By The Valuentum Team
Norfolk Southern's solid rail network supports its dividend payout, but its Dividend Cushion ratio is not great.
--> Norfolk Southern (NYSE:NSC) 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. The company has received a ~$29 billion takeout offer from Canadian Pacific.
--> Though Norfolk Southern is now a target, we still prefer peer Union Pacific (NYSE:UNP) as our favorite railroad idea. Union Pacific's operating ratio should 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 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. Much like CSX (NYSE:CSX), Norfolk Sourthern's dividend may face pressure in coming years on the basis of its poor Dividend Cushion ratio and weakening free cash flow conversion rate.
--> The US Department of Transportation recently implemented regulations that require the installation of new braking systems on trains hauling more than 70 cars of crude oil by 2021. Industry participants have voiced concern that the new rules will make shipping crude oil by train prohibitively expensive.
--> Norfolk Southern's business performance can be impacted by weather, and its exposure to coal cannot be ignored. Weak global export markets and fewer shipments to utilities may be permanent developments in the coal industry.
Note: Norfolk Southern's annual dividend yield is above average, offering a 3.4% yield at recent price levels. Though we prefer yields above 3% in our dividend growth portfolio, other factors keep us from considering exposure to Norfolk Southern. This article explains why.
Metrics at Norfolk Southern have been moving in the right direction the past few years, with the company achieving $2 billion in net income for the first time in 2014. The railroad operator's operating ratio also dropped below 70% for the year, and while that may not impress relative to peers, it does reveal several percentage points of improvement since 2012. The company's dividend policy may be attracting income investors more than its underlying fundamentals, however. Norfolk Southern has a record 130 consecutive quarters of paying dividends, even as it buys back stock and allocates investment. Its Dividend Cushion ratio suggests dividend growth may slow in coming periods, however.
Norfolk Southern's ~190-year history doesn't mean it is immune to all challenges. A hefty tilt in its carloads to coal (20%+ of total railway operating revenues) will make for a challenging time as the commodity loses favor relative to cleaner and relatively abundant natural gas in the electric generation market. The company's net debt load leaves something to be desired, and while free cash flow generation has been robust, dividend obligations are not small. Incremental costs to fend off a takeover from Canadian Pacific may distract management from operations and put a halt to meaningful changes in capital allocation. We're expecting slowing growth in the payout.
From the Comments Section: How to Interpret the Dividend Cushion Ratio -- A Ranking of Risk
As for how to interpret the Dividend Cushion ratio, itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity. Said differently, a poor Dividend Cushion ratio of below 1 or negative doesn't imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow. That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash, and that means the dividend becomes increasingly more risky.
We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.
We think the safety of Norfolk Southern's dividend is very poor. Please let us explain.
First, we measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.
That has led us to develop the forward-looking Dividend Cushion™ ratio, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.
As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Norfolk Southern, this ratio is -0.2, revealing that on its current path the firm may encounter difficulty in covering its future dividends and growth in them with net cash on hand and future free cash flow.
Dividend Cushion Ratio Cash Flow Bridge
The Dividend Cushion Cash Flow Bridge, shown in the image to the right, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. Norfolk Southern's Dividend Cushion Cash Flow Bridge reveals that the sum of the company's 5-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is less than the sum of the next 5 years of expected cash dividends paid.
Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the 5-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.
Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk of a dividend cut or a suspension of growth, all else equal, in our opinion. Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less durable a company's dividend.
Dividend Cushion Ratio Deconstruction
The Dividend Cushion Ratio Deconstruction, shown in the image to the right, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Norfolk Southern's numerator is smaller than its denominator suggesting weak dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.
Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks."
Now on to the potential growth of Norfolk Southern's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we characterize its future potential dividend growth as excellent. However, in the case of Norfolk Southern, their growth potential is very poor.
Because capital preservation is also an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In Norfolk Southern's case, we currently think shares are fairly valued, meaning the share price falls within our estimate of the fair value range, so the risk of capital loss is medium (our valuation analysis can be found by downloading the 16-page report on our website). If we thought the shares were undervalued, the risk of capital loss would be low.
Wrapping Things Up
Norfolk Southern has been a takeover target of Canadian Pacific recently, but the viability of such a deal has been questioned. The firm is heavily exposed to the US coal industry, given the concentration of its rail network in the eastern US, and we can't image the industry making a material comeback anytime soon. Norfolk Southern will also face pressure as a result of increased regulations on the shipping of crude oil by rail. These factors certainly factor into our expectations for future free cash flow and dividend growth, and the firm does not have a compelling Dividend Cushion ratio as a result.
Breakpoints: Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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.