Norfolk Southern: A Dumpster Fire With Strong Annual Return Potential (NYSE:NSC)

Introduction

It’s time to talk about Norfolk Southern (NYSE:NSC), one of the core holdings in my dividend growth portfolio.

Unfortunately, the company has entered rough waters after the pandemic.

• It struggled with extreme volatility in post-pandemic freight demand and general supply chain challenges.
• Like its peers, it was hit by consumer weakness and elevated inflation in 2022.
• The major train derailment in East Palestine, Ohio, last year came with hundreds of millions of additional costs.
• Related to the points above, it’s currently engaged in a proxy battle with Ancora Holdings, an activist investor looking to replace board members to force significant change.

My most recent article on this railroad was written on Feb. 29, when I highlighted Ancora’s attempt to influence the board with its own candidates.

As we can see below, there’s a massive gap in the operating ratios between Norfolk Southern and its Class I peers.

This has also resulted in stock price underperformance, especially compared to the CSX Corporation (CSX), which has a duopoly with Norfolk Southern in the eastern United States.

I covered CSX on April 19 when I wrote that I bet on the wrong horse by buying NSC.

Although CSX would fit perfectly into my portfolio and my investment strategy, I have not sold a single share of Norfolk Southern.

I just haven’t figured out if I want to sell NSC as I believe it’s a business with tremendous potential once management improves operating metrics.

On top of that, with the intermodal tailwinds that CSX sees, I expect that NSC could benefit from that as well.

As the company just reported its 1Q24 earnings, it’s a perfect opportunity to revisit my thesis.

So, let’s dive into the details!

A $600 Million Settlement and Major Headwinds

Roughly one year ago, a Norfolk Southern train derailed in Ohio. Long story short, the derailment resulted in hundreds of millions of additional costs, including $600 million to settle lawsuits with individuals and businesses.

The Wall Street Journal just reported that:

The settlement would resolve class-action claims within a 20-mile radius of the derailment and for residents with personal-injury claims within a 10-mile radius from the site.

The same article also highlighted the company’s proxy fight with the Hedge fund Ancora Holdings, which has resulted in Norfolk Southern making a number of changes to protect itself against the hedge fund.

This includes naming John Orr as Chief Operating Officer, a man who has many decades of experience, including working for Canadian Class I railroads, which are considered the gold standard of safety and operating efficiency.

1Q24 Was Not A Pretty Quarter

In the first quarter of this year, the company’s financial results were impacted by a wide range of factors. This included the aforementioned $600 million agreement to resolve a class action lawsuit related to the Ohio derailment incident.

On top of that, other cleanup costs and insurance recoveries also affected operating income negatively by $592 million (highlighted in the overview below).

The good news is that there were $108 million in insurance recoveries during the quarter, totaling more than $200 million toward the company’s $1.1 billion insurance coverage.

In light of these massive payments, the numbers we’re about to discuss next are adjusted. After all, if we include these “one-off” numbers, it’s hard to assess the health and developments of the underlying business, which is the main goal of this article.

With that in mind, adjusted results reveal a 4% decline in revenues. Meanwhile, operating expenses were up 3%. The mix of lower revenues and higher costs resulted in 18% lower operating income and an operating ratio of roughly 70%. That’s more than six points above CSX’s operating ratio.

With regard to the decline in revenue, as we can see below, the company took a big hit from coal, which suffered due to softer coal prices and lower volumes.

It also didn’t help that the Port of Baltimore has been impacted by the recent bridge collapse, which is expected to cost the company between $50 million and $100 million in revenue for the quarter. I expect the port to be open at the end of June or early July.

Meanwhile, the intermodal business saw continued headwinds from softness in higher-yield premium business on top of pricing headwinds that offset recovering volumes.

Within the merchandise segment, volume remained flat while revenue saw a 1% decrease. This decline was mainly driven by lower fuel surcharge revenue.

Generally speaking, fuel surcharges saw a headwind of $115 million, which turned them into the single-biggest headwind to revenue. However, as fuel surcharges usually lag by a few months. This is not an issue I’m worried about.

Moreover, intermodal storage and fees decreased by $35 million compared to the previous year.

There’s No Room For Error

So far, so good.

1Q being a poor quarter was not groundbreaking news. After all, the market knew NSC was struggling with demand, pricing, and the derailment.

What matters is its outlook and operating improvements. As I already said, the only reason I’m still long is my belief that NSC has a ton of “hidden” value.

Looking forward, Norfolk Southern expects a mixed macroeconomic environment characterized by uncertainty regarding inflation and future Fed rate actions. As most of my readers know, that’s exactly my view as well, as I’m in the camp that expects both inflation and interest rates to remain higher for longer.

However, the company believes it’s well positioned to capitalize on growth opportunities owing to its improving service product.

The normalization of auto production and ongoing infrastructure projects across its network is expected to support merchandise volume growth.

Even better, a positive price environment is expected, supported by enhanced network fluidity, cycle times, and equipment availability.

Meanwhile, intermodal volumes are projected to increase, driven by solid international trade, with the biggest risks being challenges through domestic non-premium pricing due to low truck rates. After all, long-haul trucks are the biggest competitor of railroad intermodal transportation.

Last but not least, coal volumes are expected to face challenges from high stockpiles, low natural gas prices, and the impact of the Baltimore port shutdown on export shipments.

While I believe that (international) coal demand will remain strong for many decades to come, the current environment is challenging, as natural gas prices are extremely low, which competes with coal.

With this in the back of our heads, the company spent a lot of time during the earnings call discussing its network.

The new COO, John Orr, mentioned that Norfolk is focused on closing the profitability gap with its peers through productivity enhancements.

For example, within the first 30 days of the COO’s tenure, roughly 200 locomotives were removed from the fleet, with most placed in storage or taken offline for specific purposes like High Priority Handling ballots.

Our availability count is now below 2,500 units. As shown on the slide, we will be able to increase locomotive drawdown over the next six months. Terminal 12 has improved by 8%. We are driving more waste by fine-tuning workload in our terminals through disciplined planned execution. Near term, we are targeting 20% improvement. – NSC 1Q24 Earnings Call

In addition to the quote above, car miles have also increased by 8%, with a double-digit improvement targeted. Recrews, which is an indication of network fluidity, have decreased by 22%, supported by the company’s ongoing network and terminal improvements.

Essentially, Mr. Orr is setting aggressive targets to overhaul NSC’s operations and copy the Canadian model of improving operations without cutting costs to the bone.

Our strategy is designed to mirror the great success stories of the Canadian railroads who have recognized that PSR is about more than tearing a railroad down to its studs at slashing costs regardless of the fallout. As our Board member, Claude Mageau demonstrated when he was CEO of Canadian National, a PSR operating model, when part of a customer-focused balanced strategy, can deliver top-tier revenue growth and a sub-60 operating ratio. – NSC 1Q24 Earnings Call

In light of all the improvements, the company is upbeat about its ability to have a meaningful impact on its operating ratio. I added emphasis to the quote below:

As we turn to the balance of the year, we will see our margins improve materially from here. We are finally starting to see excess service costs unwind and they will accelerate downward in Q2. That trajectory, along with the reduction in non-agreement headcount as well as other productivity initiatives leave us confident in a strong productivity story for Q2. – NSC 1Q24 Earnings Call

Expectations are for NSC to lower its operating ratio to 66% by the end of this year.

While this is obviously subject to factors beyond the company’s control (like economic growth), it’s an important target, as a 66% operating ratio is still far from satisfactory. It would be a good start at best and still above prior-year levels.

For reference, going into this year, the Class I average was in the low-60% range.

What does this mean for its valuation?

Valuation

The bull case for NSC remains strong – if it’s able to execute its plans.

Currently, NSC trades at a blended P/E ratio of roughly 20.8x. This is above its long-term normalized P/E multiple of 17.4x. This “premium” is mainly caused by the general market recovery and the proxy fight with Ancora, which is expected to put pressure on NSC to achieve its goals.

Furthermore, analysts are upbeat, as they expect 16% and 13% EPS growth in 2025 and 2026, respectively.

This year is expected to see 1% growth.

If the company is successful, it would warrant a 20x multiple, which is common during upswings.

This would pave the road for a $310 price target. That’s roughly 27% above the current price and the same target I mentioned in my prior article.

Even better, if the company is successful in achieving its longer-term targets, I expect double-digit annual returns on a prolonged basis.

After all, since 2004, the stock has returned 13.4% per year, including the Great Financial Crisis, the 2016 manufacturing recession, the pandemic, and current struggles.

Hence, I refrain from selling and will add to my position as long as NSC achieves its financial goals (adjusted for uncontrollable factors).

Takeaway

Despite facing challenges like the aftermath of the pandemic, supply chain disruptions, a major derailment, and a proxy battle with Ancora Holdings, Norfolk Southern remains a core holding in my portfolio.

The recent $600 million settlement for the Ohio train derailment impacted its financials, but with a new chief operating officer and aggressive operational targets, NSC aims to improve its performance.

While the road (rails) ahead may be bumpy, NSC’s potential for growth and its current valuation make it a compelling investment opportunity, with analysts forecasting significant EPS growth in the coming years.

As long as NSC stays on track with its plans, I remain bullish and expect potentially market-beating long-term returns.

Pros and Cons

Pros:

• Potential for Growth: Despite recent challenges, NSC remains attractive, especially with its focus on operational improvements and capitalizing on growth opportunities.
• Valuation Upside: Despite trading at a premium due to market recovery and proxy battles, NSC’s current valuation suggests potential for significant upside if it achieves its targets.
• Analyst Confidence: Analysts forecast double-digit EPS growth in the coming years, which could last if the railroad is able to start a long-term downtrend in its operating ratio.

Cons:

• Operational Challenges: NSC faces operational challenges, which may impact short-term performance.
• Financial Impact of Settlements: Recent settlements, such as the $600 million agreement for the Ohio derailment, have affected NSC’s financials. Until the derailment case is closed, we could (potentially) see more financial headwinds.
• Competitive Environment: NSC operates in a competitive landscape, facing challenges from peers like CSX and external factors like low natural gas prices and economic growth developments.