Norfolk Southern Corporation (NSC) is a national logistical company, with the most extensive intermodal network in the United States. As a major transporter of industrial products, the company engages in truck, rail and ocean freight transportation services. Norfolk's operations include the transportation of raw, intermediate and primary products, such as coal, lumber, grain and automobiles. Its network extends from the East to Midwest of the U.S., and continues to the rest of the country through its subsidiaries.
At the time of this writing, NSC stock was trading at around $66, with a 52-week range of $57.57 - $78.50. It has a market cap of about $21 billion. The trailing twelve-month P/E ratio is 11.15, whereas the forward P/E ratio is 10.45. P/B, P/S, and P/CF ratios stand at 2.2, 1.9, and 6.9, respectively. The operating margin is 30.1% while the net profit margin is 17.3%. The company has some debt issues; a debt/equity ratio of 0.8 is on par with the market average.
Norfolk Southern pays solid dividends - the trailing yield of 2.88% is relatively close to the projected one of 3.08%. Upcoming dividends are expected to amount to $.50 per share. Over the last five years, the company has gradually boosted its dividend amount by 92%. The five-year dividend history suggests that Norfolk Southern is a strong dividend-growth company, as well as a regular dividend payer.
The company has a 4-star rating from Morningstar. Out of five analysts covering the company, one has a "buy" rating and one has an "outperform" rating, while the other three issued a "hold" rating. This is good reason to suppose that Wall Street holds positive, yet quite diverse, opinions about the company's future. The average five-year annualized growth forecast estimate is 15.30%. What is the fair value of Norfolk Southern given the forecast estimates? We can determine NSC's fair value using the discounted earnings plus equity model, as follows.
Discounted Earnings Plus Equity Model
This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5 + Disposal Value
V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r
While this formula might look intimidating for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.
E0 = EPS = ($5.83 + $6.22) / 2 = $6.03
Wall Street holds diverse opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 15.3%. Book value per share is $30.60. The rest is as follows:
Fair Value Estimator
Fair Value Range
(You can download FED+ Fair Value Estimator, here.)
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for NSC is between $106 and $137 per share. At a price of about $66, Norfolk Southern is trading at a considerable discount. The stock has at least 63 % upside potential to reach its fair value.
Present Economic Outlook
The railroad industry has recently experienced a surge in demand because of the increasing demand for cars and lumber. NSC has managed to capitalize on this by cutting costs. As a result, the company improved EPS to $1.60 in Q2 2012, which was above analyst expectations. Moreover, for Q3 2012 an EPS of between $1.18 and $1.25 are projected. NSC is currently replacing its fleet of locomotives with new and more efficient machinery, which will gradually help to further reduce costs. However, slumping levels of coal freight and grain shipments - and an incumbent fuel surcharge - stand to lower the company's revenues by almost $200 million in Q3 2012.
However, railway services are considered to be one of the most fuel-efficient modes of freight transportation. They remain the backbone of Norfolk's business. The utilization of this transportation method has led to decreased expenses and eventually increased margins. The company's net margin was 17.5% for 2011 compared to 15.72% a year earlier. However, difficult conditions forecasted for the future may offset the revenue generated by the utilization of intermodal services.
Norfolk's closest industry peers are Union Pacific Corp (UNP) and CSX Corp (CSX). As my model suggests, UNP and CSX are also trading at a solid discount (i.e. at least 27% and 53% upside potential to reach their fair value, respectively).
In contrast to UNP, NSC has a considerably higher debt load. A large chunk of Norfolk's debt arose from investment into new machinery, causing the company's cash reserves to fall by $551 million. However, with a relatively lower P/E ratio NSC offers a higher dividend yield, compared to UNP.
Return on Equity
The other worthy rival in the railroad industry competitor, CSX Corp offers a dividend yield of 2.46%. The company's dividends have been increasing yearly, but stand far below the payouts provided by Norfolk Southern. NSC is striving to reduce its average fleet age. They expect this step to reduce maintenance costs and, as a result, increase their competitive edge.
The company is aiming to gain a stronger foothold in the intermodal transportation industry as it converts from truck to rail transportation. Norfolk Southern now also has authorization to double stack freight for the coming year, which will allow it to increase its total freight capacity. NSC's strategy obviously underscores the company's willingness to make investments, generate significant levels of revenue, and offer attractive returns to its shareholders.
However, based on my FED+ valuation XOM is clearly undervalued, with at least 63% upside potential to reach its fair valuation range. With an attractive entry point and product diversification, as well as a profitable railroad industry overall, Norfolk Southern appears to be a safe, yet profitable, bet for the future.