Norfolk Southern (NYSE:NSC) is one of the leading railroad networks in the eastern United States. Its railway operating revenue fell by 2% annually in Q1 2013, mainly on account of weakness in the coal business. Its coal revenue suffered a decline of $131 million (17% annually) on account of 4% decline in volume, coupled with 13% decline in coal revenue per unit (RPU). The negative mix in price on account of growth in export business and shorter-haul Northern utility volumes resulted in the fall in coal RPU.
Utility and export coal tonnage account for more than 80% of Norfolk Southern’s coal volumes. We expect the outlook in the domestic coal utility business to improve in the coming quarters on account of recent upward trend in natural gas prices, a decline in coal inventory levels and higher coal market share in U.S. electricity generation.
NSC’s export coal tonnage which grew by 25% in the first quarter could show slower growth in the future on account of challenging conditions in the metallurgical coal (used for making steel) and thermal coal (used for electricity generation) markets. While pricing in the export met coal market could improve, the growing proportion of thermal coal in the overall coal business would weigh on the overall coal RPU in the future.
Performance of Norfolk Southern’s Coal Business By Market
Coal Tonnage Mix by Market (Q1 2011)
|Coal Tonnage Mix by Market (Q1 2012)||Coal Tonnage Mix by Market (Q1 2013)||
Annual Change of Volumes in Q1 2013
|Total Tonnage (tons in thousands)||
Utility Market Suffered A Decline In The First Quarter But Outlook Is Improving
Utility coal tonnage suffered a decline of 9% in the first quarter on account of high coal inventory levels at utilities and competition from natural gas. The impact was greater on longer-haul Southern utility volumes which suffered a decline of 16%, as compared to shorter-haul Northern utility volumes which fell by only 3%. Since the difference in revenue per car between these two accounts is around 50%, the higher proportion of shorter-haul Northern utilities volumes in overall utility volumes contributed to the decline in revenue per car. 
We believe the outlook in the coal utility business is improving, based on the following factors:
- Natural gas prices are on an upward trend, and the NYMEX spot price was seen at around $4.2 (per mmBTU) at the end of April 2013.  At these prices, coal becomes more competitive against natural gas for producing electricity and certain utilities have switched back to coal.
- The share of coal in U.S. electricity generation has increased to around 40% in the first two months of 2013, as compared to around 37% in 2012. 
- Coal inventory levels at utilities are declining – utility stockpiles reduced by 7.5% at the end of the first quarter, as compared to Q4 2012. 
On account of these recent trends, we think the utility coal market has bottomed out and volumes could start to rise in the coming quarters. However, our expectations are based on continued upward trend of natural gas prices and stronger overall demand for electricity generation.
Export Coal Market – Market Is Expected To Be Challenging, Pricing Pressure Could Continue
Norfolk Southern’s export coal tonnage saw 25% rise during the first quarter with increase in both, thermal coal and metallurgical coal volumes. However, the weaker pricing environment associated with export metallurgical coal contributed to the drastic decrease in coal RPU. Negative mix, mainly related to export coal was responsible for $85 million revenue decline during the first quarter, as compared to the previous year. 
The outlook for this market is as follows: -
- Export coal volumes are expected to grow at a slower pace in the coming quarters as compared to the rapid growth seen in the first quarter on account of challenges in both metallurgical and thermal export coal markets. Coal demand from Europe and Asia is weakening.
- NSC applied a modest price increase in its export metallurgical business at the start of the second quarter, taking into account slightly better pricing dynamics in the world pricing of met coal. The y-o-y pricing comparison in met coal business is expected to improve starting in the third quarter, on account of a more favorable base.
- However, the proportion of export thermal coal in the overall coal business is increasing, and since export thermal coal contributes lower RPU as compared to met coal, we think this could have a negative impact on the overall coal RPU in the future. 
Domestic metallurgical – Outlook Will Improve From Third Quarter
Norfolk Southern’s domestic metallurgical coal tonnage fell by 12% as a result of lower steel production and the effect from RG Steel bankruptcy. The outlook for this market is expected to improve following the third quarter, once the comparable from RG steel business is removed. 
Industrial Demand Stays Challenging
Industrial coal tonnage fell by 6% annually in Q1 2013, due to softer demand and better efficiency at certain coal-based industrial plants. We expect this market to stay challenging in the near term.
Our $76 price estimate for Norfolk Southern’s stock, represents near 5% downside to the current market price.Notes: