Norfolk Southern (NYSE:NSC) reported its third quarter earnings on Tuesday, October 23, after the market close. As expected, the company posted a 27% decline in net income at $402 million versus $554 million during the same period in 2011. The 27% decline was huge considering that revenues only declined 7% primarily due to a decline in coal and merchandise shipments. The reason for the big gulf between net income and revenue declines was the drastic increase in the company’s railway operating ratio to 72.9% compared to 67.5% in Q3 2011. 
Overall, this quarter’s results show that NSC’s business could be in trouble over the next few quarters as declines in volumes and average revenues per unit combined with an increase in operating ratio could affect its bottom-line for a prolonged period.
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Revenue Per Unit Decline Troubling
The primary reason for the 7% decline in Norfolk Southern’s freight revenues was a 5% decline in average revenue per unit (RPU). The biggest driver for the decline in revenue per unit was a 9% decline in coal freight RPU, partially offset by a 1% increase in merchandise RPU.
As a standalone measure, the decline in revenue per unit is likely to be more troubling for the company’s long term prospects than the decline in freight volumes. The main reason that Union Pacific (NYSE:UNP), NSC’s counterpart on the west coast, grew revenues during the third quarter was the RPU increase. In NSC’s case, revenue per unit declined due an increase in the short haul business, which has lower than average RPU. If NSC’s management is unable to implement initiatives which reverse this trend, we could see NSC’s revenues remain on the downward trajectory in the coming quarters.
Operating Ratio Increase Must be Reversed
As we expected in our pre-earnings article, Norfolk Southern’s operating ratio increased drastically to 72.9%, an increase of five percentage points compared to the same period in 2011. During the earnings call, we were looking for specific initiatives by management to cut costs, but did not see any anything which would achieve this goal over the next couple of quarters. 
Overall, it seems that we will have to wait and see how the company will manage the expense side. In our opinion, management must cut costs as quickly as possible since all signs indicate an extended slump in freight volumes.
Coal Volumes Are Likely to Impact Earnings in Q4
According to NSC’s management, coal volume declines that affected the firm’s earnings in the third quarter largely occurred in September. Unfortunately, these declines continued into October and the company doesn’t necessarily have an idea regarding when they will end. If the September trend continues through the fourth quarter, NSC’s freight volumes are likely to take a big hit. Additionally, if the adverse mix that NSC experienced in the third quarter also continues, we might see a larger decline in the fourth quarter revenues and earnings.
NSC’s troubles seem to be company-specific since CSX Corporation (NYSE:CSX) and Union Pacific were not as adversely impacted by the slowdown in coal freight. During this earnings call, we were looking for the management to provide a clear strategic direction in terms of cost cutting, but didn’t see any specific initiatives that would help NSC’s fourth quarter results.
We currently have a $67 price estimate for Norfolk Southern, which is approximately the same as the current market price.Notes: