For a long time, investors lacked interest in railroad stocks. It wasn't just because of railroads' declining share in U.S. freight transport. Railroads all but existed in a time warp, held back by a lack of leadership, innovation, and customer service. On the road, logistics were being used to save time and fuel and provide service -- but not on the rails.
Now that we're in the middle of a transportation boom, one railroad has triggered my interest. Seeing Norfolk Southern
Beyond the boom
While all the railroads are riding this boom, which is driven by a robust manufacturing sector and strong global trade, Norfolk Southern has the horsepower to remain on top. I asked Chief Financial Officer Hank Wolf about the company's ability to survive down cycles. Wolf said that superior service was a critical factor. With Norfolk Southern now competing with road transporters for medium-haul traffic (500 to 1,000 miles) on both price and service, he believed that those transporters would also feel the effects of pricing pressure and lower volume. (For more than 1,000 miles, it's inherently cheaper to move goods by train.)
Strong margins
The company's closest competitor is CSX
As railways started experiencing higher volumes in early 2002, Norfolk Southern undertook a massive logistics effort to optimize the use of its tracks by finding shorter routes, reducing wait times at yards, and filling more railcars. Essentially, it was running trains on time -- something railroads had neglected to do for a long time. Using smarter software allowed Norfolk Southern to handle a 14% higher carload volume with 11% fewer cars, increase its average speed by 7%, and reduce the wait or dwell times at yards by 7%. Look at the resulting numbers:
|
Financial Years |
2001 |
2005 |
Annual Growth |
|---|---|---|---|
|
Freight miles traveled (millions) |
70 |
81 |
4% |
|
Revenue per ton mile $ |
0.034 |
0.042 |
6% |
|
Employees |
30,894 |
30,294 |
-0.5% |
|
Operating Ratio |
83.7% |
75.2% |
-2% |
|
Revenues $ Million |
6,170 |
8,520 |
8% |
|
Operating Profits $ Million |
1,007 |
2,117 |
20% |
|
Net Income $ Million |
375 |
1,281 |
36% |
|
Debt/Equity Ratio |
1.25 |
0.75 |
-12% |
Railroads use their operating ratio (total expenses divided by revenue) to measure efficiency, and in this case, we have to get used to looking for a number that decreases. Norfolk Southern's decreased more than 8% over the last five years. What starts as an innocuous 4% annual increase in freight volume translates into a whopping 36% increase in net profits -- almost three times what Norfolk Southern made in 2001.
Stack them high and charge a little more
Norfolk Southern derives its revenues from three segments: coal, general merchandise, and intermodal. In 2004 and 2005, intermodal -- traffic from ship to railcar to siding (the part of a track used for loading and unloading) and then to the dealer's lot -- provided the real sizzle, with 13% volume increases and 7% higher prices over the two years. In my opinion, intermodal should be the big winner for the company; this is where its touted service and logistics capabilities should play a big role, ensuring a smooth trip from Shanghai to Shinnecock, New York. Take for example, the vote of confidence UPS gives Norfolk Southern's premium intermodal segment, which is its guaranteed delivery program. Here, UPS is the company's largest client, not competitor.
Adding to intermodal's sizzle, coal volumes increased 4% annually in both 2004 and 2005, but Norfolk Southern managed to charge 15% more every year, helped by a state transportation board ruling. General merchandise did intermodal one better, adding on 7% more tonnage each year, with 9% higher prices. Besides, 66% of the company's general merchandise freight originates with Norfolk Southern, allowing it to negotiate prices without depending on other transporters, and 50% of Norfolk Southern's business is up for renegotiation this year.
Spending money wisely
Norfolk Southern is not one to worry about Wall Street. One of the equity reports put out by a leading Wall Street player in the middle of 2005 tried to prod the company into using its cash over the next few years to buy back 6% of its shares, chiding the company for being more concerned about its debt rating. Guess what the company did? It reduced debt by $600 million last year and plans to keep reducing it, by $300 million this year and $500 million in 2007.
Alienating analysts further, Norfolk Southern then spent money on finding the right people, paying a lot of attention to not slipping in service, and signaling that it's competing more with UPS now than with CSX. And while my table shows a moderate 0.5% reduction in employees in the last five years, Norfolk Southern actually increased headcount in 2005, to 30,294 from 28,475. This company is ready, it's confident about handling all the traffic that comes its way, and it's not likely to be railroaded by Wall Street's short-term concerns.
Like all railroads, Norfolk Southern has to invest huge amounts in overhaul and maintenance, and this year's not likely to differ. Management expects to spend $1.15 billion, compared with $1.02 billion in 2005. However, thanks to all the cash that it has thrown off these last three years, its capital spending is now only 48% of operating cash, instead of the 68% it consumed in 2003.
Higher diesel prices will hurt
Diesel prices are likely to hurt margins this year. Last year, 33% of the company's revenue increase consisted of passing on a diesel fuel surcharge. The cost of diesel equals roughly 8% of total revenues, and for the first time since 2001, Norfolk Southern does not have hedges to cover further hikes. While management is confident of passing on price hikes as fuel surcharges, I've factored in a 20% hike in total diesel expenses; using a conservative 7% revenue increase for 2006, my estimated net income works out to $1.45 billion, or EPS of $3.28 per stub, which is a dime lower than the average analyst estimates of about $3.38 per share.
Another area of concern, though somewhat smaller, is the bottlenecks that Norfolk Southern has started facing with increased traffic in some locations. It's spending about $50 million on doubling tracks and straightening curves this year. Actually, this is a problem most railroads would love to have.
I'll be riding in the front
Historically, shares of Norfolk Southern, like those of other railroads, were rarely quoted above 14 times trailing earnings, and rightly so. With regulated pricing and an industry mired in lethargy, most investors wouldn't have been interested. But even with conservative forecasts of 2% to 3% volume and 3% price hikes, Norfolk Southern could easily earn 15% more each year over the next three or four years. Further debt reduction will help earnings, as will relatively lower capital spending. The company added 11% more employees last year, and further hiring is likely to be more modest.
Even if it's able to maintain service levels, this company can keep its customers and then some. With an estimated consensus EPS of $4.30 in 2008, at a $53 share price, we're looking at 12 times 2008 earnings.
Despite the valuation, I believe that it's difficult to see any softness in global trade. Forty-three percent of global trade is shipped, and 66% of that is in standardized containers, which go on ship, rail, and road -- making global trade heavily dependent on the shipper's ability to offer efficient intermodal services. I see Norfolk Southern having a strong competitive advantage there.
It's not a bullet train, but for Fools like me looking for market leaders in cyclical industries, Norfolk Southern is worth riding on.
For more Foolishness, read:
- Is Norfolk Southern the Rail to Ride?
- Burlington Northern's Smooth Engine
- Canadian National Losing Steam
Fool contributor Bobby Shethia doesn't own shares of any of the companies mentioned in this article. He believes that there's nothing like chugging a beer on a chugging train. He plans to buy Norfolk Southern after the Fool's waiting period ends. The Motley Fool is investors writing for investors.
