Norfolk Southern: Off The Rails

Summary

• Norfolk Southern is hit by concerns on the economy, but certainly the East Palestine disaster as well.
• The direct impact might be small or manageable, as investors likely fear tougher long-term regulations and procedures imposed on the sector.
• Given perfect conditions in recent years, I am cautious on the sector at large, as I seek no involvement with the poster child of the current woes, being Norfolk.
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Joseph Fuller

Shares of Norfolk Southern (NYSE:NSC) have recently attracted a lot of bad publicity, in the aftermath of the crisis in East Palestine. This situation, the expected consequences on the business and industry, and general cooling down of the economy create concerns, enough of a reason to update the thesis here. To see where the company comes from I first go back to 2016 when I concluded that the sell-off seen at the time was a bit surprising.

Trip To Memory Lane

Back in 2016, NSC stock sold off to levels around the $70 mark which surprised me as Canadian Pacific (CP) was looking to acquire the business, with Norfolk's management being reluctant to engage in discussions.

The company was hit at the time by lower coal volumes and amidst this weakness, Canadian Pacific was looking to acquire the business on the cheap, with shares down 35% from their highs. At the time supporting a $31 billion enterprise valuation ($22 billion equity valuation and $9 billion net debt load), the company traded at 3 times revenues and 7 times EBITDA which looked like a very reasonable valuation. This certainly was the case as there was interest from industry leaders to consolidate.

A Boom

Since voicing a cautious upbeat tone in 2016, shares have seen a huge boom to a high of $300 in 2021, but shares sold off to a $200-$250 range in 2022 following concerns about slower economic growth. Shares have fallen to $200 now amidst the latest economic concerns, but very much its role in the East Palestine disaster, as well as the potential resulting implications from this situation going forward.

If we look at the underlying conditions, we did see an improvement, but mostly valuation multiple inflation. Between 2016 and 2022, the company has grown sales by nearly 30% from $9.9 billion to $12.7 billion. More impressive were the margin gains, with operating profits being up 60% to $4.9 billion. This made that earnings doubled in absolute dollar terms as the company reduced the share count by nearly a fifth, resulting in even more rapid growth on a per-share basis. This made that an earnings multiple in the low teens rose to a multiple in the low-twenties, and that amidst nearly perfect operating conditions.

If we look deeper into the results, we see a 14% increase in revenues to $12.7 billion in 2022, driven by growth across the board: merchandise, intermodal and notably an increase in coal revenues. Expenses rose 19%, the result of an 83% increase in fuel costs to $1.5 billion, with the full year operating ratio increasing 2 points to 62% (which of course indicates operating margin pressure decreased from 40% to 38%).

With EBITDA trending at $6 billion, leverage was modest with net debt coming in close to $15 billion, as earnings power close to $14 per share apparently made it justifiable for the stock to trade at $250 early this year. This was, however, still based on very strong demand and margins.

The East Palestine Catastrophe

Early in February the city of East Palestine was "hit" by a derailment and subsequent "controlled" blast of a Norfolk Southern train and its dangerous load. The situation was bad enough as it is, but the huge focus on quick resumption of operations and poor PR practices of the business in the immediate aftermath attracted a lot of scrutiny. While the direct costs of the disaster are huge for the society, and likely for the business as well, the real impact might be the impact of long-term (additional) regulations on the industry at large.

The poor security track record of the business was painful in the weeks after the derailment as another train of the company derailed, and the company saw a fatal injury of a conductor in Cleveland. Other costly measures already taken include the paid sick leave agreements with some of its workers, enhanced safety plans and procedures, while lawmakers look to impose stricter regulations on the industry at large after companies actually lobbied to operate these huge trains with as few as a single worker!

As is often the case, the market reaction looks like an overreaction in response to the direct financial consequences of such an event, but the real issue is that of the likely impact of potential news on the profitability of the business and the industry. That said, the impact of this incident could be bigger, certainly as there might be a big environmental liability component involved here. After all, the industry at large has seen huge expansion in operating profits, having risen to as much as >40% operating margins in some cases.

What If Profits Revert?

The reality is, is that the revenue base of the business is quite stable, as railroads have focused on strong margins gains. If we, for a minute, assume that margins might fall towards 30% on sales of $12 billion in revenues on the back of a softer economy and impact of (potential) tougher regulations, this results in operating profits of $3.6 billion. If this is the new normal (remember that 30% margins are still high in historical perspective), that would mark a big pullback from a $4.8 billion number posted in 2022. Assuming a similar interest rate expense and a 25% tax rate, the resulting $2.2 billion net earnings number falls to about $9-$10 per share.

If this happens, the pullback of the shares from $250 earlier this year to $200 does not automatically translate into a great bargain with the resulting 20–22 times earnings still looking quite full. Lower earnings power pushes up leverage ratios to about 3 times if this happens.

This is a painful conclusion as shares have seen a huge re-rating over the past years, in part for the right reasons (higher sales, higher margins and buybacks). This makes it hard to justify premium multiples in a near-perfect operating environment, as multiples currently are pressured by risk-free rates trending at 5%.

Given this, I see no reasons to be involved here with Norfolk. While the woes related to the East Palestine disaster likely blow over, I note that many peers have fallen by similar percentages (albeit a bit less). While I am not too upbeat on the railroads here just yet amidst economic concerns, higher capital spending requirements and the potential impact of new regulations, I would prefer non-Norfolk Southern exposure in that case.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.