Norfolk Southern: Why I Need A Correction Before I Buy With Both Hands (NYSE:NSC)

Introduction

I own three railroad stocks. I own Union Pacific (UNP), which gives me well-diversified exposure to the Western two-thirds of the United States. I own Canadian Pacific Kansas City (CP), which connects all three North American nations, and I also own Norfolk Southern (NYSE:NSC), which is an intermodal-heavy railroad that dominates the East with its peer, CSX Corp. (CSX).

To be honest, I wasn’t planning on writing a Norfolk article so soon, as my most recent article was published on December 28.

Back then, I wrote an article titled “Building Wealth With Norfolk Southern: Why I’m Buying More In 2024.”

Essentially, that article was based on the company’s longer-term growth opportunities and what this means for shareholder distributions and potential capital gains.

Here’s a big part of my takeaway:

Positioned as an intermodal heavyweight, NSC stands out with a strategic focus on regaining market share from the trucking industry.

The commitment to offering consistently high-quality service, investments in the supply chain ecosystem, and collaborations with key partners like FEC and Canadian National highlight a forward-thinking approach.

Meanwhile, the company’s active role in reshaping supply chains, coupled with its pivotal role in the EV market, underscores NSC’s significance in the evolving transportation landscape.

While I still believe in everything I wrote back then, the company just released its fourth quarter/full-year earnings, which shows that Norfolk is still struggling with major issues that have caused it to underperform its peers by a wide margin over the past three years (mainly caused by a poor 2023 performance).

While the railroad suffered more from consumer weakness than its peers due to its focus on intermodal operations (containers on rails), the company is also struggling to improve operations while dealing with high costs related to the major derailment in East Palestine, Ohio, in early 2023.

Even adjusted for that derailment, the company has a very elevated operating ratio.

In light of all of these issues, I will explain why I still like NSC, just not at these prices. I need NSC to come down to offer a better risk/reward.

Given economic developments and NSC’s poor numbers, there’s a high likelihood that this may happen.

I am also not ruling out that an activist investor may step in. This happens all the time in the rail industry. More recently, it happened to Union Pacific when former CEO Lance Fritz was pushed out and replaced by Jim Vena.

Earlier this month, there was speculation that this may be the case.

Now, let’s get to it!

A Tough Quarter To End A Challenging Year

The very top of the topline wasn’t half bad in 4Q23. It was actually quite good, as the company reported a 3% improvement in overall volume, driven by growth in intermodal and automotive markets.

However, total revenue and revenue per unit (“RPU”) declined due to lower revenue from fuel surcharge and intermodal storage and fees.

As we can see above, the merchandise segment experienced flat volume, challenged by lower fuel surcharge revenue.

Nevertheless, RPU less fuel increased by 1%, setting a new quarterly record.

The intermodal segment saw a 5% year-over-year increase in volume, but revenue declined by 13% due to various factors, including lower revenue from storage and fees, lower fuel prices, excess truck capacity, and a negative mix in the international business.

The coal segment reported a slight volume increase, with strong export demand offsetting declines in utility coal. Coal revenue was down by 4% due to lower commodity prices and fuel surcharge revenue.

For the full year, total volume came in at 6.7 million units, reflecting a 1% decrease from the previous year.

Notable declines were seen in intermodal and energy-related chemical commodities.

However, lower ocean freight rates, increased demand for international intermodal, and rising vehicle production activity contributed to growth in the automotive franchise.

With that said, during its earnings call, the company discussed the aftermath of the Eastern Ohio derailment.

In terms of progress, the company highlighted the completion of the bulk of soil remediation, which is one of the most important tasks.

However, the financial implications were notable, to put it mildly, with a $137 million charge incurred in the fourth quarter alone.

This charge was associated with an extension of the timeline for ongoing testing and additional work in nearby streams, while an additional $89 million was incurred in legal costs and other fees.

Despite these expenses, the company received $76 million in insurance recoveries, bringing the total recoveries in 2023 to just over $100 million.

Unfortunately, the company expects to incur costs related to future legal settlements and fees, although no specific numbers were mentioned, which makes sense.

While we’re pleased with our remediation accomplishments, we currently expect ongoing monitoring efforts and cleanup efforts will continue through 2024. There will be additional costs in the future related to legal settlements and fees, although the amounts and timing cannot currently be estimated. – NSC 4Q23 Earnings Call

With that said, in general, costs were a major headwind for the company – on top of 5% lower revenues.

Adjusted operating expenses saw a 3% increase, resulting in an adjusted operating ratio of 68.8%. Despite a sequential improvement of 30 basis points from the third quarter, the year-over-year performance represented a deterioration of 5.3 points.

Operating income, net income, and earnings per share were all down close to 20% on an adjusted basis.

Even adjusted for the East Palestine incident, the operating ratio is way too high.

Union Pacific, for example, lowered its operating ratio by 0.1 points to 60.9% in the fourth quarter.

Numbers this bad are a reason why I would not rule out activist investors stepping up to potentially buy a stake in the company to force change.

I would not be surprised if at least one major fund is already working on a proposal.

It also hurt shareholder distributions. Although the company hiked its dividend by 8.9% on January 24, 2023, it significantly lowered its buybacks to protect its balance sheet in times of uncertainty.

NSC currently yields 2.3%. Its dividend has an earnings payout ratio in the low-40% range and a five-year dividend CAGR of 12.2%.

Norfolk’s Focus On Efficiencies

Despite operating issues, Norfolk Southern used its earnings call to emphasize its commitment to safety and service.

For example, the company reported a substantial 42% reduction in the mainline accident rate during 2023, reflecting decisive actions taken to enhance safety protocols and operational practices.

Furthermore, the company saw tangible improvements in intermodal service.

Despite facing multiple significant network disruptions, Norfolk Southern managed to deliver its best intermodal service in over three years.

This accomplishment is particularly noteworthy as it occurred in a period with a 5% growth rate in intermodal volume.

Furthermore, the company is also working on improving the operating expenses issue, which did a number on its operating ratio.

In 2024, the company plans to streamline its cost structure by implementing a program to reduce management headcount by approximately 7%. This strategic move aims to offset increases in critical operating areas and align the cost structure with the evolving operational landscape.

While recognizing the temporary increase in cost structure, Norfolk Southern outlined a vision during its earnings call where, during a down cycle, it may modestly underperform to be well-positioned to secure volume and incremental margin when the freight cycle recovers.

Essentially, it means the company is sacrificing some efficiencies in bad economic circumstances to protect its service quality and potentially outperform peers when demand improves.

Given how poorly some railroads did when post-pandemic demand improved, I believe this is a smart move.

What’s Next?

Looking ahead to the four quarters of 2024, the company anticipates modest volume growth.

In merchandise markets, overall volume growth is expected to be driven by gains in steel shipments, while the automotive segment is expected to grow due to continued strength in vehicle production, including new EV business.

The intermodal outlook is optimistic as well, with expectations of increasing levels of international trade boosting demand for both domestic and international services.

However, uncertainties exist around how quickly capacity in the truck market will adjust, which makes sense, as cheap trucking alternatives pressure intermodal demand.

Moreover, the coal outlook foresees relatively flat volume levels compared to 2023, with demand for export coal expected to be high.

The company also expects to generate pricing above rail inflation in 2024 despite challenges such as a persistently weak truck market.

Furthermore, the company described its domestic operations as a “coiled spring,” positioned to yield strong incremental value as the truck market recovers.

Despite a soft freight environment in 2023, the company focuses on creating value with a resilient network to drive growth, which is also something I highlighted in my prior article (using the chart below).

Looking at the longer-term future, the company envisions outsized gains on the upcycle, leveraging volume growth within existing resources, ample productivity runway, and strong core pricing that can outpace inflation pressures.

With regard to its poor performance, the goal is to narrow the margin gap with peers over time, delivering shareholder value through earnings momentum and free cash flow generation.

This year, revenue growth is expected to be roughly 3%.

What does this mean for the valuation?

Valuation

Using the data in the chart below:

• Analysts seem to agree with the company as they expect an earnings recovery. 2024 is expected to see 10% EPS growth, followed by 11% and 10% growth in 2025 and 2026, respectively.
• NSC currently trades at a blended P/E ratio of 20.1x, which is a bit above its normalized valuation of 17.2x.
• Combining a 17.2x fair valuation, expected EPS growth, and its dividend, the stock has an implied annual return of 7.1% per year through 2026.

Although I am not bearish on the company, this is not a margin of safety that satisfies me – at least not given the circumstances.

Bear in mind that NSC is up more than 17% since I turned bullish on October 20!

If it weren’t for this surge, NSC would be much more attractive.

However, given the pressure on economic growth, ongoing efficiency issues, and ongoing uncertainty regarding East Palestine, I am not likely to buy at these levels.

I am looking for 10% to 15% weakness before buying more. If that happens, I will likely massively expand my position, as I believe that NSC is a goldmine if it fixes its issues.

Using the chart below, we see a comparison between the NSC stock price (% below its all-time high) and the leading ISM Manufacturing Index (the black line).

As we can see, NSC’s stock price has decoupled from economic growth indicators, which tend to lead it very well because railroads are very cyclical.

Unless we get a sudden economic bottom, we could see a 10% to 15% stock price decline.

If it happens, I’m buying with both hands.

For now, however, I’m giving the stock a neutral rating to reflect my risk/reward assessment.

Takeaway

In its recent earnings report, Norfolk Southern faces difficulties in the volatile railroad industry.

Despite challenges, including a major derailment in early 2023 and economic uncertainties, NSC remains on track with its commitment to safety and service.

Meanwhile, the company aims to streamline costs and anticipates modest growth in 2024, especially in the intermodal and automotive sectors.

However, as the stock’s recent surge causes a somewhat unfavorable risk/reward, I’m eyeing a potential 10-15% dip for a more compelling entry point, believing in NSC’s long-term potential if it resolves its current challenges.