Despite stellar performance by Norfolk Southern Corp. (NSC) in the first quarter of fiscal 2011, we maintain our cautious stance on the company.
The company’s earnings as well as revenues surpassed Zacks Consensus Estimates and grew year over year on favorable pricing and volume trends across all segments. However, huge capital expenditure on increasing headcounts followed by higher compensation expenses, surging fuel prices, tightened railroad regulation, competitive pressure and the current market dynamics in some of its product lines, compel us to remain on the sidelines.
Given a revival in economy, Norfolk remains on the growth trajectory capitalizing on improving industry fundamentals and cost control measures. The company has shown favorable trends in all its segments, particularly in Intermodal and Coal.
We believe Norfolk’s major Intermodal corridor initiatives are likely to boost Intermodal strategy and be favorable for growth in the coming years. Business expansion including the company’s new collaborative venture with FedEx Corp. for providing rail intermodal services will also accelerate growth. Further, increasing freight demand in a tight capacity in truck market will drive strong pricing gain in this category.
We remain highly optimistic on the company’s Coal segment, given the expected growth in metallurgical export coal due to Australian flood disruption causing coal supply constraints in the global market, and increased demand of steel in the domestic as well as global markets like Asia.
To support higher coal shipments, the company deployed 1,500 new coal cars to its network, beginning in May and expects deliveries to be completed by end of this year.
We remain bullish on the company’s long-term fundamentals and growth prospects due to its continued investment in key projects and new business opportunities.
The company continues to make strategic long-term investments and expects to invest $2.2 billion in 2011. Approximately half of the budgeted investments are allocated to Intermodal facilities, including three new Crescent Corridor terminals in Tennessee, Alabama and Pennsylvania. Norfolkalso plans to invest approximately $15 million in MidAmerica Corridor, through a joint venture with Canadian National Railway (CNI).
Norfolkcurrently aims at improving rail safety by implementing positive train control (PTC), which will require capital expenditures of at least $1 billion from 2012 through 2015. Approximately $146 million will be spent in 2011 to upgrade systems and track structure for the implementation of PTC. The company is also expected to introduce the “Track 2012” initiative, a long-term plan to operate in a more efficient, safer and profitable network.
However, Norfolk faces intense competition from motor carriers and railroads, and substantial competition from ships, barges and pipelines. The primary competitor is CSX Corporation (CSX),which operates in the same territory as the company.
The company also remains exposed to railroad regulations like Surface Transportation Board and PTC. These regulations not only put additional cost burdens on their implementation but significantly affect the business as they regulate the pricing policies for rail services.
However, in the near term, we expect Norfolkto face several headwinds. The near-term growth of Norfolk is expected to be tempered by its aggressive outlook on accelerated crew capacity, increasing locomotive and freight car material expenses, and compensation benefit expenses.
Although this is a significant strategic move for long-term gains, it is likely to remain detrimental to margins in the near term. The steeply rising fuel price is also expected to have an adverse bearing on the company’s cost structure.
Going forward, we believe lackluster performance in some of the product lines also remains a concern. Chemical shipments are expected to decline due to completion of the Tennessee Valley Authority Fly Ash project in December 2010. Additionally, uncertainties in the housing sector are expected to remain detrimental for paper, clay, and forest products’ volumes.
Thus, we reaffirm our long-term Neutral recommendation on Norfolk Southern, supported by a Zacks #3 Rank (Hold).
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