Riding the rails has been a great place to be over the past year -- particularly with Norfolk Southern (NSC 0.39%).
Its stock has been a solid performer over the past year, gaining 30%, and outpacing the S&P 500 by 13 percentage points and the Dow Jones U.S. Railroads Index by eight percentage points. More recently, Norfolk Southern stock has demonstrated particular strength, gaining over 7% during the month of May.
But that's the past, and what we're interested in is whether Norfolk Southern will deliver market-beating returns over the long haul. Here is the case for, and against, investing in Norfolk Southern today.
The case for Norfolk Southern
Norfolk Southern had a disappointing first quarter, but the railroad posted record results in 2013 for both revenue and earnings.
The first quarter of 2014 was a challenge for all railroads due to harsh winter conditions, so investors and analysts will be watching Norfolk Southern's second quarter closely for signs that it's recaptured the momentum of last year. The railroad demonstrated particular strength in its intermodal segment, growing revenues and traffic volume by 6% in 2013 -- a potential engine to drive earnings forward this year.
Norfolk Southern's rail network is also well placed to capitalize on the trend of hauling crude, natural gas and petroleum products by rail, including from North America's shale regions. During its most recent quarter, Norfolk Southern transported 12% more in its chemicals segment -- driven primarily by increased transportation of crude-by-rail. Its network is also well positioned to move Canadian heavy oil to refineries in the U.S. that can process the bitumen that comes out of the Alberta Tar Sands.
And then there's cash. Norfolk Southern ended the first quarter with just over $1.5 billion in cash and cash equivalents, well above the $672 million from the year earlier quarter. Given its strong cash position, investors should be optimistic about a potential dividend raise. Last year, free cash flow rose 34%, prompting a 4% increase in the quarterly dividend. Today, Norfolk Southern offers a dividend yield of 2.1%, one of the best among North America's Tier 1 railroads.
The case against Norfolk Southern
As previously mentioned, Norfolk Southern had a weak first quarter. Compared to the same period a year earlier, revenue and volume declined 2% and 1%, respectively. In addition, operating income declined over 3%, and earnings fell 18% from the first quarter of 2013. Not a great way to start the year.
A big part of the challenge facing Norfolk Southern is the declining role of coal in the North American economy. According to the Association of American Railroads, coal is the single most important commodity to the railroads, accounting for more than 20% of Class I railroad freight revenue. And Norfolk Southern is one of the railroads most exposed to a decline in U.S. coal-fired power plants given their eastern U.S. rail network.
Coal revenues have been a problem for the railroad industry over the past few years as natural gas prices remain well below historical highs, and utility stockpiles remain high. With the cold winter, and rising natural gas prices, some utilities are switching back to coal. The long-term trend for coal use in North America, particularly for U.S. electric power generation, is in decline. This creates a particularly strong head wind that Norfolk Southern will continue to face.
Revenue from coal has fallen quite dramatically over the past few years for Norfolk Southern -- accounting for 25% of freight revenues in 2012, 22% in 2013, and just 20% in the recently completed quarter. The trend continued in the first quarter with coal carloads down 13% compared to the same period a year earlier.
Finally, there is the issue of Norfolk Southern's operating ratio. At 75.2%, it has one of the highest operating ratios among Tier 1 railroads. Every railroad strives to lower its operating ratio, ensuring more revenue flows to the bottom line as profit, and giving the company added flexibility to be competitive in terms of pricing. An optimist might see this as an opportunity, but history has shown that making significant progress in lowering a railroad's operating ratio requires nothing short of a shift in operating culture -- an incredibly difficult thing to accomplish.
What's a foolish investors to do?
Investors in transportation stocks have had a good ride recently, particularly those with a stake in Norfolk Southern, North America's third-largest, publicly traded railroad.
Railroad stocks offer excellent leverage to, what appears to be, accelerating economic growth in North America. However, to achieve market-beating returns, investors should select only the very best in any industry. A stubbornly high operating ratio, economic and political pressures making coal a less viable fuel for electricity generation, and a recent run-up in the value of its stock are issues that will make it difficult for investors in Norfolk Southern to achieve market-beating returns over the next three to five years.
