Norfolk Southern Looks Overvalued

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 |  About: Norfolk Southern Corporation (NSC)
by: Daniel Jones

Summary

In recent years, Norfolk Southern's fundamentals have soared, allowing its stock to appreciate far faster than the S&P 500.

In the long run, this makes the business an attractive long-term prospect, but it's not good enough to buy a healthy and growing company if that business looks overvalued.

For Norfolk Southern, it looks as though investors are paying a pretty steep price, even for a business that Warren Buffett might categorize as wonderful.

One of the most interesting and profitable companies these days is Norfolk Southern (NYSE:NSC). With a market cap of $32.6 billion, the company is one of the largest publicly-traded railroad businesses in the world and, given the large amount of infrastructure its business requires, has an attractive economic moat. With stock prices near their all-time highs, investors might think that a business like Norfolk Southern might make for an interesting play. But based on my analysis, the company might be one of many businesses whose shares are drastically overvalued.

Shares have soared… and for good reason!

NSC Chart

NSC data by YCharts

Since the end of 2009, shares of Norfolk Southern have been on a tear. Between that time and Aug. 22, 2014, the railroad business's stock has risen 101.2% from $52.42 to $105.48. This by itself is noticeably higher than the 78.3% increase in the S&P 500. To put it simply, $100,000 invested in the business at the end of 2009 would have more than doubled to $201,221, while the same amount of capital invested in the S&P 500 would have turned into a more modest (but still respectable) $178,320. If you account for dividends paid and reinvested, then the $22,901 return spread would have grown to a spread of $36,549 in favor of Norfolk Southern.

Of course, this share price appreciation didn't take place for no reason. Over the past five fiscal years, Norfolk Southern's revenue has risen 41% from $7.97 billion to $11.25 billion. According to its most recent annual report, the rise in sales was driven by a few different factors. Although management attributed some of its growth to its coal transportation operations, most of Norfolk Southern's increase in revenue came from higher general merchandise traffic.

NSC Revenue (Annual) Chart

NSC Revenue (Annual) data by YCharts

Between 2009 and 2013, the business saw the number of carloads transporting general merchandise rise 20% from 2 million to 2.4 million. This, combined with the fact that the company's overall revenue per ton mile rose nearly 16% from $0.0503 to $0.0581 while its revenue ton miles grew 22% from 159 billion to 194 billion, helped the business's top line.

From a profit standpoint, Norfolk Southern's results were even more impressive. Over the same five-year period, the railroad company's net income increased 85% from $1.03 billion to $1.91 billion. This was due, in part, to the company's sales growth, but can also be chalked up to improvements in its cost structure. Most notably was its compensation and benefit expenses, which dropped from 30.1% of sales to 26.7%, and its purchased services and rents, which fell from 17.6% of sales to 14.5%. This was, however, partially offset by a jump in Norfolk Southern's fuel costs from 9.1% of sales to 14.3%.

NSC Net Income (Annual) Chart

NSC Net Income (Annual) data by YCharts

As a result of its strong performance, especially on the bottom line, Norfolk Southern's operating metrics have come in pretty high. In 2013, the business's net profit margin hit 17%. This is a significant improvement over the 13% net profit margin reported in 2009, and demonstrates that the business is able to see impressive economies of scale despite its size.

NSC Return on Equity (Annual) Chart

NSC Return on Equity (Annual) data by YCharts

Norfolk Southern's return on equity also came in strong during 2013. For the year, management reported that this metric, which is a measure of the profits investors receive for each dollar invested into the business, hit 18.2%. This too was better than the company's performance in 2009, when its return on equity was only 10%. As margins increased during this timeframe and its book value of equity has risen modestly because of a 16% reduction in share count, the company's return on equity has become inflated.

Norfolk Southern is healthy… but it might be overpriced

There's no denying that Norfolk Southern is a strong, stable enterprise; its rising share price and improved profitability is evidence enough to prove this point. However, there are cases where even companies like it can be overvalued, leading investors who invest in the enterprise to suffer with subpar returns for years to come. Although it cannot be proven that the business is definitively overvalued, a recent analysis I conducted of it using one of my own equity analysis methods makes its shares at least look appear pricey.

P/E Valuation Approach
2013 2012 2011 2010 2009
Share Price (Dec. 31) $92.83 $61.84 $72.86 $62.82 $52.42
Earnings per Share $6.05 $5.38 $5.55 $4.08 $2.82
Price/EPS 15.34 11.49 13.13 15.40 18.59
Average P/E 14.79
X X
Forward EPS 6.48
= =
Value $95.84
Click to enlarge

In the table above, we are looking at Norfolk Southern's share price at the end of its fiscal year for years 2009 through 2013 and comparing it to the business's earnings per share reported for that fiscal year. While there are several different ways to look at price in relation to profits, I determined that if the market is even moderately efficient as academicians believe (but I dispute), then the market should align the company's value on or around its final day of operation for the year with its closing share price for that year.

By looking at this price/earnings per share ratio, it's easy to see that, in 2013, Mr. Market believed it just to pay $15.34 for each dollar of profit that Norfolk Southern earned for the year. This was up from the $11.49 paid for 2012 but down significantly from the $18.59 seen in 2009. By averaging all five years worth of data together, we see that investors have paid, on average, $14.79 for each dollar of earnings during this timeframe.

Given this, and assuming that analysts are correct and the railroad operator will earn $6.48 for its current fiscal year, investors can buy the business for 16.28 times earnings. By multiplying its five-year average P/E by its current share price, investors get a fair value estimate on the company of $95.84. This metric alone suggests that Norfolk Southern's shares are overvalued in the range of 9%.

Price/Book Value Valuation Approach
2013 2012 2011 2010 2009
Share Price (Dec. 31) $92.83 $61.84 $72.86 $62.82 $52.42
Book Value per Share $36.55 $31.08 $30.00 $29.86 $28.06
Price/BV per Share 2.54 1.99 2.43 2.10 1.87
Average BV per Share 2.19
X X
Current Book Value per Share $39.02
= =
Value $85.45
Click to enlarge

Another way to look at the enterprise is through its book value, a favorite valuation metric of Warren Buffett. In the table above, we employ the same method but, instead of using earnings per share in the denominator, we place Norfolk Southern's book value per share. Despite the fact that the business's book value of equity hasn't changed much during this timeframe, the big drop in its share count caused the company's book value per share to rise 30% from $28.06 to $36.55.

Applying the same five-year average approach yields an average price/book ratio of 2.19 which, given the range of its measure in each of the past five years, doesn't seem extreme. From here, if we take the company's current book value per share of $39.02 and multiply it by this five-year metric, we arrive at a fair value share price for Norfolk Southern's stock of $85.45, 11% lower than its P/E estimate.

The final method I employed to value Norfolk Southern's stock is its price in relation to its free cash flow per share. Just as in the case of the two previous methods, I used price in the numerator and the company's free cash flow per share in the denominator. As we can see in the table below, the business's free cash flow is far more volatile than earnings. This is because, unlike in the case of the income statement, which utilizes accrual accounting, the statement of cash flows uses cash accounting.

Price/Free Cash Flow per Share Approach
2013 2012 2011 2010 2009
Share Price (Dec. 31) $92.83 $61.84 $72.86 $62.82 $52.42
Free Cash Flow (billions) $1.11 $0.82 $1.07 $1.24 $0.56
Free Cash Flow per Share $3.58 $2.62 $3.23 $3.48 $1.52
Price/Free Cash Flow/Share $25.93 $23.60 $22.56 $18.05 $34.49
Average Price/FCF per Share $24.93
X X
2013's FCF per Share $3.58
= =
Value $89.25
Click to enlarge

This means that, in years where capital spending is on the rise, Norfolk Southern's free cash flow will be lower even if net income increases. On the other hand, a decrease in capital expenditures can push the business's free cash flow higher irrespective of what net income is. Of course, investors also need to consider other factors at play like depreciation and amortization, inventory changes, and fluctuations in the business's accounts payable and accounts receivable.

Using the same approach as above, we arrive at a five-year average price/free cash flow per share ratio of 24.93 which means that, for every $1 the business earns in free cash flow, investors have to pay $24.93. Applying this average to Norfolk Southern's free cash flow per share of 3.58 in 2013 (since analysts don't have the company's forward free cash flow approximated) would result in a value on the business of $89.25, pretty much in the middle of the P/E and P/BV approaches.

Although these averages show a value that is below where the company's shares currently trade, they aren't so low that they seem ridiculous and they are close enough together that it's difficult to call any of them a definitive outlier. Given these considerations, averaging these metrics together puts a value of about $90.18 on Norfolk Southern's stock, which suggests that shares in the business are overvalued by some 14.5%.

Putting it All Together
Estimated Value 10% MOS 20% MOS 30% MOS
Price/EPS $95.84
Price/BVPS $85.45
Price/FCFPS $89.25
Estimated Value $90.18 $81.16 $72.14 $63.13
Current Price $105.48 $105.48 $105.48 $105.48
Potentially Overvalued By: 14.5% 23.1% 31.6% 40.1%
Click to enlarge

However, many investors like myself like having a margin of safety when we invest. Instead of buying shares at fair value, buying them at a substantial discount to that fair value is where all the upside potential comes into play. Personally, I tend to prefer a company that has a 30% margin of safety, which would imply a buying target on Norfolk Southern of $63.13, but for an enterprise with as large an economic moat as this, combined with its impressive track record, it wouldn't be unreasonable to require a more modest margin of safety in the range of, perhaps, 10%. For investors who find this level sufficient, Norfolk Southern might be an attractive play with shares trading at about $81.16.

Takeaway

Norfolk Southern has had a really nice run in recent years. With the business benefiting from an economic recovery, sales and profits have soared, allowing its shares to outperform the broader market. In the long run, it's impossible to say if the business will continue doing well, but with its impressive economic moat, the odds are likely in its favor. However, just because the railroad operator is attractive doesn't mean that it's cheap. A few years ago, investors had the opportunity to buy this wonderful business at a wonderful price but today the business appears like it's more of a wonderful business at a steep price, which may only be appealing to the longest term investors.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.