King Coal’s Weakness Continues To Hamper Norfolk Southern’s Earnings

Norfolk Southern (NYSE:NSC) reported its fourth quarter earnings on January 22 after the market close. The company posted around a 14% decline in net income at $413 million versus $480 million during the same period in 2011. This drop is considerable in the context that revenues declined 4% primarily due to a decline in coal and merchandise shipments. The reason for the big gulf between net income and revenue declines was the increase in Norfolk’s railway operating ratio to 73.4% from 70.4% in Q4 2011. ^[1]

Overall, this quarter’s results again show that NSC’s earnings for 2013 are in trouble. The company has not cut costs to offset the decline in coal revenues, and this will cause earnings growth to be muted. Declines in volumes and average revenues per unit combined with the increase in operating ratio will impact its bottom-line for an extended period.

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Coal Remains a Drag on Earnings

The primary reason for the 4% decline in Norfolk Southern’s freight revenues was a 23% decline in coal freight revenues. Overall, this decline was driven by a 13% decline in volumes and 10% decline in revenue per unit (RPU).

In our opinion, Norfolk Southern’s RPU decline is troubling since the company is not able to offset volume declines with price increases, something which other railroads such as Union Pacific (NYSE:UNP) have been able to do to drive top-line growth.  If NSC’s management is unable to implement initiatives which reverse this trend, we are likely to see NSC’s revenues continue to decline in the coming quarters.

Operating Ratio Increase Must Decline

Another troubling trend for Norfolk Southen is that its operating ratio increased 3 percentage points to 73.4%, which is also an increase quarter-over-quarter.  During the earnings call, we were encouraged by management’s focus on lowering the firm’s long-term cost curves. ^[2]

However, we will have to wait and see how management cuts costs in the next few quarters given the threat of a continued slump in coal freight volumes.

Coal Volumes Are Likely to Impact Earnings in 2013

The major reasons that coal freight volumes are declining are low natural gas prices, high inventory levels and low global demand. We expect these conditions to continue for the foreseeable future and expect the coal freight segment will continue to be a drag on NSC’s revenues. How and when these factors recovery are difficult to predict because pricing in the U.S. natural gas market remains at extremely low levels.

We currently have a $67 price estimate for Norfolk Southern, which is approximately the same as the current market price.

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1. 8-K, SEC [↩]
2. Earnings Call Transcript, Seeking Alpha [↩]