Is Norfolk Southern's Q1 Performance Sustainable?

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Douglas Adams


  • Norfolk Southern posted a banner 1st quarter performance, with net income surging just over 27% YOY. Income from operations jumped 10%, while EPS surged 30%.
  • Tax cuts and credits in December and February saw company tax liabilities fall from 34% in 2017 to 22% with company guidance projecting 24% tax liability for 2018.
  • Severe capacity constraints in the trucking industry saw the company's intermodal segment post 19% earnings growth during the quarter.
  • Investors pushed the stock up 11% after the company's 1st quarter earnings report. Is 1st quarter growth a one-off event or sustainable?

Norfolk Southern (NYSE:NSC) put up strong first quarter numbers, with net income surging just over 27% YOY to $552 million. Income from operations jumped 10% to $835 million, while EPS surged 30% to $1.93/share. Dividends for the quarter were up 18% to $0.72/share. Investors danced a bullish jig, sending the stock up 11% for the month of April, with presumably ample room to run.

Interestingly, much of the good cheer came as a result of events outside of the company's immediate operational reach, both economic and political. On the political side, the impact of the Tax Cut and Job's Act (TCJA), which included a one-time 15.5% tax holiday on foreign earnings, dropped to the company's bottom line like money falling from the sky. NSC is not an isolated example - the earnings reports thus for the first quarter from S&P companies have been some of the best in decades, with earnings per share up 26% YOY. TCJA is responsible for a good portion of these gains. Coupled with tax credits enacted retroactively by the budget compromise hammered out in February, NSC's effective tax rate fell from 34% in 2017 to 22% through the end of the first quarter, with the company offering forward guidance of an effective rate by year's end of 24%. Still, double-digit growth from core earnings is a broad indicator of corporate health and historically translates into a boon for holders of the company's capital over the intermediate term.

On the economic side, severe capacity constraints in the trucking industry pushed the company's intermodal revenue into record territory at $678 million for the quarter, up 19% YOY. The lack of supply in the trucking industry has stretched available manpower to the limits in certain markets across the country, driving up freight prices in the greater economy. Final demand prices for transportation and warehousing increased 4.7% in April, down from a 4.9% YOY jump in March for the two highest back-to-back posts since November 2010. The headwind in the trucking industry has created a boon for intermodal trailer transport that is likely to continue for the foreseeable future.

Figure 1: Norfolk Southern against the S&P Benchmark

NSC's (green line, upper frame) first quarter operational gains produced strong anticipatory market momentum (middle frame) since the second week in April with consummation coming with the earnings call and first quarter release on the 25th of April. The PPO (red line, upper frame) crossed its signal line (blue line, upper frame) during the period in a bullish move that has been sustained through Friday's market close after spending much of the year to date in a rather bearish mode, largely mirroring the path of the S&P benchmark (green area, upper frame). The PPO (black line, middle frame) crossed its signal line in the second week of April, creating a range of -2 on the downside and just over 1% on the upside. In a ratio measure against the S&P benchmark, NSC broke through its 200-day trading average (blue line, lower frame) and is now outperforming the benchmark by over 5% since its earnings report release (see Figure 1, above).

The company's perennial source of revenue comes from its merchandise segment, hauling chemicals, agricultural commodities, metals/construction, automobiles and building materials in its market mostly east of the Mississippi, but including Iowa, Missouri, Louisiana, and Eastern Texas. The merchandise segment posted earnings of $1.6 billion for the period for a 1% YOY gain. Chemical transit posted a 4% gain for the period stemming mostly from higher shipments of natural gas to meet demand for heat due to colder winter temperatures across the snowbelt states of the upper Midwest, mid-Atlantic and New England states. Agricultural commodity shipments eked out a 2% gain for the quarter despite declines in soybean and corn shipments due to market fluctuations being offset slightly by increased ethanol shipments to mid-Atlantic refineries. Metals, automobiles, and forest products were largely flat for the period.

The main revenue driver was its intermodal segment, which posted a 19% gain for the period. Intermodal volume was up 8% for the quarter, while resulting revenue per unit shipped gained 10% for the period - the only company segment in double digits in the revenue-per-unit metric. Most of the gain in the category came from the increasing severity of capacity headwinds faced by the trucking industry with declining pools of long-haul drivers, a function of both demographics as well as the relative strength of the economy. The average age of a long-haul trucker is about 55 years, which means the pool of drivers by age group is currently flat, but rapidly declining. The median pay for an employee long-haul driver came to $42,480/year which divides out to about $20.42/hour, falling in per-mile range of $0.24 to $0.40 through the end of 2017. Per week mileage averages between 2,000 to 3,000 based on a 70-hour duty tour over an eight-day period. The national average van rate for April came to $2.16/mile, up 2 cents from March, surpassed only by the $2.24/mile January rate which was a record high.

By contrast, owner-operated incomes through the end of 2017 came in at roughly $60,000 with the rate per mile up 5% YOY. Of course, ownership requires both initial and ongoing outlays of working capital that throws up a rather steep financial barrier of entry to the field. When the economy is strong, demand for the transportation services increases as more goods enter the market to satisfy higher levels of final user demand. Simultaneously, with a stronger economy comes an uptick of job choice where the lure of less nomadic blue-collar positions in construction and manufacturing becomes the greatest, making the unbridled wanderings of the road less appealing. Construction jobs in March were estimated at 248,000 with an average hourly wage of $29.63 through the end of April. Manufacturing jobs posted 391,000 jobs across the country with an hourly wage range of $24.64/hour for non-durable and $28.24/hour for durable manufacturing positions for the same period. Transportation and warehousing job openings for the month reached 293,000, with an average wage of $24.26/hour.

Flat to declining pools of available long-haul drivers in a strong economy mixed with new regulatory oversight adds another dimension to the increase in intermodal volumes. The electronic logging devices (ELD) mandate first passed by Congress in 2012. ELDs electronically synchronize with the truck's engine to record a plethora of operational data, including odometer readouts, miles traveled, engine vitals, GPS location, speed and braking histories, as well as active driver hours and truck wear. The data is relayed over the Internet to dispatchers and supply chain managers in real time, replacing the after-the-fact paper logs sheets of old. Current US law holds truckers to 14-hour duty tours of which 11 may be spent behind the wheel. A mandatory 10-hour rest period follows each on-duty tour. Paper logs invariably reflected the vagaries of the road, vagaries that are now captured, calibrated and conveyed in real-time. This last wisp of freedom has literally uprooted many long-haul truckers, causing them to simply hang up their keys. An unemployment rate of 3.9% has cushioned the financial impact of these voluntary job-leavers with growing opportunities in other blue-collar venues of the so-called temporary or seasonal "gig" economy. Trucking payrolls have suffered accordingly, applying upward price pressure on transportation and warehousing services due to scarcity bottlenecks created by the lack of capacity to meet current, let alone rising, levels of demand across the greater economy. ELD finally came online with the start of the New Year. The timing of the capacity headwinds in the trucking industry, a strengthening economy, and the introduction of the ELD is likely not coincidental. The resulting bottlenecks make intermodal transport all the more competitive and timely. The trend is likely to continue moving forward as the labor force continues to tighten.

The third segment of NSC's operational mix is the perennial question mark of coal. Coal shipments were up 17% YOY in 2017 but down 18% YOY in 2016. In the first quarter, coal managed a 3% gain YOY with export being the driving force for the period amidst double-digit decline in demand from traditional end-users like electric power utilities. The demand for coal from the electric power sector came to 664.75 million short tons through the end of 2017, down from a peak demand of 1.04 trillion short tons set in 2007, holding down 58% of the company's demand for coal through the end of the first quarter. That percentage is down from 61% YOY and down from 65% in the first quarter of 2016. The US demand from electric utilities for coal has fallen in every subsequent year since 2007 save 2014. Similarly, US production of coal came to 774.12 million short tons through the end of 2017 from a peak of 1.2 trillion short tons in 2008, with more year-over-year variability than the demand side. US coal exports came to 97.0 million short tons through the end of 2017, close to the all-time high of 125.7 million short tons posted in 2012. The export market's growth rate for coal is up 14% YOY - the only coal demand category to post positive growth for the period and the last two years YOY. Export coal tonnage was down 30% in 2016 due primarily to the strength of the dollar in world currency markets. The domestic coal market will continue to dwindle in the face of alternative sources of electrical power that are both cheaper and generate a lower carbon footprint, such as natural gas, wind and solar. The strengthening of the dollar in world currency markets will also be a dampening factor on US coal exports and NSC coal shipment volumes moving forward.

How is NSC's tax cut largess being spent? NSC is following a well-trodden path of late: On the heels of TCJA, S&P companies that have reported earnings thus far for the first quarter have bought $158 billion of their own stock during the quarter, a record pace on data back to 1998. Domestic cash piles have been further augmented by US multinational firms triggering the TCJA repatriation clause. Apple (AAPL) brought the majority of its $269 billion in overseas cash back to the US. Since 2012, the company will have put out $210 billion in buybacks and dividends during the period through the end of June 2018. The sum is more than the market value of all but 20 of the biggest listed companies in the US, according to a Bloomberg news item based on Birinyi Associates data. Dividend payments are on the rise where S&P companies are projected to return the better part of $1 trillion to shareholders through enhanced buyback and dividend programs.

NSC purchased 2.1 million outstanding shares during the first quarter at a cost of $300 million, up from 1.7 million purchased during the first quarter 2017 at a cost of $200 million. Since the beginning of 2006, the company has repurchased 170.6 million shares at a total cost of $11.6 billion. The outlay was a driving piece in the 30% increase in EPS for the company during the quarter. Dividend payout for the quarter came to $205 million, up 14% from $177 million YOY.

Labor costs fell 3% during the period to $737 million. The company's 27,000-strong unionized railway labor force was down about 1,000 workers YOY, applying downward pressure on employment, health costs, incentive and stock-based compensation programs. The company's trainee and engineer headcount will increase by about 500, which were hired last year and will come on board in the next four months. Overall employment rolls are expected to remain largely flat for the remainder of the year. Overtime and recrew costs, about 2.6% of total compensation, edged up $19 million through the end of the first quarter.

NSC's long-term debt liability comes to $22.1 billion with the addition of a $500 million senior note at 4.15% issued during the quarter that matures in 2048. The company's debt to equity ratio comes to 61.84 which means the company employs $0.61 for each dollar of equity used to finance its ongoing operations. The railroad business is a highly capital-intensive industry, so most of the debt is secured by equipment. In doing so, the company is able to carry large amounts of expensive equipment on its balance sheet at a fraction of its market value when expensed. NSC's debt to equity ratio compares favorably to railroad peers CSX (CSX) at 80.31, Canadian Pacific (CP) at 126.75, Genesee Wyoming (GWR) at 65.15, and Union Pacific (UNP) at 68.17. Still, debt is not as tax advantaged under TCJA and rising interest rates will eat away future profit margins, creating a headwind to growth moving forward.

The main capital investment for the 2018 year is the ongoing upgrade of 125 DC to AC locomotives of which 40 have already been placed in service. In the interim period until delivery, the company is leasing 90 AC locomotives to complete the revitalization of its fleet. AC engines generate AC current to power the locomotive's traction motors. Many railroad companies have determined that AC is more cost effective for long, heavy-haul trains, offsetting potentially higher maintenance costs. Additionally, the consolidation of the company's dispatch operations in its Atlanta operational headquarters is expected to be completed by October, with the full centralization of operations completed at the facility the following month. Overall, materials costs decreased in the first quarter to $90 million, down from $92 million YOY as higher maintenance costs on freight cars and locomotives were partially offset by lower roadway repairs during the period.

NSC has had a strong quarter, logging solid growth from its intermodal segment that appears sustainable for the foreseeable future. TCJA clearly had a positive impact on the company's bottom line, with the impact filtering through the company books for likely the next several years. As the general economy continues to gain momentum, what slack that still lurks in the labor market will disappear as the economy reaches one of the lowest levels of full employment in the post-WWII era. Here, too, opinions among economists vary. Some think the economy is already beyond full employment and further fiscal stimulus set in place by policymakers only invites inflation. If true, current joblessness is more structural, pointing to insufficient skillsets, outsized wage demands and/or worker mobility issues. The biggest caveat here is wage growth in the broader workforce remains stuck in a very narrow range with few instances of outsized wage offers in markets needing particular job skills that are unobtainable at prevailing wage offerings.

That said, the strength and continued job creation could be an ongoing draw for employee long-haul truck drivers. The higher transportation and warehouse service costs rise, the more cost effective and timely intermodal transport becomes. There is likely room for NSC's intermodal segment to grow on a sustainable basis with the proper capital outlay. The capacity issues in the trucking industry appear to set up a favor growth play for NCS's intermodal segment for the foreseeable future. Intermodal comprised 23% of total revenue or $2.45 billion, up 11% YOY through the end of 2017. In the first quarter, intermodal contributed $678 million, which is an annualized pace of $2.7 billion or just over a 10% gain on 2017.

The main headwind for the company comes from sub-par growth from its other revenue segments, a reality that escapes the short-term impact derived from a lower tax liability. Merchandise comprised 60% of the company take through the end of 2017, up 3% YOY. In the first quarter, merchandise claimed 59% of total revenue, up a scant 1% YOY. Annualized, merchandise comes to $6.42 billion, a 1% gain YOY. Year-over-year growth in 2017 came to 1%, while YOY growth in 2016 fell 6%. The picture for coal does not improve the outlook. Coal revenue came to $1.74 billion through the end of 2017 or 17% of total revenue. Annualized, coal revenue comes to $1.73 billion for no positive gain at all for the year. Coal logged a 17% growth in 2017 YOY but lost 18% YOY in 2016 due to the relative strength of the dollar for a net growth of 1% to the downside over the two years. Declining domestic demand for coal, coupled with a stronger dollar, places downward pressure on volume sales in both markets for the balance of the year. Squeezing more growth out of either of these segments could be problematic.

Can projected intermodal growth carry the company? Year to date, NSC is up 3.7%, outpacing the S&P 500 by about 2 percentage points. Since the 9th of April, NSC is up 18% on the heels of its solid first quarter performance, pulling further away from the S&P benchmark by just under 14 percentage points. Is NSC's first quarter performance sustainable throughout the balance of the year? That is a coin toss.

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

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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