Norfolk Southern�(NYSE:NSC), among my top picks for November, is one of the nation’s premier rail transportation companies, operating approximately 20,000 route miles in 23 states. It serves every major container port in the Eastern U.S. and provides connections to many of the country’s other rail carriers.
Norfolk is the product of more than 200 railroad mergers, reorganizations and consolidations over the last 150 years. Its rich history began in 1838 with a nine-mile stretch in Virginia. Now, at $25 billion in market cap, Norfolk is the fourth-largest rail carrier in the U.S., with over $9.5 billion in annual revenues.
Most of the major rail carriers are as profitable now as they’ve ever been. Decades of consolidation have resulted in the top four carriers generating over 80% of total revenues, and despite the competitive structure, they often share joint ventures, resources and equipment among one another.
The Staggers Act of 1980, much like the Airline Deregulation Act of 1978 before it, largely deregulated the rail industry and allowed rail carriers to establish any rate they wanted if adequate competition existed in the area. Make no mistake, the railroad system in the U.S. is still subject to regulation, and this heightens the importance of competitive advantage and strong management, something Norfolk excels at.
With barriers to entry nearly impossible to overcome, operating efficiency, rail location and freight mix separate good railroads from great ones. I believe Norfolk is set up to benefit greatly over the next several years.
It has an ideal freight mix, separated into three categories: coal, general merchandise and intermodal. Coal represents 31% of operating revenues and is up 28% in 2011 from a year ago.
General merchandise, which largely represents automotive parts, consumer products, construction and chemicals, represents just over 50% of operating revenues. This segment has grown 11% year-to-date and most closely rides on overall consumer demand.
Intermodal, has been the fastest-growing segment for Norfolk in recent years and continues to represent a tremendous future opportunity. It currently represents nearly 21% of total operating revenues, an increase of 19% from a year ago.
Intermodal freight transportation is the movement of freight in specialized containers that can use multiple modes of transportation (ship, rail, truck) without any handling of the freight itself. This process allows freight to come into a port via ship, get transferred to a rail car and then subsequently moved onto a truck closer to its final destination, all without any cargo handling. This reduces costs, improves security and cuts down on damages and losses.
Norfolk has amped up its investment in intermodal operations the past few years by expanding coverage and adding new warehouse facilities and intermodal terminals, specifically along the East Coast. This has given it a competitive advantage — and this growth segment is what separates Norfolk from its rivals.
Chief Executive Wick Moorman has been in place since 2005 and has held several positions in the company prior to taking over, including VP of technology. Not surprisingly, he’s been a big proponent of leveraging technology to continually become more efficient and improve margins.
Norfolk’s most recent quarter resulted in a 24% jump in net income and an 18% increase in revenues from a year ago. Free cash flow is up 9% year-to-date, and management has steadily improved the balance sheet the last few years with a current cash reserve of around $825 million. Additionally, according to Morningstar, rail operators should be able to raise rates slightly faster than inflation going into next year.
Despite the stock being up over 18% so far this year, Norfolk is still trading at just 12.6 times 2012 earnings, according to Thomson estimates, well below some of its lesser-positioned peers. Conservatively applying a 15x multiple to expected earnings gives us a stock price of nearly $90 per share, a 20% premium to where it currently trades.
Norfolk has performed admirably this year in the midst of macroeconomic duress, and it should perform even greater as the economy recovers. Keep holding.
Research associate: James Mack
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