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Norfolk Southern's Wide Moat Remains on the Rails

Coal may still be in long-term decline, but positive near-term trends have led us to boost our fair value estimate. 

We increased our

We still believe coal is in a secular decline at the rails, but based on recent results which we attribute to current higher prices of natural gas and export coal (both lapping easy comparisons) we believe coal cars will increase 6%-8% in 2017. But due to a couple of shorter haul trends in the mix, revenue per unit is likely to decline. The former marks a revision from our prior expectation of a mid-single-digit volume decline this year. Norfolk’s coal declined 16% in 2016, at double-digit levels in the first three quarters, then just 4% in the fourth. We now model 2017 overall volume to improve about 3% and revenue per unit to expand 1%, versus respective declines of 6% and 3% in 2016 (and fourth-quarter declines of just 1% in revenue and 3% in revenue per unit). Leading our volume expectation is intermodal, where we expect the firm to grow international containers 3% and domestic 5%. This compares with fourth-quarter growth of 8% and 10% in domestic excluding discontinued Triple Crown products.

Norfolk Southern delivers reliable returns, and it typically produced the highest margins among U.S. railroads since the rail renaissance began in 2004. By outearning its cost of capital for several years, it joined the rarefied company of Canadian National. However, Norfolk's operating ratio degraded to 75.4% in 2009 and it was stuck between 69% and 73% from 2010 to 2015. This pales in comparison with progress made by Union Pacific and Canadian Pacific, which lack Norfolk's exposure to Appalachian coal. However, in 2016 the firm looked back on track, reaching a record 68.9% OR.

A railroad's competitive advantage is inseparable from its track location. Norfolk hauls coal directly from Illinois and Appalachian mines; it also transfers Powder River Basin coal eastward from Western rails. The market's legitimate concern about coal demand destruction from cheap natural gas and lower exports has weighed heavily on Norfolk's shares during recent year. However, coal runs in unit trains hauling exclusively coal (often using customers' cars) so we think the rail will be able to adjust its train and crew starts to match demand, but the decline of high-margin export coal loads is indeed a stiff earnings headwind.

Norfolk Southern has increased intermodal volume impressively during the past decade, such that this is the highest-volume segment (3.9 million units of the firm's 7.3 million total in 2016), and intermodal revenue (22% of total) surpassed coal (15%) in 2014. Recent capacity and speed improvement capital projects have focused on enhancing Norfolk's intermodal franchise. For example, track enhancement on the I-81 Crescent Corridor (from New Jersey to New Orleans) and raising overhead clearance in 28 tunnels in the Heartland Corridor (through the Ohio Valley) were designed to improve velocities in order to steal share from trucking.

Like its peers, Norfolk Southern is raising rates in accord with the value it provides, applying fuel surcharges, and (long run) increasing profitability through better operations. We anticipate Norfolk will be able to improve margins as it increases intermodal volume and as the rail makes even more efficient use of fuel and labor.

While the rails don't outearn their cost of capital by much, our wide economic moat rating stems from our confidence that rails will leverage cost advantage and efficient scale competitive advantages to generate positive economic profits for the benefit of share owners with near certainty 10 years from now and more likely than not 20 years from now; by our methodology, this defines a wide economic moat.

Norfolk Southern Has Cost Advantages, Efficient Scale The rail's wide economic moat is based on cost advantages and efficient scale. While barges, ships, aircraft, and trucks also haul freight, railroads are the low-cost option by far where no waterway connects the origin and destination, especially for freight with low value per unit weight. Moreover, railroads claim quadruple the fuel efficiency of trucking per ton-mile of freight and due to greater railcar capacity and train length make more effective use of manpower despite the need for train yard personnel. Even for goods that can be shipped by truck, we estimate railroads charge 10%-30% less than truckers to transport containers on the same lane.

The network of track and assets that Class I rails have in place is impossible to replicate. Norfolk Southern's system spans like a spiderweb across the densely populated Eastern U.S., capturing about half of the rail volume in the region. Its rights of way and installed track form a nearly impenetrable barrier to entry, but these assets require continuous renewal. Norfolk Southern's historical annual capital investment averages 17%-20%. Of the $2 billion budgeted for 2016, NS will invest about 39% in roadway, 17% in locomotives, 12% on precision train control, and 6% on freight cars. Typically 60%-70% of rail investment is maintenance capital expenditures, with the remainder driving regulatory compliance, productivity, and growth (like intermodal capacity).

Efficient scale followed industry consolidation escalated by the 1980 Staggers Act, which permitted extensive rail line sales, abandonment, and combination. North America had more than 40 Class I rails in 1980, but today has just eight major railroads (a Class I generated at least $452.7 million of 2012 operating revenue). Staggers also allowed private contracts and rate setting. On all but the busiest lanes (like Wyoming’s coal-rich Powder River Basin), generally a single railroad serves an end-of-the-line shipper, and only two railroads operate in most regions in North America. Indeed, we opine that absent government intervention, the rational number of competitors on the continent would be two, via additional consolidation, since in most regions customers already have only two capable providers. The steep barrier to entry formed by the need to obtain contiguous rights of way on which to lay continuously welded steel rail spanning a significant portion of a huge continent fends off would-be entrants. Railroads may build new spurs or restore abandoned lines, but we anticipate no new mainlines will be built, given massive barriers to entry.

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