piece. We perform such work for all companies in our coverage universe.
Norfolk Southern's Investment Considerations
• Norfolk Southern is primarily 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 US.
• Norfolk Southern has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 13.8% in coming years. Total debt-to-EBITDA was 2.3 last year, while debt-to-book capitalization stood at 45.6%.
• Norfolk Southern is heavily exposed to a decline in US coal-fired power plant retirements (and higher-cost Central Appalachian coal), given its rail network in the eastern US. We expect the pace of dividend growth to face pressure in coming years on the basis of its poor Valuentum Dividend Cushion score and weakening free cash flow conversion rate.
• The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $70, we'd take a closer look. Shares are trading at $94 each at present.
• We prefer peer Union Pacific. Union Pacific's operating ratio will be the best among peers in coming years, and we like its exposure to growth in Mexico and future export expansion on the West Coast.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Norfolk Southern's 3-year historical return on invested capital (without goodwill) is 8.3%, which is below the estimate of its cost of capital of 9.6%. As such, we assign the firm a ValueCreation™ rating of POOR. The company has a strong competitive advantage in that its rail network would be difficult to reproduce, but maintaining such a network is prohibitive at times. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. We do believe, however, that renewed pricing strength will drive higher returns in the out-years of our valuation model, which makes a strong case for an improved ValueCreation rating.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Norfolk Southern's free cash flow margin has averaged about 9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Norfolk Southern, cash flow from operations decreased about 5% from levels registered two years ago, while capital expenditures fell about 9% over the same time period. Canadian National and Union Pacific have the best free cash flow margins in the group, however (as the image below reveals).
Source: Valuentum, Factset
Our discounted cash flow model indicates that Norfolk Southern's shares are worth between $70.00 - $106.00 each. Shares are trading at $94 each at present. Though the range seems a bit wide for a railroad, carload units and pricing can swing wildly through the course of an economic cycle. We think the range is appropriate. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers.
The estimated fair value of $88 per share represents a price-to-earnings (P/E) ratio of about 14.5 times last year's earnings and an implied EV/EBITDA multiple of about 8.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 4.7% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 5.7%. Our model reflects a 5-year projected average operating margin of 32.5%, which is above Norfolk Southern's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.8% for the next 15 years and 3% in perpetuity. For Norfolk Southern, we use a 9.6% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $88 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Norfolk Southern. We think the firm is attractive below $70 per share (the green line), but quite expensive above $106 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Norfolk Southern's fair value at this point in time to be about $88 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Norfolk Southern's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $113 per share in Year 3 represents our existing fair value per share of $88 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
We prefer peer Union Pacific as our favorite railroad idea. The firm's operating ratio will be the best among peers in coming years, and we like its exposure to growth in Mexico and future export expansion on the West Coast. Norfolk Southern has a strong business model, but it doesn't have as much going for it as some of its other railroad peers.
Additional disclosure: UNP is included in the Best Ideas portfolio.