Norfolk Southern (NYSE:NSC) is one of the leading railroad networks in the eastern United States. The company’s revenue fell by 2% and 3% annually in Q1 and Q2 2013, respectively, mainly due to decline in the overall revenue per unit (RPU). In this article, we assess the key drivers and challenges to Norfolk Southern’s business in 2013, which will impact its bottom line.
We believe the volume outlook for the company is positive for the rest of 2013 due to continued growth in the chemicals, intermodal, automotive and housing markets. However, its RPU will continue to remain challenged due to ongoing weakness in the coal segment. Moreover, we expect NSC’s profitability to stay under pressure in the near term due to changes in product mix.
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Expanding Chemicals Business
NSC’s chemicals volumes expanded by a healthy rate in the past few quarters primarily due to increased shipments of crude oil by rail. Owing to inadequate pipeline infrastructure, we expect the high demand for crude by rail shipments to continue in 2013. Moreover, the continued growth in the automotive and housing sector will also boost shipments of crude oil and plastics.
Highway to Rail Conversion Opportunity
We expect the intermodal segment to be a major growth driver for NSC in the future due to significant highway-to-rail conversion opportunities and expansion in NSC’s intermodal capacity. The opening of new corridor terminals through Crescent Corridor program and new business opportunities with international shipping partners will fuel growth in this segment.
Continued Growth In The Automotive Sector
The automotive sector in the U.S. has seen high growth in the recent past due to factors such as a recovery in the overall economy, population growth and high vehicular age. NSC’s automotive shipments rose by 8% in Q2 2013, and we expect the strong demand to continue in this sector. However, difficult y-o-y comparisons could negatively impact the growth rate going forward.
Housing Sector Improvements
Growth in the housing sector supports shipments of housing-related materials such as lumber, appliances, cement, aggregates, and rebar. Housing starts have increased in 2013, and in July 2013, they rose by 5.9% m-o-m and 20.9% y-o-y.  We expect continued recovery in this sector to boost NSC’s housing-related shipments during the year.
Rising Operating Ratio
NSC’s railway operating ratio increased by 150 basis points and 270 basis points annually in the first and second quarter of 2013 respectively. This mainly reflects changes in product mix carried by the company as the proportion of higher margin coal business has decreased over the last few years. Even though the company has seen efficiency improvements in the recent past, we believe its margins will stay under pressure during the rest of 2013.
Decline In Average Revenue Per Unit And Weakness In The Coal Market
Norfolk Southern’s revenue per unit declined by 5% annually in Q1 2013 and Q2 2013, mainly on account of challenges in the coal market since the coal RPU declined by 13% and 14% respectively during these two quarters. A negative mix in price has been caused mainly by lower volumes of export coal and longer-haul southern utility coal. We expect continued challenges in the coal sector during this year, and this will also negatively impact the overall RPU. The domestic coal market remains subdued due to lower demand for electricity, competition from natural gas and high coal inventory levels. The export coal market will remain challenging due to weak demand from both Europe and Asia.
Our $74.30 price estimate for Norfolk Southern is broadly in line with the current market price.Notes: