Description

A temporary problem (chemical railcar derailment) with horrible headlines (dark clouds, comparisons to Don Delillo's White Noise) has created an opportunity to own a Class I rail at a price that is likely to deliver a high teens IRR (and perhaps even a 20% IRR if the stock re-rates faster).

Norfolk Southern is one of the five remaining Class I rails in North America. In the last twelve months NSC generated $12.7 billion of revenue putting it behind its closest competitor CSX at $14.8 bn and ahead of Canadian Pacific with $9.8 bn after the KSU merger.

Currently, NSC trades at the lowest multiple among all five rails:

Its P/E is at a 1.4 standard deviation below its 5-year average:

With an entry P/E of 14.6x (entry yield of 6.9%), mid-single digit revenue growth, operating income growth slightly in excess of revenue growth, and continued share repurchases, NSC should be able to sustain EPS growth of about 9-11%, resulting in a long-term IRR of 15.9-17.9%.

If the stock re-rates to 18.2x earnings that would be a 24% uplift to the multiple. Over ten years it would raise the IRR by 2.4% per year.

This opportunity exists as a result of the negative headlines related to NSC’s Feb 3 derailment in East Palestine, Ohio. The train derailed because of overheating of its wheels.

After the train derailed, tank cars containing hazardous chemicals continued overheating for days due to a polymerization process. A decision was made to vent the chemicals. Eventually, East Palestine’s own fire department decided to burn the chemicals.

The NTSB’s preliminary report can be found here: https://www.ntsb.gov/investigations/Documents/RRD23MR005%20East%20Palestine%20OH%20Prelim.pdf

Congress held hearings to figure out what happened. The most recent one was on March 22nd. Here is the link: https://www.youtube.com/live/eLYzJk6d2Qk

My conclusion from watching the hearing is that there is little that NSC could have done to prevent the accident, and that NSC is not at fault. They have responded proactively to the tragic incident, helping the community in many different ways (as described by NSC’s CEO in the hearing). 

NSC set up a website showing its contributions to the community ($26.6m so far): https://nsmakingitright.com 

The EPA has tested the air and water and has not found health issues in the community. This work continues: https://www.epa.gov/oh/east-palestine-ohio-train-derailment-emergency-response 

Of course, it is impossible to know if there will be massive liabilities established against NSC once all investigations and lawsuits run their course. I can only make a judgment based on what is known today. The parties in the Congressional hearings are very motivated to find a culprit; the fact that it is so hard to show that NSC is guilty is an indication that this was truly an accident. A number of ideas have been floated to prevent similar accidents in the future, including better training for local fire departments so they can better deal with hazardous chemical railcars.

Business Merits

NSC’s network is on the eastern half of the US, among dense urban centers. This is good and bad. It’s good because these are heavily populated areas where demand for rail services is likely to continue growing. It’s bad because the relatively short length of haul pits NSC against trucking competitors. 

It is possibly for this reason that NSC and CSX (which operates in the same region) will forever trade at discounts to CP. However, the discount seems excessive. NSC trades at 13x EV/EBIT while CP trades at 23x (after giving CP credit for its projected $1 bn EBITDA merger synergies, the multiple drops to 19x).

NSC talks a lot about trucking competition and about needing to provide a product and service that is competitive and customer-friendly. Their main goal this year is to get back to 2019 service levels and then work hard to gain market share from trucks.

Business Quality

This is a good quality business. ROIC is in the low teens; their goal is to get it to mid-teens. Railroads are critical infrastructure assets. They are cyclical and we may be entering a low part of the cycle. If the United States tips into recession, the rails will likely de-rate further. This is a risk. If however we end up with a soft landing, arguably the worst is already priced in.

Moats: these are the five types of moats. Does this company have any of them?

1. Low-cost production

2. High switching costs

3. Network effects

4. Intangible assets

5. Efficient scale

Class I railroads are considered very wide moat businesses. Nobody can replicate their network. Nothing similar will ever get built. Are there technological threats? Yes.

The advent of electric trucks is a threat. One of the bull cases for rail is that moving freight by rail is much more energy efficient. Many large customers have decarbonization goals and shipping by rail fits right into that imperative.

However, if trucks were to go electric, it would remove this competitive advantage from rails, and would in fact make rails worse than trucks on this metric. This is a risk.

The other two bull cases for rail are (1) the increase in ecommerce. NSC pointed out that over 300 million square feet of warehouses will need to be built in the cities it serves. Ecommerce boxes are increasingly moving by rail and NSC thinks this is a good long-term driver of volume.

The second (2) case is on-shoring. Many types of advanced manufacturing are moving back to America and this should also result in additional rail volume over time.

Management Quality

I have no particular insights here. The management team seems average. They are cognizant of the principles of PSR and Norfolk Southern currently operates with an Operating Ratio of 62%, up from 60% at the end of 2021 but down from 90% in 2000.

Competitive Position and Industry Structure: (Threats of Entrants, Threat of Substitutes, Bargaining Power of Buyers and Suppliers; Sources of Power (Scale Economies, Network Economies, Counter-Positioning, Switching Costs, Branding, Cornered Resource, Process Power)

See the section on moat.

Valuation

See above.

Risks

Pre-Mortem: Why did this investment fail?

The biggest risk is some currently unforeseeable liability. The cleanup in East Palestine will take another two months. This will be a continued distraction for NSC management, and will result in slowed service at least in that part of the network.

Catalyst

No more bad news.