Newsletter Value Investor Insight carried an interview December 22nd with Robert Jaffe, who started his own fund, Force Capital, after working with Steven Cohen of SAC Capital for eight years. Force Capital now manages about $1.2 billion, and its core long-short fund has earned net returns of 17.0% per year since inception in mid-2002, versus 13.0% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview (also with co-workers with Mark Cohen, Paul Klibanow and Eric Newman) in which they discuss Norfolk Southern (NYSE:NSC), which was trading at $49.72 at the time of the interview (current price here):
Norfolk Southern (NSC), is in another less-than-glamorous business, railroads.
Eric Newman: An important part of the thesis here is the ongoing change in the competitive environment for railroads. From about 1830 to the 1950s, railroads were basically the only means of ground transport in the U.S. The industry was then devastated when 40,000 miles of supply were added to the ground transportation system through interstate highways. Regulated railroads couldn’t compete against a trucking industry that moved things faster, more reliably and door-to-door.
Today you have a dramatically changed landscape in ground transport. Having been deregulated, railroads have driven costs down through consolidation and have improved speed and reliability by investing in new technology. It’s now 15-40% cheaper to send goods via rail and the truckers’ remaining speed advantage is decreasing due to road congestion. The highway system has barely grown over the past 30 years, but the number of trucks on the road moving freight has doubled.
In addition, truckers are facing other major secular headwinds. They have a labor shortage – nobody wants to be a long-haul trucker anymore – and increasing insurance costs and emissions-control regulations are putting significant pressure on their costs.
On the demand side, the explosion of international trade, as U.S. manufacturers continue to extend their supply chains overseas, will continue to keep demand for ground transport growing nicely.
RJ: All of which bodes well not only for railroads’ ability to take market share, which they’re doing, but also to increase prices, which they’re also doing. The CFO of one of the large trucking companies told us recently that the railroads should raise their prices 10% tomorrow. Given the high fixed costs of the business, the operating leverage is high. A 10% increase in revenue for Norfolk Southern would translate into a 20-25% increase next year in EBITDA.
Within the railroad industry, what distinguishes Norfolk Southern?
EN: Norfolk is one of the four major rail carriers and primarily focused on the eastern half of the U.S. Their network largely runs north-south and east-west, which makes for a more rational, costeffective way to move goods. CSX, their main competitor in the east, has been struggling with a more complex route structure, cobbled together through several acquisitions. Having spent heavily over many years to upgrade and rationalize their network, we expect Norfolk’s capital spending needs to decrease. Today, after necessary capital expenditures, the company is throwing off more than $1 billion per year in free cash flow. In addition to being smart operators, management has also proven to be smart allocators of capital. When the shares fell more than 20% in the month after second- quarter earnings came out, they bought back 4% of the total shares. Given the level of cash flow and the fact that reinvestment needs have decreased, we think they’ll continue to reduce the share count significantly.
Now trading around $50, what potential do you see for the shares?
RJ: As with Lamar, part of the opportunity lies in a re-capitalization. After buying half of Conrail in 1998, the company’s net debt to EBITDA got as high as 7x before they worked it down over several years to 2x. We believe now that they should lever themselves again, given that the business is now far healthier and its prospects are bright.
We expect Norfolk to increase its EBITDA by 10% per year over at least the next three years. If they levered the company to only 5x net debt to EBITDA and used the proceeds to buy back shares, they could reduce the share count in three years by more than 240 million shares. The result would be that earnings per share, by our estimates, would hit $7.50 in 2009, up from around $3.60 this year. At the current 13x forward multiple at which the shares trade, we’d be looking at a share price in the next couple of years at around $100. If they levered up to the previous 7x level, the upside would be much higher.