Our rating on Norfolk Southern Corp. (NYSE: NSC). The slowdown in manufacturing and the impact of tariffs had caused rail volumes to decline in 2H19, but management continued to drive EPS growth through productivity improvements. The coronavirus derailed that streak in 2Q20, but volumes have picked up since bottoming in May and margins are again rising. The shares are 11% below their 52-week high and offer value, in our view.
The beta on NSC is 1.40.
On October 28, Norfolk Southern reported that total railway-operating revenues declined 12% from the prior-year period to $2.5 billion. (The prior quarter’s decline was 29%.) Total volume was down 7% year-over-year. The railway-operating ratio (expenses divided by revenue) improved by 240 basis points to 62.5%
NSC saw volumes tumble in 1Q and 2Q, and was unable in 2Q to match cost cuts with revenue declines. The company’s volumes have been picking up in recent months, and it is back to posting margin improvements. In its 1Q report, the company withdrew its previously issued outlook for flat revenue and its core operating ratio guidance for 2020.
The company had been one year into a strategic plan to reduce its operating ratio to 60% by 2021. The plan draws on the popular ‘precision scheduled railroading’ program that was created by the late CSX CEO Hunter Harrison. The program focuses on productivity gains that come from streamlining operations and fully leveraging assets, including cars, train crews and yards.
EARNINGS & GROWTH ANALYSIS
Norfolk Southern Corporation has three main operating segments: General Merchandise, which accounted for 63% of 3Q sales; Coal, 11%; and Intermodal, 26%. Recent results and outlooks for each segment are provided below.
Within the segment, low natural gas prices are reducing domestic utilities’ demand for coal. Looking ahead, we expect segment volume to remain challenging as natural gas prices remain under pressure.
In the Intermodal segment, revenue declined 1%. Volume was up 1%. The segment is experiencing challenging industry conditions due to extra truck capacity, but volume is expected to continue to recover in 4Q.
In the Merchandise segment, sales decreased 10%, reflecting lower shipments of categories such as Chemicals, Agricultural Products and Metals and Construction. We had expected lower volume in 3Q, but an improvement from 2Q, when segment revenue declined 26%. We still expect conditions to improve into 2021.
The operating ratio (expenses/revenues) is widely used by railroad investors to assess efficiency; a lower operating ratio signals rising margins and is positive. Norfolk Southern had lowered its ratio for 17 consecutive quarters, but the trend reversed in 2Q20. During the third quarter, railway-operating costs declined for compensation and benefits, purchased services, materials and fuel. Management continues to focus on lowering its annual operating ratio to 60.0%.
FINANCIAL STRENGTH & DIVIDEND
Total debt of $12.7 billion resulted in a debt/total capitalization ratio of 46%.
In October 2019, management raised the annualized payout by 8% to $3.76 per share. This was the fourth increase, totaling 54% — in a 24-month period.
MANAGEMENT & RISKS
The Chairman and CEO of Norfolk Southern is James A. Squires. Mr. Squires joined NSC in 1992 and most recently served as its president. Mark George was appointed CFO on November 1, 2019; he has 30 years of experience in financial management.
Management announced a plan in early 2019 with the goal of streamlining operations and driving growth. Through the plan, by 2020, the company expects its operating ratio to be below 60%. The plan includes steps such as reducing the headcount by 3,000 employees; reducing the active locomotive fleet size by 500 units; increasing the average train weight; cutting car dwell; boosting train speed; and maximizing fuel efficiency.
The plan goes beyond cost cuts, though, as management anticipates revenue growth from both pricing and volume increases. Management’s goal is 5% annual top-line growth, fueled by increases in consumer spending, e-commerce growth, and manufacturing.
Investors in NSC shares face risks. On an industry level, railroads appear poised for a period of consolidation, and pricing dynamics may change. Norfolk Southern itself had been targeted as a potential takeover candidate by industry rival Canadian Pacific, the second-largest railroad in Canada.
Rail carriers are also highly sensitive to the macroeconomic environment, and are subject to risk from fluctuating fuel prices, fuel hedges, bad weather, strikes and other labor actions, and government regulation.
NSC also faces risks related to government regulation, and may incur extraordinary costs related to positive train control systems, the transportation of flammable liquids, and braking standards.
We note that NSC has a relatively high exposure to coal shipments among the railroads in Argus coverage. The company’s operating margins are also on the low side, which could make the stock a target for activist investors.
Norfolk Southern Corp. The railroad serves all major eastern ports and connects with rail partners in the western U.S. and Canada.