Railroads have largely outperformed broader indexes of late, and I continue to find that they are undervalued. In this article, I will run you through my DCF model on Norfolk Southern (NSC) and then triangulate the result with an exit multiple calculation and a review of the fundamentals compared to CSX (CSX) and Union Pacific (UNP). I find that all three are meaningfully undervalued.
First, let's start with an assumption about the top-line. Norfolk Southern finished FY2011 with $11.2B in revenue, which represented a 17.4% gain off of the preceding year. I model 15.5% per annum growth over the next half decade or so. This is believable given positive secular trends from free trade and improving momentum in the global economy.
Moving onto the cost-side of the equation, there are several items to consider: Operating expenses, capital expenditures and taxes. I model cost of goods, which have been on the decline, trending from 71% to 67.5% over the explicitly projected period. During that same time, I model capex staying constant at around 15%. Taxes are estimated at 33% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model).
We then need to subtract out net increases in working capital. I model this hovering around -0.1% over the explicitly projected period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 8.5% yields a fair value figure of $82.72, implying 24% upside. Assuming a multiple of 14x and a conservative 2013 EPS of $6.44, the stock could hit $90.16.
CSX trades at a respective 13x and 10.4x past and forward earnings with a dividend yield of 2.8%. Consensus estimates for its EPS forecast are that it will grow by 8.4% to $1.81 in 2012 and then by 14.9% and 13% in the following two years. Assuming a multiple of 14x and a conservative 2913 EPS of $1.97, the stock would hit $27.58, implying 27.2% upside. CSX is the new hot railroad stock and is led by top management. With 20% greater volatility than the broader market, it is, from a technical position, also well positioned to generate high risk-adjusted returns from a recovery.
Union Pacific trades at a respective 15.8x and 11.5x past and forward earnings with a dividend yield of 2.3%. Consensus estimates for Union Pacific's EPS forecast are that it will grow by 20.4% to $8.09 in 2012 and then by 14.2% and 14.5% in the following two years. Assuming a multiple of 15.5x and a conservative 2013 EPS of $9.20, the stock would hit $142.60, implying 34.3% upside. Union Pacific merits a premium due to the fact that it is the largest railroad and has years of successful operating experience. The company is a very safe stock and, in my view, expectations have been set unreasonably low in terms of growth. This will, again, enable the company to outperform broader indexes.
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