Friday, June 5, 2015

Norfolk Southern (NSC) Dividend Stock Analysis

Norfolk Southern Corporation, together with its subsidiaries, engages in the rail transportation of raw materials, intermediate products, and finished goods. As of December 31, 2014, it operated approximately 20,000 miles of road in 22 states and the District of Columbia. Norfolk Southern Corporation is a dividend achiever, which has raised dividends for 14 years in a row.

The most recent dividend increase was in January 2015, when the Board of Directors approved a 3.50% increase in the quarterly dividend to 59 cents/share. This was the second increase in a year however, and represented a 9.30% dividend growth over the same time in 2014.

The company’s largest competitors include CSX Corporation (CSX), Union Pacific (UNP), and Burlington Northern Santa Fe which is part of Berkshire Hathaway (BRK/B).

Over the past decade this dividend growth stock has delivered an annualized total return of 15% to its shareholders. Future returns will likely be lower, and will be dependent on growth in earnings and starting dividend yields obtained by shareholders at time of investment.

The company has managed to deliver a 10.70% average increase in annual EPS over the past decade. Norfolk Southern is expected to earn $5.94 per share in 2015 and $6.84 per share in 2016. In comparison, the company earned $6.39/share in 2014.

Earnings per share have also been aided by share buybacks. The number of shares outstanding has decreased from 412 million in 2005 to 312 million by 2015.

Railroads are an oligopoly in the US, as 80% of industry revenues are generated by BNSF, Union Pacific, Norfolk Southern and CSX. The first two operate largely on the west coast, while the last two operate largely on the east coast. Railroads compete for customers, but also share assets as well. They compete with trucks, pipelines, ships and aircraft for hauling goods. Trucking provides more flexibility in transporting goods, though they are more expensive. It makes sense to transport goods on long distances using a combination of rail and other modes of transport for maximum cost savings when moving goods.

Long-term growth for Norfolk Southern will be driven by the growth in US economic activity. When economic activity improves over time, this would translate into more goods being shipped in the country.

The railroad's best prospects are long-term. As Warren Buffett put it, an investment in railroads is an all-in wager on the economic future of the United States. Over time, the movement of goods in the United States will increase, and railroads like BNSF, Union Pacific, Norfolk Southern and CSX should get its full share of the gain. Railroads move goods across longer distances in a much more efficient way that long-haul trucks. This provides railroads a cost advantage.

Today, the United States has half the usable track it had in 1970, though companies like BNSF are hauling much more freight than they did back then, and the American Association of Railroads estimates that freight loads will nearly double by 2035. That congestion—a signal of demand—means opportunity: Improve existing tracks and add new ones, and boost sales.

The economic moats around railroads are the billions of dollars it costs to build them and the fact that the rights of way they need are all but impossible to obtain today. Therefore, it is unlikely that a new railroad will be created, though other modes of transportation could chip away market share. However, given the fact that it costs 3 – 4 times lower to transport goods through a railroad than truck, railways have inherent cost advantage. This cost advantage could also allow railroads to raise prices, and still remain competitive. Railroads have some geographic advantage as well.

Furthermore, rail companies can increase profits by improving productivity. For example, using smart systems to optimize speed depending on terrain could generate significant fuel savings over time. Reducing the amount of time railcars sit idle, could also improve profitability (since using those assets more effectively reduces the need to buy too many railcars to begin with). Raising the length of trains could further boost productivity. Improving productivity reduces cost, and increases profitability over time.

Norfolk Southern transports raw materials, intermediate products and finished goods classified in the following commodity groups (percent of total railway operating revenues in 2014): intermodal (22%); coal (21%); chemicals (16%); metals/construction (13%); agriculture/consumer products/government (13%); automotive (8%); and, paper/clay/forest products (7%).

Growth in Norfolk Southern will be aided by increase in intermodal traffic and chemicals. It will likely be hurt by decreasing demand for coal, which will decrease the amount of coal transported by rail. The company has invested heavily in intermodal operations. Intermodal freight transport involves the transportation of freight in an intermodal container or vehicle, using multiple modes of transportation (rail, ship, and truck), without any handling of the freight itself when changing modes.

The thing to consider with railway companies like Norfolk Southern, Union Pacific or BNSF is that their fortunes are exposed to the cyclical fluctuations in demand for transportation. The downside is that these companies have substantial needs for capital, in order to comply with new regulations, replace track, locomotives and railcars and maintain their rail networks along the way. Maintaining their tens of thousands of miles of track is a cost that trucking companies do not have.

The annual dividend payment has increased by 17% per year over the past decade, which is higher than the growth in EPS. This was possible mostly due to the increase in the dividend payout ratio. Future rates of growth in dividends will be limited to the rate of growth in earnings per share.

A 17% growth in distributions translates into the dividend payment doubling almost every four and a quarter years on average. If we check the dividend history, going as far back as 2002, we could see that Norfolk Southern has actually managed to double dividends almost every four and a quarter years on average. The item to add however was that in 2000 the company did cut its dividends by more than 50%. Therefore, just like we saw with Union Pacific, while the dividend is likely sustainable, this is a cyclical company which is more likely to cut distributions than your typical consumer staples or healthcare dividend stock. So even if you plan on holding for the next 100 years, there will be hiccups and dividend cuts are likely every one or two decades.

In the past decade, the dividend payout ratio has more than doubled from a low of 15.40% in 2005 to 34.70 in 2014. The high percentage in 2009 was mostly an aberration, as earnings seem to have been hit by the Great Recession. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

Norfolk Southern has managed to grow its return on equity a little over the past decade, from 14.80% in 2005 to 16.80% in 2014. I generally like seeing a high return on equity, which is also relatively stable or rising over time.

Currently, Norfolk Southern is attractively valued at 15.80 times forward earnings, and it has a decent current yield of 2.50%. I initiated a small position in the railroad, because it is easier for me to track companies when I have skin in the game. I am interested in Norfolk Southern on dips below $95/share. I recently also initiated a small position in Union Pacific (UNP), to which I also plan on adding on dips below $90/share.

Full Disclosure: Long UNP, NSC

Relevant Articles:

Union Pacific (UNP) Dividend Stock Analysis
The Value of Dividend Growth
Dividend Investors have an advantage over everyone else on Wall Street
How to be a successful dividend investor
How to get dividend investment ideas

Popular Posts