Description

Given the NSC situation we thought we would look at it vs the the primary (and quite obvious) point of comparison, CSX. Both Eastern Rails are exactly the same size (21,000 route miles) and have essentially traded within a very tight band of their respective TEV’s over the course of the last 17 years, as shown below. So this is an analsys of potential short CSX vs long NSC trade. It it not short CSX outright. 

From ‘06 through ‘16, the TEV of each varied between a slight premium and slight discount each year depending upon the vagaries of mix or execution in any given period. But the remarkably tight correlation between the Enterprise Values (which reflected networks of almost exact equal size, equal revenues, and similar mix exposures) began to break down at end of ‘16 (as the market moved to capitalise the impact of incoming CEO Hunter Harrison’s PSR implementation) and then really blew out as Harrison’s team (after his November 2017 death) executed on their plan and saw the fruits of labor in ‘2018. From end of 2015 (when NSC rejected CP/Harrison) through the end of 2018, NSC went from trading at parity with CSX (both with TEV’s of around $34 billion) to a massive 21% discount ($14 billion discount with CSX at $65 billion and NSC at $51 billion). For a brief period of time, the relative discount became even wider.

This forced Norfolk’s (very weak) CEO to do a massive about face and introduce his own version of PSR, (PSR the Squires way!) called TOP-21.

For NSC shareholders, the goal of TOP-21 was to adopt some of the principles of PSR in order to bring margins close to CSX levels. This would reduce the ever widening discount noted above. For Squires, the goal of TOP-21 was simply keep his job. A long dissertation on PSR is beyond the bounds of this discussion (happy to discuss below). The acronym has become (very unfairly) maligned for the service issues rails have experienced post Covid. In a nutshell, like any lean or effective business operating system, the principles are simple to grasp but execution and consistency are extremely difficult to practically implement. It requires almost as much of a cultural makeover as an operational one. This is precisely why the organisations that have brought in outside agents (CNI 1999, CP 2013, CSX 2017) have had enduring success. Those that have half-heartedly tried to cynically manipulate PSR to improve margins and keep their jobs (Lance Fritz and Jim Squires) have left more damaging legacies.

But Squires (a corporate lawyer with little enthusiasm for railroading and who had never worked a single day on the railroad) was as good a politician as he was bad an operator. By putting out a 40% margin target (60% OR by ‘21) with his TOP-21 plan (introduced in early ‘19), he was able to do just enough to avoid unwanted investor pressure.

For implementation, the overarching principle seemed to be to copy and paste what could be visibly observed at CSX. Just as we saw with the TEV, NSC’s rail headcount had also been literally 1 for 1 with CSX’s over a 15 year period and began to diverge around ‘17.

 So NSC plucked the low hanging fruit. They lengthened existing trains, thereby reducing the number of trains required. As crews and locomotives are proportional with the number of trains and not traffic, this meant a reduction in employees and locomotives. This would restore labor levels closer to CSX levels and would enable NSC to limp to Squires 60% OR target by ‘21. The plan was clearly set to hit a predefined margin target. Ironically, the most successful PSR operators do the opposite. For them, The OR (1-OPM) is just an outcome of a million different processes optimised and done well. They have no actual target. Put simply, obsessively focus on process and PSR principles and the score will take care of itself. Listen to any public (or private) conversations with Keith Creel and Jim Vena and this is what you will hear.

To forestall investor criticism that an outsider was truly needed to help inject and implement a plan capable of sustained success, Squires did eventually an outsider. Yet this new COO, Cindy Sanborn, had been COO at CSX prior to Hunter Harrison’s arrival and lasted just 4 months after his arrival. From there, she spent a few years at UNP in a much lower capacity. (She was not Jim Vena’s right hand). Industry contracts at the time were completely confused by her appointment. She made only modest revisions to TOP-21 and was far from the change agent or leader that Norfolk deserved.

How did plan fare financially? NSC, by their accounting, did see the OR decline from 65.4% in ‘18 to 60.1%% by ‘21. While the actual operating ratio (excluding land sales) was 60.9% and was still some 300 bps above CSX’s (rail only) OR of 57.6%%, it was a substantial improvement from the actual 2018 Operating Ratio of 67.2%. (Squires really dipped into land sales in ‘18 to obfuscate the incipient margin differential embarrassment). Top-21 having been “successful”, Squires decided to step down on his own terms as well as handpick his successor.

A look back at the profit variance from ‘18 to ‘21 did reveal a few things that were disconcerting in terms of how the ‘21 margin goal was reached. Leaving out the impact of fuel prices (on both surcharge revenue and fuel expense), almost all the improvement was from labor and fuel efficiency (longer trains so less crews and less locomotives). This was fine but there was relatively less improvement in Purchased Services and Equipment Rental. Given PSR’s primary focus on improving asset turns (higher freight car velocity from faster trains and lowering terminal dwell), this was not an encouraging sign. Indeed, from ’18-’21, Purchased Services and Rental Expense was flat despite a 14% reduction in RTM’s. While higher intermodal mix could possibly have explained this, Intermodal RTM’s also fell 6% during this time. Unable to achieve the operations requisite to achieve productivity goals for the large Purchased Services and Equipment Rental line, Squires reduced materials, casualty, and other expense items. Some of the reduction in materials expense was justified by changes in operating practice and lower volumes but undoubtably some of the accruals in casualty and other were used to pad the stats. Much to their credit, the new CEO essentially trued up some of these costs in ’22.

Also ’22 saw service collapse for NSC. It happened at all rails but BNSF, NSC and UNP were hit the hardest and longest. Of these rails, BNSF has not enacted PSR, NSC has sort of faked it, and UNP essentially had success with it for 18 months before ousting the very figure who was making implementation succeed. So it was not PSR that created the problems, it was poor implementation by inexperienced management teams who tried to promise more than they had the capacity to deliver. Problems would have surely happened had Vena been at UNP or Mike Cory at NSC but they would certainly have been shorter lived and actions taken more decisive. Both CP and CSX had initial challenges but counter-measured much faster and with greater success.

The issue at Palestine may or may not have been caused by NSC. Derailments have been trending down and will always occur. PSR rails have had better safety metrics and obviously a company that has terrible safety record will be symptomatic of a company with terrible culture and operational acumen. Contrary to public misperception, safety and profitability are absolutely aligned in the railroad industry.

I do not see the liability as more than $1.5 billion. Given $1 billion in insurance, this would net out to $500 million, or less than $2 per share. The rapid collapse in the stock relative to peers and the fact that NSC has lost all the relative gains made under Squires Top -21 is symptomatic of shareholders concern that NSC management lacks the ability or operational acumen to overcome the current service collapse caused by the shutting of the main line running through Palestine (through early June). That this is happening at the same time that CSX is seeing its own service metrics rapidly and markedly improve makes the situation even more stark.

Yet the opportunity for NSC is precisely that they have not truly optimized their network. At last investor day, management spoke about “industry competitive margins.” Like their better managed peers, they sought to shift from rightsizing to growing.  This was certainly appropriate for peers, but for NSC this seemed premature given the precariousness of their service and the substantial de-leveraging of much of the productivity achieved by TOP-21.

For example, CSX Rail (excluding the dilutive effect of both the Quality Carriers Truck Acquisition and the Pan Am Southern Acquisition) had EBITDA margins of 52% in FY ’22 vs. NSC’s 46.7%. Not only was this 530 basis point difference quite wide but it was also 100 basis worse than ’21 (54% vs. 49.7%). In short, NSC was not being honest with itself about where it was. They sought to explain this away by pointing to new COO (tacitly admitting that Sanborn was an issue) and showing the progress that had occurred since his arrival in March ’22. In fairness, ops were improving prior to Palestine but again the COO (though regarded highly) has had no meaningful PSR experience as he worked at literally the one railroad who has not implemented it.

The market is now capitalizing the margin differential into the future. NSC used to trade at a slight premium to CSX because its inferior margins were not deemed structural (or 500 to 600 bps differential was not deemed structural). At some point, the logic went, NSC margins would approach CSX levels while growth and capital intensity would be comparable. So the higher multiple reflected the inevitable EBITDA outgrowth.

The margin differential has not changed but the market’s conviction in margin convergence has been entirely lost. 2023 will be tough for NSC and next quarter awful but the re-rating is not reflecting the shorter term earnings hits or even Palestine liability but rather a total loss of faith in a management team that was already perceived as being weak already.

The opportunity here is that one of two things happen.

1. After management (correctly) resolves the Palestine issue, they rapidly and quickly improve operations to best in class levels. Alan Shaw is not Jim Squires and the new COO proves himself every bit as capable as his competitors at CSX or CP. The market slowly sees faith restored and some of the current discount is closed. In this scenario, investors look through this year and are willing to underwrite an NSC with slightly lower margins and slightly lower multiple than Eastern Competitor.
2. Things get worse. CSX continues to improve while NS’s operations continue to tread water. The record discount continues to widen as CSX’s service prowess leads to concerns around share loss. While painful in the short term, we think this probably produces the best long term outcome as it forces the board and management to truly (and correctly) implement the cultural and operational challenges that the Squires regime superficially made. Given how poor management is regarded (Alan Shaw seen – rightly or wrongly- as Squires lacky) we think any true shift to a proven operator would immediately induce the market to restore a premium to NSC’s relative multiple as confidence in its ability to close the gap with its Eastern peer was restored.

Below are the scenarios ranging from a further widening in multiples to a re-rating that priced in margin and multiple parity. Note that I am using ’22 EBITDA numbers for both CSX and NSC. I am doing this to establish a baseline as Q2 and Q3 will be ugly for NSC in relation to CSX. For CSX margins, I am using rail EBITDA margins. This requires backing out the noise caused by the Quality truck and Pan Am Southern Acquisitions. (NSC must not be allowed to use CSX’s non rail business margin profiles to obfuscate its own inferior rail margin profile). I value the Quality and Pan-AM Southern Acquisitions at Cost. For NSC, I assume the net liability from Palestine (after insurance settlement) at $500 million.

This produces the following ratios.

The cases go from bearish to bullish. Bearish assumes further widening while bull case assumes some outside intervention that substantially improves investor confidence in NSC management.

So I like the risk/reward skew especially because I think as the ratio goes down, the probability that substantial and meaningful change is enacted goes up. And this is what would be required to bring about the bull scenario. This would be better for NSC than the Squires-like situation where the new CEO can do just enough to maintain board and investor support without truly doing the underlying work that needs to be done. And then there is always the possibility that, over a longer time horizon, the new CEO proves  more than a Squires puppet and actually gets serious about closing the gap with his Eastern competitor.

Catalyst

Operational improvement in 2H '23 or ouside intervention.