Description

Norfolk Southern Corporation (NSC) provides a compelling long investment opportunity from a combination of operating improvement and modest core business improvement.  A stable business, high dividend yield (2.8%), and reasonable multiple provide downside support.  If NSC can finally catch up to its competitors on operating performance in this sustained low growth economy, you can buy company at today at ~10x pro forma EPS. 

Company description:

Norfolk Southern Corporation (NSC) provides rail transportation services.  The company transports bulk commodities, intermediate and finished goods primarily in the Southeast, East and Midwest as well as to and from the rest of the country via interchange.  The company was founded in 1982 and is based in Norfolk, Virginia.

Summary investment thesis:

NSC’s stock price has been cyclically depressed due to declining industry volumes which are poised to improve in coming quarters.  In addition, NSC is in the early stages of an operational turnaround with significant runway for fundamental improvement which should accelerate earnings growth above peers.  The stock remains unloved by analysts who do not fully appreciate the potential improvement in results.  NSC’s valuation remains reasonable versus its historical range and cheap versus its railroad peers, providing potential upside as well as a margin of safety to the investment.

Key investment points:

Suppressed industry volumes suggest opportunity for rebound:

Railroads shipments are clearly levered to economic activity given the nature of the goods they transport.  However, despite continued headline GDP growth, year-over-year rail shipment growth turned negative beginning in Q2 2015.  By the end of 2016 the industry will likely have seen 6 consecutive quarters of negative volume trends, a level of performance which actually rivals prior periods of economic recession. (I can't figure out how to paste this into this presentation, but you can view historical volumes from multiple sources).

This creates a relatively asymmetric set-up with respect to carload trends starting in early 2017, as it is an extremely rare occurrence that volume growth would be negative for three years in a row.  Note that railroad share prices actually peaked in late 2014, 6-9 months before the downturn in industry fundamentals.  As stock prices typically lead inflections in fundamental trends, I believe a bottom is approaching in overall rail shipments which would prove beneficial to NSC. 

Canadian Pacific as an “activist”:

On 11/17/15, peer railroad Canadian Pacific (CP) made public an unsolicited offer for NSC.  The proposal of $46.72 in cash and 0.348 of CP stock per NSC share valued NSC at approximately $95 per share versus its undisturbed price of approximately $80 prior to rumors of the offer.  Canadian Pacific CEO Hunter Harrison is widely viewed as the best-in-class railroad operator, having executed a highly successful operating turnaround at CP since joining the company in 2012.  The value of the proposed transaction was largely driven by CP management believing they could simply run NSC’s operations more effectively than current NSC management.  Over the ensuing months NSC successfully rebuffed CP, playing up regulatory antitrust concerns while also highlighting its own operational improvement plan which it felt would ultimately create more value for shareholders.  While the transaction is dead (at least for the foreseeable future, although Harrison argues that it is inevitable), these events have effectively provided a catalyst for long-awaited operational improvement at NSC that will drive significant upside performance for the stock.

 Company-specific turnaround story should disproportionate benefit NSC:

NSC posted the worst operating ratio (an industry convention, the ratio of total operating costs divided by total revenues) of the rails in 2015, and NSC’s operating ratio was also 200 bps worse than its most direct comparable eastern peer CSX.

And based on the last 5 years performance, it is clear now why Harrison targeted NSC (he also unsuccessfully targeted CSX for similar reasons earlier in 2015). 

When Harrison joined CP, common perception was that CP’s industry high operating ratio was structural.  He disagreed and blamed poor operations.  He has been making the same comments about the ability to generate improvement at NSC. 

In response to CP’s overture, NSC proposed its own operating plan targeting a 65% operating ratio by 2020.  Below is a simplistic example of how operating trends might progress towards this target.

Note that 2.5% annual volume growth actually represents below-trend growth over time, especially considering the industry (including NSC) is lapping what will be back-to-back years of volume declines in 2015 and 2016.  Further, +2.5% annual pricing growth is also below trend; industry pricing growth has been +3-4% annually as rails have shown consistent ability to increase pricing above the rate of inflation.  The point is that with below-trend volume growth, below-trend pricing and only modest operating improvement that many would actually consider disappointing based on investor response to NSC’s proposal, NSC would still generate consistent EPS growth at an approximate 12% CAGR over the next 5 years which I believe would drive meaningful share price performance over that time.  

However, the 65% targets should be exceeded.  This can be seen by all competitors already operating below this level and targeting further improvement.  In addition, much of the operating improvement should be front-loaded in 2016-2017, which should accelerate benefits in the stock price accordingly.

NSC’s historical fundamental underperformance is largely due to mismanagement as opposed to anything structural that would drive this level of margin difference.  NSC has been slowest to accept the structural decline in its core coal business as well as general weakness in commodity-related shipments that necessitate a more flexible cost structure to be able to drive earnings growth even in times of weaker shipments. 

The best illustration of this is seen in compensation and benefits, the largest operating expense for rails representing 44% of NSC’s non-fuel related expenses in 2015.  NSC has been significantly behind peers in cutting headcount as a response to changing industry trends, only finally beginning to achieve year-over-year headcount reduction in Q1 2016.

An additional -6% headcount reduction putting NSC more closely aligned with recent peer trends would represent $0.37 of incremental EPS or a +7% increase to 2015 EPS.

However, the potential runway NSC has in terms of headcount reduction is even better illustrated by looking at its poor labor productivity which has now started to inflect positively, measured by calculating gross ton miles (the product of total weight and the distance moved by train) relative to number of employees.  As shown below, even after NSC’s most recent headcount cuts it still ranks a distant last relative to peers in terms of labor productivity using gross tons per mile.

If NSC were simply able to improve to the level of eastern peer CSX, this would imply a -10.5% headcount cut for NSC or a +12% increase to 2015 EPS.  I believe this is actually a bare minimum level of potential improvement for NSC; CSX is widely considered to be poorly run which represents a low hurdle for NSC to reach, and all rails are improving labor productivity in this environment which is further raising the bar to which NSC should aspire.  Note that this -10.5% headcount cut alone would represent an approximate 300bps improvement to NSC’s operating ratio, almost single-handedly bridging the gap to the company’s 65% target without any benefit from other expense cuts or operating leverage from future revenue growth.

The key is that after rejecting a CP proposal that would likely have created significant value for NSC shareholders, NSC management finally appears properly motivated to improve results.  This was evident in the company’s Q1 2016 results that were significantly ahead of analyst expectations, but I believe the company recognizes they need to continue to exceed expectations to avoid increased shareholder scrutiny (either to force management change or renewed consolidation discussions).

 Past fuel surcharge headwind likely a future tailwind:

Railroads typically attempt to minimize fuel risk by tying fuel surcharges passed on to customers to diesel costs which match their fuel expense.  However, NSC is an anomaly in this regard with close to half of its surcharges based on WTI crude oil.  One would expect WTI and diesel prices to be correlated and of course they are, but during this cycle WTI has fallen significantly more than diesel which has caused NSC to significantly under-earn on its surcharges relative to peers.  Approximately two-thirds of NSC’s WTI-based surcharges are not triggered with WTI below $64, implying NSC is currently not earning any surcharge revenues on approximately 30% of its shipments.  NSC is currently working with customers to restructure all of its surcharges to be diesel-based, a process that will take 2-3 years based on current contract structures.  Alternatively, WTI could simply trade higher over that period to narrow the revenue gap.  Either way I ultimately expect this surcharge-based headwind to be reversed, representing a 200bps tailwind to NSC’s OR over the next few years.

Coal headwind diminishing:

Rail coal shipments are effectively in secular decline due to conversion of power generation usage from coal to natural gas.  In 2011 NSC coal revenues represented 31% of revenues which was viewed as a heightened risk factor versus western peers such as Union Pacific (UNP) whose exposure was only 22% of total revenues.  Eastern coal has been in an accelerated decline since then which has proved to be a major headwind for NSC (as well as CSX).  This risk has certainly not been eliminated and coal revenues should continue to decline as a percentage of total revenues in the next several years.  However, the exposure has certainly been diminished with coal revenues now representing only an estimated 13% of total NSC revenues in 2016.  Further, the gap vs. western rails has narrowed, with NSC’s exposure now much closer to the estimated 11% of 2016 revenues for UNP.

Analyst sentiment continues to be very negative:

The sell-side (which I typically view as a contrary indicator) remains relatively negative on NSC.  This appears to be based on the company’s historical performance rather than the future, as well as a lack of understanding of the company’s operational potential.   NSC has 32% buy ratings vs 55% for CSX, 69% for UNP, 68% for CP, and 41% for KSU.

Valuation:

NSC’s current valuation of 13.7x forward earnings is approximately in the middle of its 10-year average range of 10x-16x.  However relative to peers NSC’s valuation is near the bottom of the group based on consensus estimates.

So NSC trades at the low end of industry and relative valuation metrics, yet has the most embedded self-help of all the rails.  NSC should ultimately trade at a premium to most of its peers as the early stages of its turnaround unfold.  This improved valuation would reflect the company’s accelerated earnings growth and factor in the relatively depressed level of current earnings relative to NSC’s ultimate earnings power.

Thoughts on Upside:

As demonstrated above, in the slow operating improvement scenario and low economic growth, NSC would be generating about $9/share of EPS in 3-4 years.   At nearer peer multiples of 14x, this suggests NSC could trade to $125/share (+50%, in ~3 years assuming it trades on a 1 year forward multiples).  Alternatively, assuming no revenue growth from 2016 levels, multiples below current (14x), and operating performance improvement to the 62-63 range implies 15% upside.

A more plausible situation is that NSC achieves slightly better than 65% OR before their goal of 2020, for the reasons mentioned above.  There are a lot of combinations of these outcomes that can be assumed, but if NSC can achieve 63% OR by 2018, and revenue growth remains slow and subdued in a continued low macro environment, then NSC would achieve ~$8/share of EPS in 2 years, or trade at ~10x EPS.  Depending on multiple from the market, this should provide 30-50% upside in 2 years.

Risk factors:

The biggest risk factors in this investment as being macroeconomic.  These risks are easily hedged, either with other rails or different cyclical stocks.  Also, historically rail stocks tend to outperform in a recession and recovery earlier than other stocks in an eventual recovery as business inventories are re-built.

Another risk would be poor execution, although given the recent activist activity, shareholders will likely have little patience for management's failure to drive improvement.

Catalyst

Demonstrated execution of cost reduction and operating improvement through next few quarters.

Renewed industry consolidation speculation.