Shares of Norfolk Southern (NSC) have taken a beating in recent months. While the entire railroad sector is feeling the pressure from lower coal volumes and a deterioration in general merchandise volumes, the weak share price performance comes as somewhat a surprise.
This follows the fact that Canadian Pacific has already made two offers for the company in an effort to consolidate the rail industry across North America. Despite the interest from its Canadian counterpart, Norfolk´s shares remain under pressure.
While the near-term prospects for consolidation might be subdued following the rejection of Norfolk´s board, I think that shares offer appeal at current levels. After a 35% pullback from the highs, the market has already priced in some bad news. Potential consolidation could act as a potential upside trigger on top of this.
Like most railroad businesses, Norfolk ships three main categories across its network. This includes intermodal, coal and general merchandise. This means that its business has come under pressure, just like its competitors. This follows the secular shift away from coal. Other headwinds include the "industrial recession," in part resulting from the strong dollar. On top of this headwind comes the fact that a lot of trucking capacity has been added in recent years as lower gasoline prices make that form of transportation much more competitive.
There are some bright spots as well, but they cannot make up for the headwinds. The housing market and automotive sector are cited as bright spots, although we have heard some alarming sounds coming out of the automotive sector as well in recent weeks.
While the slowdown in the business is obvious, the valuation is further complicated by the fact that Canadian Pacific (NYSE:CP) has expressed an interest for the business. This company has already made two offers for Norfolk, with both of them being rejected by the board.
As many investors would be interested to see a premium for their shares, and the board has rejected the proposals made by Canadian Pacific, Norfolk Southern has taken some actions to improve the operating performance. In order to save costs, Norfolk is engaging in layoffs, consolidation of the coal docks operations and a consolidation of regional businesses.
What's interesting is that Norfolk seems quite stubborn to negotiate with Canadian Pacific. The same strategy was applied by CSX (CSX) when Canadian Pacific tried to acquire that business last year. Both CSX and Norfolk have largely similar networks in terms of the geographic location. By tying up with either of these businesses, Canadian Pacific would be able to form a great network which covers the entire Eastern Coast of North America. The company is very committed to engage in dealmaking, citing that "status quo is not an option for North American rail."
Canadian Pacific has seen a real turnaround in recent years and is performing with the best operating metrics within the industry. As it's dealing with a struggling Canadian economy, it seeks to expand the business. Besides simple expansion, CP aims to improve the operating performance of its acquisition targets while it has the option to use its premium valued-stock as an expensive currency to pay for dealmaking.
Being Chased By The Canadians
As recent as December 23, Norfolk announced that its board has rejected a second takeover offer from Canadian Pacific. The Canadians were happy to pay $32.86 in cash and 0.451 shares of the new company, on top of which came a 0.451 contingency right. This right could at a maximum reach a value of $25 in case shares of Canadian Pacific would fall substantially, at least in relation to the share price of Norfolk itself.
Norfolk's board cited high regulatory risks, a modest acquisition premium and uncertainty with regard to the contingent value pricing as key reasons behind the decision to reject the offer. The latest offer furthermore included a lower cash component compared to the initial offer which Canadian Pacific made for Norfolk.
In October of last year, when the company made the first offer for Norfolk, it was willing to pay $46.72 in cash and 0.348 shares in the newly formed company. Following enthusiasm regarding the initial offer in November, when shares hit a temporary high of $98 per share, shares have now fallen back to just $72 per share. This indicates that shares trade at roughly a 10% discount compared to the offer value, as investors take the rejections of the board very seriously.
Comparing CSX And Norfolk
With both CSX and Norfolk being rather similar size, operating in the same geographical area, and both having attracted interest from Canadian Pacific, it makes sense to compare both businesses.
Norfolk is currently valued at $22 billion by the market, as the net debt load of $9 billion values the entire business at $31 billion. This valuation is just slightly more than the near $29 billion at which network is valued on the balance sheet.
Based on the trailing results, this $31 billion valuation values Norfolk at 1.1 times PP&E, 2.9 times trailing revenues and 7.2 times trailing EBITDA. Based on trailing earnings of $1.7 billion, equity of the business is valued at 12-13 times earnings. While Norfolk has shown relatively modest growth, with trailing revenues being just 25% higher compared to 2005, it has delivered on a lot of growth for its shareholders. Norfolk has bought back roughly a quarter of its outstanding share base over the past decade.
Equity in CSX is valued at $22 billion as well at the moment, as it too has roughly $9 billion in net debt. This $31 billion valuation is the same as Norfolk Southern. Its rail assets are valued at roughly $30 billion on the balance sheet, translating into a 1.0 times multiple.
As CSX is slightly larger in terms of its operations, it trades at somewhat lower valuations. Based on trailing numbers, CSX trades at 2.5 times sales and 6.3 times EBITDA. Equity trades at 11 times trailing revenues and unlike Norfolk Southern, this already includes the challenging fourth quarter results.
This shows that CSX actually trades at somewhat more modest multiples in comparison to Norfolk. CSX furthermore has a somewhat better track record as it has grown revenues by some 40% compared to 2015, as it has less exposure to the challenged coal markets.
I must say that I'm somewhat surprised to see shares of Norfolk trade down so much from a high of $98 in November to current levels in the low seventies. It's clear that the interest from Canadian Pacific is real and it makes me wonder at which levels shares would be trading if Canadian Pacific had no expressed interest in the company.
As management and the board are not eager to talk about a combination, investors act reserved. That being said, there is still some premium being priced into the shares as Norfolk trades at a roughly 10-15% premium compared to CSX based on sales, EBITDA and earnings.
For that reason, I would prefer CSX over Norfolk Southern as both companies have pretty even chances to end up being involved in future consolidation in my eyes. Besides the lower valuation, I furthermore like the fact that CSX has less exposure to coal. Irrelevant of a potential tie-up, I think that shares of both companies have fallen enough to create appeal for both companies on a standalone basis, provided that you have a long-term investment horizon.
Disclosure: I/we 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.