Norfolk Southern: Risk and Opportunities

NSC: Norfolk Southern logo
Norfolk Southern

Norfolk Southern’s stock (NYSE: NSC) lost almost 40% – dropping from $197 at the beginning of the year to below $119 in late March – then spiked over 60% to around $192 now. That means it has fully recovered to the levels where it started the year.

Why? While the Covid-19 outbreak and associated lockdowns resulted in an uncertain outlook for the broader markets, the multi-billion-dollar Fed stimulus announced in late March helped the markets stage a strong recovery. Investors are now expecting a quicker economic rebound with economies opening up gradually, which will bode well for Norfolk Southern’s transportation business.

But is this all there is to the story?

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No, not quite. Despite the recent rally, Trefis estimates Norfolk Southern’s Valuation at about $217 per share, roughly 13% above the current market price based on two key opportunities and a risk.

The first opportunity we see is to Norfolk Southern’s Revenue growth over the coming years. We know 2020 will be a year marking a drop in revenues led by lower volume as well as an impact on pricing. However, as we look beyond 2020, with the containment of Covid-19 and availability of vaccines pushing the virus out of the center of attention and resulting in economic growth, we believe Norfolk Southern will see a rebound in demand for railroad transportation. With the economy opening up and lockdown restrictions already being lifted in several cities, the industrial production is gradually picking up pace, and it will likely result in increased transportation demand in the near term.

The second opportunity we see is to Norfolk Southern’s Expenses, which have been trending lower, when looked at as a percentage of revenue, over the past few years. Norfolk Southern, in line with other major railroad companies, has been focused on reducing its operating ratio, and it managed to bring it down from 69.6% in 2016 to 64.7% in 2019. While the Covid-19 pandemic has resulted in increased costs for the company, Norfolk Southern aims to achieve an operating ratio of under 60% over the coming years, thereby boosting margins. In the near term, lower crude oil prices will have a positive as well as adverse impact on the company. On the positive side, the fuel expenses will likely trend lower. Fuel accounted for $1.0 billion in expenses, or 8% of total revenues and roughly 11% of the company’s total expenses in 2019. However, the fuel surcharge is an important element of average revenue per carload garnered by the company. With lower fuel prices, the overall pricing will also be impacted.

That said, there is a risk associated with Norfolk Southern’s coal freight business, in line with a larger trend seen across railroad companies. There has been a decline in demand for coal as an energy source and an increased use of cleaner fuels, such as natural gas. Climate change consciousness is growing. There is considerable social and political pressure on fossil fuel producers to reduce emissions, and on consumers to reuse, reduce, recycle. The result – a lower demand for coal. For perspective, the U.S. coal consumption is expected to decline by roughly 40% between 2018 and 2020, according to the US Energy Information Administration. This means lower production, and lower need for transportation. Another factor why there is increased dependency on natural gas as an energy source is its low pricing. In fact, natural gas prices have plummeted over 50% since early 2017. For Norfolk Southern, its coal shipments have declined 12.6% between 2017 and 2019. This trend could continue over the coming years, and weigh on Norfolk Southern’s overall performance.

The near term risk for Norfolk Southern stems from the impact of Covid-19. Increased unemployment, lower consumer spending power, and restrictions in place for various manufacturing plants means lower demand for railroad transportation, evident from the company’s Q2 performance. The company’s top line contracted 29% in Q2 2020, primarily due to massive declines in coal and automotive shipments. Looking at the bottom line, the company posted a 40% decline in its EPS, which stood at $1.43 per share. The EPS decline was due to margin contraction, as the company reported an operating ratio of 71%, compared to 64% in the prior year quarter. However, the situation is changing on the ground with the economy gradually opening up. The rebound in economic growth and its timing hinge on the broader containment of the coronavirus spread. Our dashboard forecasting U.S. Covid-19 cases with cross-country comparisons analyzes expected recovery time-frames and possible spread of the virus. Further, our dashboard -28% Coronavirus crash vs. 4 Historic crashes builds a complete macro picture. The complete set of coronavirus impact and timing analyses is available here. For Norfolk Southern, the key trend to watch out for will be the operating ratio in Q3, as the demand improves over the coming months.

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