Norfolk Southern (NYSE:NSC) is set to release its Q4 2012 earnings Tuesday, January 22. This quarter’s earnings release will be closely watched by investors since Norfolk Southern’s earnings declined 27% in Q3. The primary cause of the decline in earnings was NSC’s management choosing to keep to fixed costs in hope of a rebound in demand, which did not occur during the fourth quarter and is unlikely to do so in the near future.
Therefore, during this earnings call, we will be closely watching for cost cutting initiatives that the management undertook during Q4 because this is likely the only way for NSC to improve its bottom line. Additionally, we will be closely watching NSC’s price per unit of freight since increases in pricing power can help the firm offset volume declines.
Q3 Recap: Earnings Bogged Down By Margins
During the third quarter of 2012, Norfolk Southern posted a 27% decline in net income, which came in 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 (proportion of operating costs to revenues), to 72.9% compared to 67.5% in Q3 2011. 
Operating Ratio Must Improve
We watch profit margins closely because it has a big impact on Norfolk Southern’s price estimate. For example, if Norfolk Southern’s EBITDA margins fall to around 36% by the end of our forecast period, our price estimate would fall approximately 10%.
Pricing Power Can Help Offset Volume Declines
Another troubling aspect in Norfolk Southern’s Q3 earnings miss was the fact that the company’s average revenue per unit declined by 5%. We think that the decline in revenue per unit is likely to be more troubling than volume declines over the long term. Norfolk Southern’s western counterpart, Union Pacific grew revenue its third quarter because the increase in RPU offset a decline in volume.
Overall, we would like to see an uptick in RPU for Norfolk Southern’s business. Additionally, we need to see managment communicate initiatives during the earnings call, which show how it will increase its long haul business and lower the short haul business, which has a lower average RPU. The company needs to demonstrate that it has pricing power over customers since it will help them mitigate declines in volume.
We currently have a $63 price estimate for Norfolk Southern, which is approximately 5% below the current market price.Notes: