Norfolk Southern Earnings Preview: Intermodal To Offset Coal Headwinds

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Norfolk Southern

Norfolk Southern (NYSE:NSC), one of the leading railroads in the eastern U.S., is scheduled to report its third quarter 2014 results on October 22. Its carloadings data for the quarter through week ended September 27, 2014 reported strong growth in its intermodal and merchandise volumes, which should have a significant positive impact on revenues. However, the decline in coal carloads could temper growth. The decline in coal volumes comes as a surprise considering that coal volumes grew in the previous quarter.

Revisiting Third Quarter 2014

Norfolk Southern’s revenue increased 8.6% year-on-year on the back of a 7.9% growth in volume. [1] The high revenue growth helped Norfolk Southern drastically improved its operating ratio (operating expense expressed as a percentage of revenues) from 75.2% in the first quarter to 66.5% in this quarter. The company’s diluted earnings per share increased 22.6% compared to the previous year’s third quarter, primarily due to the favorable impact of revenue and operating ratio improvement.

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Low coal volumes likely to present headwinds

In the previous quarter, Norfolk Southern’s coal carloads increased 2.2% driven by the demand for coal at utilities as they moved to replenish their inventory. However, as per the carloadings data for the quarter through week ended September 27, 2014, coal volume declined 3.5%. One of the reasons for the decline in coal carloads may be the weakness in demand for U.S. thermal and metallurgical coal in international markets, which is impacting Norfolk Southern’s export coal shipments.

Declining prices of thermal and metallurgical coal, due to high exports from Australian coal suppliers and low demand from China, have created a challenging environment for U.S. coal. Recent reports put global prices for thermal and metallurgical coal at their 5 year lows. [2] [3] U.S. coal suppliers are unable to compete at such low prices, which leads to lower coal carloads for Norfolk Southern.

It is interesting to note that despite the same macroeconomic factor impacting CSX (NYSE:CSX), Norfolk Southern’s primary competitor operating in the same region, its coal carloads grew 5.6%. This leads us to believe that there might be other reasons as well because of which Norfolk Southern’s coal volumes are down. One of the reasons maybe Norfolk Southern’s loss of contract to one of the northern utilities in the first quarter of 2014. It is most likely that these coal carloads shifted to CSX.

The impact of decline in coal volumes on Norfolk Southern’s revenue can be offset by an increase in coal revenue per unit. In the previous quarter, Norfolk Southern’s coal revenue per unit increased 4.5%. This was because of the higher mix of long haul coal originating in the Illinois basin and Northern Appalachia Pittsburgh moving to southern utilities. With natural gas prices at around $4.00 per million btu during the third quarter of 2014, [4] coal from Illinois basin would have remained profitable, which could have a positive impact on Norfolk Southern’s coal revenue per unit due to the long haul.

Intermodal revenue per unit could increase

Norfolk Southern’s international intermodal volume was up 16% in the second quarter due to the expedited holiday season shipments. Shippers had imported their holiday season merchandise earlier than usual due to concerns regarding the possible disruptions that could have been caused by the ongoing labor contract negotiations between ILWU and PMA. Since shippers have already imported some of their third and fourth quarter merchandise, they will have fewer shipments later in the year, leading to a slowdown in international intermodal volume growth.

Though this may affect volumes, lower international intermodal volume is beneficial for Norfolk Southern. Norfolk Southern’s international intermodal revenue per unit is around 33% lower than that of its domestic intermodal shipments. [5] Therefore, lower international intermodal shipments will lead to a favorable product mix, which could help bring up the intermodal revenue per unit.

Tightening trucking capacity in the U.S. is driving intermodal volumes away from highways to rails. We believe this is the primary reason for the 9.7% increase in Norfolk Southern’s intermodal carloads during the third quarter through week ended September 27, 2014. [6] This domestic demand is likely to offset the slowdown in international intermodal shipments. Additionally, an increase in rates for its domestic intermodal services should help boost revenue per unit. Norfolk Southern increased the rates for its transcontinental service on June 1, and its Equipment Management Program service effective from September 1. These services represent 17% of Norfolk Southern’s domestic intermodal business.

For the remaining 83% of Norfolk Southern’s domestic intermodal service, price increases during the second half of the year will be dependent on escalators included in contracts. Escalators trigger price increases based on the Rail Cost Adjustment Factor, which measures the rate of inflation in railroad inputs such as labor and fuel. Re-pricing of these contracts will have to wait till 2015 since contracts are priced on an annual basis.

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Notes:
  1. Norfolk Southern Second Quarter 2014 Financial Review, July 23 2014, www.nscorp.com []
  2. THERMAL COAL-Prices remain weak as Australian exports surge, October 7, 2014, www.reuters.com []
  3. Metallurgical Coal at 6-Year Low as Chinese Demand Slows, September 25, 2014, www.businessweek.com []
  4. Henry Hub Natural Gas Spot Price, www.eia.gov []
  5. Norfolk Southern’s (NSC) CEO Wick Moorman on Q2 2014 Results – Earnings Call Transcript, July 23 2014, www.seekingalpha.com []
  6. Norfolk Southern Carloadings Report, www.nscorp.com []