Norfolk Southern Aims To Get Back On Track

| About: Norfolk Southern (NSC)

Summary

Coal weakness has caused Norfolk Southern to be oversold.

The general merchandise segment continues to be strong.

Management is determined to improve operational efficiency.

Shares are cheap, and contrarians should keep NSC on their radar.

Norfolk Southern has had a very volatile year, as the stock is now -26% lower than its high in 2014. The company has great coverage in the eastern United States with over 20,000 miles worth of track. Coal accounts for a huge part of Norfolk Southern's revenue stream. There's no question that coal has faced huge weakness, and this weakness is expected to continue, as cleaner renewable sources of energy become more popular. While the pessimism over Norfolk Southern's coal exposure has been high this year, investors need to take a step back and look at the bigger picture to see if there is value to be had for a contrarian investor. The company has a fantastic general merchandise segment and intermodal freight division that could potentially offset the weakness in coal that is expected to last for the long term.

General merchandise segment continues to be strong

While investors have been selling NSC because of its coal exposure and the loss of hope of an acquisition from Canadian Pacific Railroad (NYSE:CP), I think there are strong divisions in Norfolk's business that could offset the weakness in its coal division. The company has had steady growth in its general merchandise revenues, and chemicals are the reason for this continued year-over-year growth. NSC had a compounded annual growth rate of 8% in its industrial segment. Industrial sulfur, oil and other chemicals drove revenues, and as the oil rally continues, we can expect both volumes and margins to increase as we head into the latter part of 2016. Last September, NSC acquired 282 miles of railroad from Delaware & Hudson. This gives the company a greater presence in the New York and New England markets, which are hot spots for general merchandise and automobiles, both of which will provide a boost to NSC's general merchandise segment. This increasing YoY revenue for general merchandise is expected to increase the long-term revenue, which has been at a very poor 0.9% over the last five years.

Management determined to improve operational efficiency

Norfolk Southern's management has a strategy in place to improve its operating margins. This improvement is looking to offset the weakness of the commodity prices and its decreasing coal carloads. The company's locomotive engineer assist or display event recorder (LEADER) technology helps its conductors regulate speed and dynamic braking in order to improve fuel economy and minimize accidents, both of which will drive its margins. The LEADER technology has been shown to produce a 2.2% improvement in fuel efficiency, and it could go even higher as the technology continues to improve. Net margins have been a very impressive 16% over the last twelve months, which is impressive considering the immense weakness of the coal segment, which dragged margins down in the last year.

In an effort to improve margins in the long run, Norfolk Southern has been investing in updating its locomotive fleet with eco-friendly technology that will improve fuel efficiency, minimize accidents and also allow the company to get higher scores on clean air regulations that may be put in place once the government starts implementing a carbon tax for emissions. The average age of its locomotives are 23.1 years, and 30.1 years for its freight cars. Most of its current locomotives were built before 1999 and are quite fuel-inefficient, as well as more prone to incidents considering wear and tear. I believe the investment in building new locomotives and freight cars will drive long-term margins and unlock value for shareholders who intend on holding NSC for many years.

Conclusion

There's no question that investors are very fearful over owning NSC right now, especially considering the huge weakness in its commodity segments and its overexposure to coal. This opens up buying opportunities for contrarian investors, as NSC is extremely cheap right now, especially considering management's determination to do what it can to offset weaknesses in commodities that it can't control. Norfolk Southern currently trades at a P/B of 2.1 and a P/CF of 8.2, both of which are lower than their five-year historical average values of 2.4 and 9.7, respectively. The operating margin over the last year has been very impressive at 29%, and is expected to improve with the margin improvement efforts put forth by NSC. Operating cash flow is 2.3x more than net income, and the cash flow margin is at a very healthy 20.4%. If you have an investment horizon of five years or more, now is the time to start buying NSC on the way down, because I believe the sell-off is way overblown, especially considering the strength in its segments which are not commodity-related.

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.

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