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Norfolk Southern (NYSE:NSC) is in a tough spot. The nation’s third-largest railroad has run into resistance as a result of lower economic expectations. Investors are de-risking their portfolios as it’s now highly unlikely that the railroad can grow its volumes going forward due to an aggressive Fed and the aforementioned slower economic conditions. Moreover, like all of its American peers, the company is engaged in labor issues with unions, and the fact that lower demand in 2020 and related layoffs have caused severe supply chain issues. In this article, I will walk you through my thoughts as I assess how I’m dealing with these uncertainties as a dividend growth investor in this railroad.
Hint: it’s waiting for weakness as buying NSC on weakness is the best way to generate long-term value through capital gains and income.
So, let’s get to it!
Let’s Start With Labor
In July, I wrote an article covering two of Norfolk Southern’s peers. I highlighted labor-related risks due to unhappy and overworked workers demanding higher pay.
Essentially, the Presidential Emergency Board, named by President Biden, has two “deadlines” of 30 days. As I wrote back then:
[…] negotiations could last until mid-September. At that point, the 12 unions representing railroad workers could go on strike, or major railroads could lock out the workers and try to work on a deal where Congress intervenes and imposes a labor deal to their liking. Both of these things need to be avoided. Especially because the government is already blaming inflation on big businesses. For example, Biden is blaming “big oil” for high gas prices, meat processors for high meat prices, and railroads for bad services.
Fast forward a bit to the end of August, August 30, to be precise, and we’re still not getting good headlines.
Simply put, most unions are still negotiating with freight railroads over wages and benefits as unions still enjoy a lot of support for potential strikes – if needed.
So far, three unions representing 11% of the more than 144,000 rail union members have worked out new contracts. These new contracts call for a 24% wage hike during the five-year period from 2020 to 2024 with a 14.1% pay bump effective immediately.
The remaining unions can put more pressure on railroads by striking – after September 16. According to FreightWaves:
Per the Railway Labor Act, the remaining unions would be able to legally stage a work stoppage or strike after a cooling-off period ends on Sept. 16. That date is a month after the Presidential Emergency Board (“PEB”), a three-person independent panel appointed by President Joe Biden, gave the unions and the railroads a 124-page report with recommendations on how to resolve the contract negotiations impasse.
I do not believe that strikes are going to happen. Strikes would be a catastrophe for the North American economy and it would without a doubt accelerate the ongoing manufacturing downturn. It also would make it impossible for Democrats to tackle inflation ahead of the midterms – that’s impossible anyway, but it will result in some bad headlines.
I believe the first labor deals look promising, which could help to finish more contracts as we slowly move towards the deadline in September.
With that said, labor issues aren’t only a problem from an employee’s point of view, but also from the point of view of railroads. In the US, most lack the labor necessary to move the required goods.
This brings me to Norfolk’s progress.
Norfolk Remains In A Good Spot
In July, Norfolk released its 2Q22 earnings. Total revenue came in at $3.3 billion, up 17.9% versus the same quarter in 2021. Revenue was $160 million higher than expected. GAAP EPS came in at $3.45. This was pretty much in line with estimates as it was technically just $0.03 below estimates.
If we look beyond these numbers, the company did actually very well given the circumstances. The company achieved record revenues in all segments, except for coal, which was still up 34% year on year. Moreover, this was the result of strong pricing as volumes were down across the board.
It also helped that revenue per unit hit record levels in every single segment, with an average growth rate of 20%. Even adjusted for fuel surcharges, that number was 10%.
Unfortunately, the company had operating issues – like all of its American peers. Total operating expenses rose by 21%, beating revenue growth by 500 basis points. Fuel costs rose by 117% to $408 million.
Purchased services and rents increased by 12%. Compensation and benefits, the largest cost factor, declined by 2% to $614 million, which won’t last given labor negotiations and the need for additional labor.
This brings me to the company’s operating improvements. While the operating ratio rose by 260 basis points to 60.9% (the lower the better), the company made great progress when it comes to repairing supply chains.
In general, it’s fair to say that challenges were caused by imploding volumes in 2020. As a result of lower volumes, railroads cut employment levels, made trains longer, and focused on operating efficiencies – more than prior to the pandemic.
Then, demand came back roaring. As retailers refilled their inventories. Supply chains were not prepared for this kind of change in demand as it caused major issues at manufacturers, global ports, and railroads, which are the key to many different supply chains.
The good news is that these problems are slowly easing. In 2Q22 (versus 2Q21), Norfolk Southern used 3% more locomotives to transport 3% less volume. That’s not great for its operating ratio, but it did smoothen the supply chain a bit. The average train length was up 4% with average train speeds rising by 1mph.
Related, terminal dwell fell to 26.4 hours as of July 25 (that’s 3Q22). This is the best result since 4Q21.
Moreover, the company had close to 900 conductor trainees in July – up from less than 60 in 1Q21. and 7,190 qualified T&E employees (train and engine). That’s up from 6,947 in 1Q22.
Adding to that, the company launched TOP in 2Q22, which is an acronym building on the legacy of Thoroughbred Operating Plans. The company launched this additional focus on operations to create more balance in its network, meaning increasing reliability without destroying operating margins, to put it a bit bluntly.
This includes using distributed power (“DP”) to make trains longer. DP is basically adding one or more trains between cars. This allows railroads to make trains longer and reduce the stress on equipment.
As a result, the company used 20% more DP and increased its train arrival performance by 7 percentage points. That’s good, but more work needs to be done as the company acknowledged.
Shareholder Value & Outlook
In the first six months of this year, the company generated roughly $1.2 billion in free cash flow. That’s down compared to the prior-year period as the company added new assets including its rail replacement program and its DC-to-AC locomotive conversion program – meaning it bought more efficient locomotives. While this is currently causing headwinds, it will deliver high operating cost savings down the road. Moreover, on a full-year basis, the company expects full-year CapEx to be close to $1.9 billion, which is at the high-end of the company’s guidance and roughly equal to analyst estimates.
As a result, the company reduced share repurchases, but it boosted dividends. In the first six months of this year, dividend payments were up 19%.
Unfortunately, the NSC ticker is down roughly 18% year-to-date after falling more than 7% in the past four trading days alone.
This isn’t because of issues at NSC, but because investors are de-risking their portfolios. Economic growth is slowing rapidly as my manufacturing indicator shows, consisting of Empire State and Philadelphia Fed data.
When we overlay the indicator above and the year-on-year performance of NSC’s stock price, we see that the correlation remains flawless. What we’re dealing with now is something long-term investors will deal with a lot more in the future: the cyclical behavior of NSC.
Hence, I haven’t been worried for a single second.
If anything, a decline towards $220 per share would make the risk/reward much more attractive. A move lower is not unlikely as the economic growth slowing trend is amplified by a hawkish Fed, which seems to be determined to keep hiking in order to fight inflation. Hence, it’s no surprise that the 7% stock price decline started on the day of the Jackson Hole speech of Jerome Powell.
With that said, the company is trading at 11.2x 2023E EBITDA of $6.4 billion based on its $71.7 billion enterprise value consisting of $57.1 billion in market value equity, $14,000 in expected net debt, and $580 million in pension-related liabilities. Moreover, the implied free cash flow yield for 2023 is 5.3%, which supports the current dividend and opens up the door to new (aggressive) hikes. Additionally, analysts do not see a decline in 2022 EBITDA as tailwinds remain strong. Auto production is recovering as supplies become more available, supply chains smoothen, which means container demand is still high, and commodity exports are strong – fueled by the war in Ukraine. Yet, risks remain high. Lower economic growth will pressure the demand side, which could lead to negative revisions. The good news is that the market is currently pricing in lower growth expectations.
If economic risks were not rising, NSC would be a huge buy at current levels as the valuation has come down to very favorable levels.
Right now, I’m close to 15% up on my average NSC investment. I expect that number to come down as I wouldn’t be surprised if NSC were to attempt to hit $220 again.
I have gradually added to my position over the past few months, and I will add more aggressively if the stock were to fall to $220.
That’s my entire strategy. I believe NSC should not be actively traded but bought whenever weakness occurs. There’s too much value in this company, which I believe will accelerate when higher demand and higher operating efficiencies meet, which could happen in 2023.
For now, NSC faces operating inefficiencies it needs to solve by accelerating hiring and working out new labor deals with unions on top of slower economic growth and a Fed that isn’t just refraining from supporting the economy but actively trying to pressure demand to reduce inflation.
It’s a toxic mix. However, NSC is doing good. It is using pent-up transportation demand to offset pricing issues and improve operating indicators like dwell time.
So, long story short, I’m looking to buy more at even better prices. If you’re looking for quality transportation exposure, I think that’s the strategy to go with.
(Dis)agree? Let me know in the comments!
This content was originally published here.