Soft Intermodal, Derailment Outflows, and Wage Inflation Present Near-Term Challenges for Norfolk

Senior Equity Analyst

Matthew Young

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Eastern Ohio incident

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Norfolk Southern is a well-managed enterprise, and from the start of the rail renaissance in 2004 through 2008, it posted the highest margins among U.S. Class I railroads. However, its operating ratio (expenses/revenue) deteriorated to 75.4% in 2009 and remained stuck between 69% and 73% from 2010 to 2015. This fell short of progress made by peers Union Pacific and Canadian Pacific, which lack Norfolk's exposure to Appalachian coal. However, by 2017 the rail was back on track, improving to an adjusted 60.1% in 2021. In recent years, Norfolk renewed its commitment to pricing discipline and adopted precision railroading principles. Despite setbacks in 2022 linked to labor constraints and service issues, PSR has yielded more efficient use of locomotive assets and labor. Norfolk is grappling with derailment disruption, wage hikes, and sluggish U.S. industrial production in 2023, but we look for OR gains to resume longer term as the firm optimizes network service and refines its PSR playbook. Of note, in late 2019, former Canadian National CEO Claude Mongeau (2010-16) joined Norfolk's board of directors to help bolster PSR efforts.

Norfolk hauls coal from Illinois and Appalachian mines, and transfers Powder River Basin coal eastward from the Western rails. Thus, utility coal plant closures will likely pose headwinds over the long run. On the positive side, coal runs in unit trains hauling exclusively coal (often using customers' cars), thus we think the rail can continue to adjust its train and crew starts to match demand. 

Norfolk generated healthy volume growth on average within its intermodal franchise over the past decade. In fact, intermodal revenue surpassed coal in 2014 and is the highest-volume segment (56% of total volume, versus 10% for coal). Capacity expansion helped the rail capitalize on net positive truck-to-rail conversion activity over the years. Norfolk's domestic and international intermodal volumes are facing lackluster retailer restocking, competition from depressed truckload rates, and the East Palestine derailment disruption in 2023, but we still see intermodal as a key long-term growth opportunity.

Business Strategy & Outlook

In our view, each of the North American Class I railroads we cover, including Norfolk Southern, enjoys a wide economic moat rooted in cost advantages and efficient scale. Core pricing and margin resilience in past freight recessions and in the face of substantial coal volume losses over the past decade-plus are a testament to their robust competitive positioning. With near certainty, we expect the rails to continue to turn their two core moat sources into economic profit for the next 10 years and more likely than not 20 years from now.

Cost advantage is a key factor in Norfolk's wide moat. While barges, ocean liners, aircraft, and trucks also haul freight, railroads are by far the low-cost option where no waterway connects the origin and destination, especially for freight with low value-per-unit weight (bulk commodities). Along those lines, railroads enjoy roughly quadruple the fuel efficiency of trucking (per ton-mile of freight), and through greater railcar capacity and train length, rails make more effective use of locomotive assets and manpower despite the need for train yard personnel. Rails can also carry significantly more freight at once. We estimate Eastern railroads tend to charge 10%-20% less than truckers in the same geographic corridor/lane. Marine shipping by barge is less costly than rail for certain bulk commodity shippers that are located near the inland waterways offering access to the desired destination. However, customers in a position to ship via barge already do so, thus removing most threats barging could pose to current railroad volume. Even for intermodal container freight, which consists largely of consumer-related products, rail has historically been cheaper than its key competitor truckload shipping on average over the cycle thanks to the rails’ fuel efficiency and more economical use of labor. 

Furthermore, route density plays an important role in rails’ cost advantage relative to a would-be new railroad entrant in a given corridor. We don’t expect any new mainlines to be built, but the incumbent Class I providers would enjoy vastly lower unit and marginal costs than an upstart, given immense network/lane density--the existing seven North American Class I railroads have thousands of customers across myriad end markets and geographies that drive significant freight volumes across their networks.

In addition to cost advantage, the Class I railroads benefit from efficient scale. That is, would-be rational competitors have little incentive to enter because massive up-front infrastructure costs and the potential for creating excess capacity amid limited demand would preclude economic profit and destroy value. The network of track and assets that U.S. Class I railroads have in place is essentially 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. Would-be entrants are fended off by 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 North America. Railroads occasionally build new spurs or restore abandoned lines, but we anticipate no new mainlines will be built, given the massive barriers to entry.

Efficient scale followed industry consolidation escalated by the 1980 Staggers Act, which permitted extensive rail line sales, abandonment, and combination while allowing for private contracts and rate setting based on market demand. In 1980, more than 40 Class I rails operated across North America, and today there are only seven; by definition, a Class I rail generates at least $475 million of revenue. Consequently, a single railroad often serves an end-of-the-line shipper, only two railroads operate in most regions, and the rails have been able to reinvest while becoming quite profitable. In fact, we suspect that barring government intervention the rational number of competitors on the continent would be two, via additional consolidation. This is because in most regions, customers already have only two capable providers that service the market effectively and efficiently.

Of note, as shippers continue to optimize/diversify their transportation options, railroads are a ready solution, and Norfolk Southern's intermodal franchise is targeting additional share gains from over-the-road trucking on shorter-haul lanes in the east. Thanks in part to previous service investment (such as the Heartland and Crescent corridors) and its partnerships with intermodal marketing leaders J.B. Hunt and Hub Group (which originate most domestic intermodal freight from shippers), we think Norfolk Southern's intermodal division is poised to expand over the long run and despite near-term demand congestion-related headwinds.

Wide

Economic Moat

Norfolk Southern

Norfolk Southern Corp. is a transportation company, which owns a freight railroad. It engages in the rail transportation of raw materials, intermediate products, and finished goods primarily in the Southeast, East, and Midwest and, via interchange with rail carriers to and from the rest of the United States. The company transports overseas freight through several Atlantic and Gulf Coast ports. It offers an extensive intermodal network in the eastern half of the United States and is a transporter of coal, automotive, and industrial products. The company's services include property leases and sales, wire line or pipeline and fiber optics projects, access property, managing private crossings, promoting businesses with signboards, and natural resource management. Norfolk Southern was founded on July 23, 1980, and is headquartered in Atlanta, GA.

Earnings data Q1 2024

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Norfolk Southern Corp. is a transportation company, which engages in the rail transportation of raw materials, intermediate products, and finished goods. The company also transports overseas freight through several Atlantic and Gulf Coast ports. Its services include property leases and sales, wire line or pipeline and fiber optics projects, access property, managing private crossings, promoting businesses with signboards, and natural resource management. The company was founded on July 23, 1980 and is headquartered in Atlanta, GA.

Norfolk Southern Corp.'s stock NSC, +1.43% was up by 2.2% in premarket trading on Friday after BofA analyst Ken Hoexter upgraded the rail transport company to buy from neutral and raised the firm's price target to $248 a share from $204 a share. “NS has demonstrated faster service gains than we expected, following two network outages in 2H (Aug 28 IT infrastructure failure and Sept.

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Pioneering initiative will launch innovative safety pilot program ATLANTA , Oct. 19, 2023 /PRNewswire/ -- Norfolk Southern Corporation (NYSE: NSC) and the Brotherhood of Railroad Signalmen (BRS) announced a partnership Thursday to create an innovative new program called the Signal Safety Collaboration. This one-year pilot program, which was developed with input from the Federal Railroad Administration (FRA), will establish a collaborative process – including joint inspections, information sharing, and training – to identify further improvements and best practices that enhance signal safety for the benefit of our employees and the communities we serve.

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