Norfolk Southern: Improving Volumes, Chugging Along For Now (NYSE:NSC)

Introduction

Norfolk Southern (NYSE:NSC) is one of seven class I railroads in North America (technically you could say six, after the takeover of Kansas City Southern by CP in 2021). In recent years, the company has been an underperformer relative to peers as the company’s growth rates on both the top and bottom line have slowed. It’s also had to grapple with margin pressures, labor issues, and fluctuating intermodal volumes, not to mention a major train derailment in Ohio that happened last year, costing the company close to $2 billion. While sentiment is weak, I see value in the company’s shares, noting that costs related to the derailment will eventually subside and that recent volume growth coupled with efficiency initiatives and activist involvement should be catalysts that could move the stock over the next few quarters and years to come.

Background

Shares of Norfolk Southern have historically performed in line with the performance of the market. Over the last five years, we can see that the S&P500 and Norfolk Southern’s share price traded roughly in line, except until early 2023 when their paths began to diverge and the market soared while NSC struggled to keep up. Over this time period, Norfolk Southern has delivered a return of just 7.4% (including dividends) while the overall market has gone on to post a 86.2% total return.

In my view, this isn’t all that surprising when we look at the company’s CAGRs in terms of revenue and EBITDA. Over the last twenty years, Norfolk Southern has delivered a CAGR of 3.2% in revenue and 5.9% in EBITDA. More recently, we can see how these growth rates have come down as revenue and EBITDA have only grown at 0.8% and 2.6%, respectively, over the last ten years and 1.2% and 1.0%, over the last five years, respectively (source: S&P Capital IQ). While we can observe some margin expansion prior to the pandemic in 2019, this has become harder to sustain with margins falling led by declines in revenues from 2022 to 2023.

So what’s been going on here? For a bit of background, up until the financial crisis, Norfolk Southern had been one of the best run companies out of the Class I railroads, boasting high margins and strong operating ratios. Post-recession, the company’s operating ratios and EBITDA margins were flatlined for the next five years and the company lagged behind peers like CP Rail (CP:CA) and Union Pacific (UNP). By 2017, the company started executing and adopted ‘precision railroading’, which is a term and strategy for being more efficient with railcars and labor, essentially maximizing their time in operation as much as possible.

When we look at the more recent period, Norfolk has had issues with margins. Initially, in 2022, most of its margin pressures were labor related. At the time, labor relations weren’t the best, so the company needed to hire more workers.

They also deemphasized the use of furloughs as a way to cut costs during poor cycles. Furloughs are basically periods of absences where railroads temporarily let go their workers until they’re called back. It has its advantages of cutting costs immediately, but leaves a sour taste with unions and the workers they represent.

Beyond labor, Norfolk also started to see worsening intermodal volumes. These were pressured by equipment shortages as well as supply-chain congestion during a time when both rail and trucking were experiencing serious challenges. While this proved to be a temporary phenomenon, the domestic business in particular was weak, with declines in volumes close to 5% on a year over year basis for much of the back half of 2022 and into early 2023.

Recent Results

Norfolk Southern’s story today is still one of margin pressure, however volumes are improving for the company. When we look at the latest Q1’24 results for Norfolk Southern, the company reported quarterly revenues of $3.0 billion, which was down 4% on a year over year basis. This was in spite of volumes actually growing 4%, driven by the intermodal.

How did revenues fall when volumes were up? This quarter, Norfolk Southern had to deal with challenges with respect to lower fuel surcharge and headwinds in intermodal that led to declines in revenues on a year over year basis. In terms of the individual segments, merchandise revenues were essentially flat during the quarter (down 1%) but intermodal and coal took hits of 8% and 10%, respectively, during the quarter.

With respect to lower fuel surcharges, we can see what an impact this made on the Q1 results. Out of $69 million decline, $57 million could be solely attributable to fuel surcharges. As a reminder, fuel surcharges are additional fees that railroads (and other transportation companies) pass onto their customers to account for the fluctuating costs of fuel (eg. oil, coal, gas). We see this in the trucking industry too. Likewise, Norfolk Southern passes on this to their customers so that they don’t have to constantly adjust their base price. So even though the fuel is an expense for companies, many railroads and trucking companies actually benefit from higher fuel costs as they make a margin in charging fuel surcharges.

As you might imagine, the declines in commodity prices had an adverse impact for Norfolk Southern. During the quarter, coal pricing was noticeably weaker and intermodal faced headwinds with lower volumes and adverse mix because of softer demand in the company’s higher yield premium business.

On operating expenses, the company saw them down 1% on a quarter over quarter basis but up 15% on a year over year basis. There were some headwinds from the Eastern Ohio incident (a toxic chemical derailment that occurred early last year) but also from higher compensation and benefits to start the year and increased purchased services and rent expense. Keep in mind that while the fuel expense was down 10%, we see this offset by lower fuel surcharges on the revenue side.

While Q1 results may have looked bad from a revenue and operating margin perspective, I don’t view them to be all that concerning.

For one thing, management commented that they expect to see margins “improve materially from here” and that they are “finally starting to see excess service costs unwind and they will accelerate downward in Q2”. This is positive in my view, particularly as the company has also noted that they will be reducing their non-agreement headcount. With cost efficiencies coming down, Norfolk Southern looks to be on a path to improved profitability coming into the balance of the year.

The fact that volumes were up shouldn’t go unnoticed by investors. When looking at U.S. weekly rail traffic, we can observe a 3.9% year over year increase. With total carloads up 1.1% and intermodal volume up 6.3%, this illustrates an acceleration in demand for intermodal and if we assume that Norfolk captures a proportional share in participating in this growth, I’d wager that Q2’24 results are likely to be stronger than Q1’24. We’ll find out in a few weeks on July 25, but for now I find Norfolk Southern’s chances of beating to the upside of analyst targets to be a more probable scenario rather than a miss.

In terms of catalysts for the stock, investors should keep in mind that $592 million of operating expenses are temporary due to the one-time derailment incident. It’s unclear when these expenses will go away, but I expect them to dissipate sometime in the next few quarters, likely in early FY’25. So far, Norfolk Southern has already spent $1.7 billion in fines, settlements, community assistance, and clean-up costs related to the derailment incident.

Excluding these operating expenses, I calculate that Norfolk Southern should have at least 300 basis points of operating margin expansion, even before any pickup from fuel surcharges. With volume tailwinds, cost cutting and efficiency measures in place, less expenses related to the derailment incident, and the potential for higher fuel surcharges from here if and when commodity prices rise, I think the outlook looks strong for the company, despite negative sentiment surrounding the company. I wouldn’t be surprise to see mid-single digit revenue growth from here over the next three to five years. Management does expect that it can still achieve its guidance for between 67% to 68% operating ratios for the year, which combined with revenue growth, could have some meaningful impact to the company’s bottom line.

Finally, the last major catalyst for the stock would be the impact of activist investors. With the current issues at Norfolk Southern, there has been interest from investor group Ancora Holdings, who nominated a slate of directors and tried to kick out CEO Andy Shaw out of his job. Later, Norfolk Southern accepted a few nominees and gave Ancora three board seats. Overall, I think CEO Andy Shaw has been doing a good job over his three years at Norfolk Southern and we should keep in mind that he inherited several issues when he assumed the role. With activist, I view this to be a positive as Ancora is likely to act in the best interest of shareholders and pressure the company into making better operational decisions.

Valuation and Wrap Up

On sell-side sentiment and their target prices, analysts seem to be pretty constructive on the near-term outlook for the company. Of the 26 analysts who cover the stock, there are 16 ‘buy’ ratings and 10 ‘hold’ ratings with an average price target of $270.04, with a high target of $300.00 and a low target of $233.00. From the current price to the average price target one year out, this implies about 25.1% upside, not including the current dividend yield of 2.5%.

When looking at the valuation for Norfolk Southern, the company trades at 12.6x EV/EBITDA, which is slightly above the long-term ten year average multiple of 11.2x EV/EBITDA. Historically, the company’s valuation has traded within a range of 7.1x and 17.0x EV/EBITDA, so we seem to right at the midpoint of that range today (source: S&P Capital IQ).

When we compare Norfolk Southern to its class I railroad peers, Norfolk Southern trades at a slight discount on an EV/EBITDA basis, but at a large premium on a P/E basis at 34.7x earnings. I don’t find the current P/E multiple to be all that relevant in valuing Norfolk Southern, because of the one-time impact of the derailment last year. When we look at the forward multiples, at 11.6x EV/EBITDA and 17.5x P/E, Norfolk Southern looks a lot more attractive compared to the peer group forward multiples of 13.5x EV/EBITDA and 20.0x P/E (source: S&P Capital IQ).

In terms of the risks to the investment thesis, Norfolk Southern’s results could be impacted by swings in the broader U.S. economy. Higher interest rates, a slowdown in GDP, and other macroeconomic factors could weigh heavily on results. Out of the derailment specifically, there’s a risk that additional fines, lawsuits, and other related costs could last beyond what’s typical. Usually, these things blow off after a couple of years, so I wouldn’t be too concerned about this, but it’s still something to watch. One risk I would pay close attention to is the union and labor relations and any disputes that may arise. As I discussed earlier, Norfolk Southern has had company-specific labor challenges before and so monitoring the impacts of labor management with respect to reducing their non-agreement headcount will be important.

To summarize, I find Norfolk Southern a compelling opportunity among the major class I railroads. Right now, the company is out of favor because of a weak quarter and margin pressures. Looking forward though, assuming volume growth can continue, I think the impact of cost cutting and lower one-time impacts from the derailment that took place last year could meaningfully improve operating margins. With a path to an improving outlook, Norfolk Southern is my favorite railroad play in the medium term which is why I rate shares of the company as a ‘buy.’