Norfolk Southern (NYSE:NSC) saw a steep decline in its stock in mid-September, falling almost 10% when it announced that its Q3 earnings will be approximately 25% below analyst estimates. We currently have a $66 price estimate for Norfolk Southern, which is approximately the same as the current market price.
We believe that NSC’s long term health is in good order and that the issues it faces will be relatively short lived. Specifically, we believe that coal freight volumes will pick up as result of economic stimulus around the world and long-term global demand. Consequently, we believe that margin pressures that the company has been experiencing due to the company’s high fixed costs will be alleviated as freight volumes pick up.
According to our estimates, coal freight is currently NSC’s biggest business, making up approximately 26% of the $66 Trefis price estimate for NSC’s stock. Unfortunately for the company, coal export volume was down from the last quarter and year over year as lower Chinese demand played a huge factor in denting worldwide coal demand. This is especially important since lower coal demand has caused a decrease in coal prices, and miners are feeling pressures to stay profitable. As prices decrease, NSC will likely make price concessions for its coal freight business, or risk losing these revenues altogether.
While we agree with the market that depressed coal prices will effect the company, we think that this decline in prices is likely to be short lived. The stimulus packages announced by the Chinese government, the European Central Bank and the Federal Reserve are likely to increase economic activity around the world. We expect these actions to buoy the coal markets over the long term, keeping NSC’s coal freight revenues in line with our estimates.
Pressure on Margins Will Be Short Lived
Since a railroad has high fixed costs, a slowdown in sales will have a sharp downward effect on the company’s margins. In NSC’s case, the company did not cut costs to offset the decrease in freight volumes; it is maintaining capacity in anticipation of a pickup in freight demand.
Since we think that the slowdown in freight volumes will be short lived, we expect NSC’s margin pressures to be a short term phenomenon also. As freight volumes increase, NSC would face lower fixed costs per extra unit shipped as these volumes can usually be handled by increasing the length of the train. As volumes increase, every dollar of fixed costs would be spread over a wider base of revenues, helping ease the margin pressures that the company is facing.
Downside Risk Factors
If we are wrong in our opinion that the decline in coal freight volumes and NSC’s EBITDA margin will be short lived, we will see meaningful downside to NSC’s value. For example, if the stimulus packages in China, the U.S. and Europe fail to kindle global economic activity, we could see revenue per carload of coal freight fall to 2009 levels. If this were to materialize, it would cause a 10% decline in NSC’s value.
Additionally, if global demand fails to pick up, and NSC doesn’t cut capacity to match the decline in volumes, we could see a prolonged period of low margins for the company. If NSC’s margins were to fall to 2009 levels and stay there over our forecast period, we would see an additional downside of around 5% to the company’s value.