Although stronger equity markets Friday helped lift Norfolk Southern’s stock price – by approximately 11:30 a.m., it was up 0.52 percent to $166.81, a gain of 87 cents – the first reaction after the earnings call was decidedly negative. Norfolk Southern stock traded as low as $160.01 in overnight trade after closing Thursday, before the earnings release, at $165.94. Even with its midday gains, it was still underperforming broader indices on an up day.
Deutsche Bank downgraded Norfolk Southern shares to Hold from Buy by the end of the day Thursday. “The company’s 4Q underlying OR [operating revenue] of 67.8 percent is 600 bps worse than the company’s direct competitor (CSX) on an apples-to-apples basis and now is the worst among all North American Class 1 rails,” the report from the team led by Amit Mehrotra said.
The reference to CSX (NYSE: CSX) is based on its fourth quarter OR of 60.3 percent. It was below 60 percent in the third quarter.
Norfolk Southern has said it is going to move toward precision railroading (PSR) principles in a program it is calling “Clean Sheeting.” It has an investor’s day scheduled for February 11. A transcript of the earnings call supplied by SeekingAlpha shows Norfolk Southern executives several times during the call deferring questions from analysts to that day.
“We started out three years ago with the goal of the sub 65 operating ratio by 2020, and here we are with the 65.4 operating ratio in 2018,” CEO Jim Squires said in response to an analyst’s question. “So that represents excellent progress under our prior strategic plan and we made many other financial improvements along the way. So, we are pleased with our performance up to this point. We recognize that we have much more to do and that we are intent on continuing to drive financial results and shareholder value in the future and we have a lot, lot more to say about that at Investor Day.”
The Deutsche report noted that Norfolk Southern will be competing against CSX for eastern business as the latter has done much of the heavy lifting. “We believe CSX is ready and able to take spillover volumes and undoubtedly has a cost advantage which will likely make NSC’s commercial discussions more difficult,” the report said. The type of discussions Deutsche refers to are those where a railroad adopting PSR needs to go to its customers and lay out a plan that on the upside is intended to have more tightly adhered-to schedules but which is less flexible in its service requirements for customers. They have been described by multiple rail executives as conversations that aren’t fun to have but hold out the hope for a more disciplined and reliable service offering in the end.
“The bear argument is that NSC is likely to see market share losses to CSX as it implements PSR,” the Deutsche report said. “CSX has improved service and reduced costs. Indeed lower structural costs are a potent recipe for market share wins.”
The report was not all negative. Deutsche said Norfolk Southern has always demonstrated “strong cost management.” But even after saying that, the report noted that “there appears to be much more room for CSX on the cost side than we previously thought and PSR for Norfolk Southern will likely need to be more about network optimization than cost takeout. Our sense is this may be harder to achieve.”
Morgan Stanley’s transportation team, led by Ravi Shankar, may have had the understatement of the earnings season when it declared Friday that the financial performance of Norfolk Southern, strong on its face, was “not what it seemed.” “We believe the market will be disappointed if OR targets fall short of the 60 percent in the next 2-3 years benchmarks that have been set by CSX and UNP originally,” the report said. “We believe it will be equally important to observe NSC’s approach to volumes/growth as we believe it is unhealthy to have a hyper-focus on a singular OR number which may not be supportive of sustainable growth.”
Two other analysts held their ground with their ratings on Norfolk Southern. At Merrill Lynch, Ken Hoexter wrote that many of the revenue numbers in the quarterly report were solid. “NS posted underlying improvement, with service gains building through December, and strong volume and pricing increases leading into 2019, particularly in Intermodal,” Merrill Lynch wrote. “Nevertheless, in an environment where peer rails are posting large efficiency gains, NS saw a number of costs rise faster than its 3.1 percent carload growth.”
Merrill Lynch reiterated its Neutral recommendation on Norfolk Southern. It cut its earnings per share (EPS) estimates for this year by 2 percent and 3 percent respectively, to $10.40 and $11.60. EPS for 2018 was $9.51.
At CFRA, Jim Corridore maintained its Hold recommendation on Norfolk Southern and raised its estimate of EPS for 2019 to $10.28 from $10.05. The increase was based on “strong industry fundamentals” offset in part by “higher than peer average costs.” “We expect pressure to build on NSC to accelerate its operating margin improvement, and despite strong industry fundamentals and solid EPS growth, we see limited appreciation potential for the shares versus peers until they do,” he wrote.