Norfolk Southern Corp (NSC): Too Far Too Fast?
Norfolk Southern Corporation (NSC) is a major U.S. railroad company servicing the area east of Iowa and Kansas. The company owns about 15,000 miles of track and leases another 5,000 across 22 states. A close look at a breakdown of the company’s revenue segmentation reveals that the company a diversified, but vulnerabilities do exist:
Coal has been a drag on revenue growth for quite sometime. In 2010 for example, coal made up 28% of the company’s revenue and it now makes up just 15%. While the new administration has promised to bring back the coal industry, this is easier said than done. While the federal government might reduce regulatory barriers to the production of coal and its use in electric generation, it will be very difficult for coal to compete with natural gas priced at $3.50 per million BTUs. In the final analysis, one might expect revenues to shrink in the coal segment.
Since rail provides very economical transportation services to the industrial sector of the economy, it tends to follow the ups and downs characterized by the business cycle. When the economy expands, so does rail traffic in order to transport goods from supplier to manufacturer, and from manufacturer to the end user. It is no secret that manufacturing has been moving overseas for decades. As a result, rail traffic has suffered. President Elect Donald Trump has made the revival of manufacturing a cornerstone within his economic plan, and investors have clearly taken notice. NSC closed the day’s trading at $91.62 just before the election on November 4 2016. Yesterday, the share price closed at $109.26 for a 19.3% gain. The question is, “Is this repricing warranted?”
The chart below provides a technical picture of the share price action for the past 5 years. We believe the technical picture is telling us that the share price has gone “too far, too fast.” Both the RSI and MACD suggest the shares are overbought. Furthermore, the shares are up over 65% from the Q1-2016 lows. With so much “easy money” being made, these factors lead us to believe the bulls could be getting complacent.
Valuation supports this assessment. The company’s shares trade at a PE of just over 20 based on trailing 12 months earnings and 18 based on analyst’s expectation of next year’s earnings. We think this is a bit too aggressive for a company that will probably grow revenues slower than GDP in the near term. Revenues fell from $11.6 billion in 2014 to $10.5 billion in 2015. We expect reported revenues to be in the $10 in calendar year 2016 stabilizing in and 2017. At the same time, EPS fell from $6.35 (2014) to $4.98 (2015) and we expect EPS of about $5.00 for both 2016 and 2017. Stepping back a minute we see that revenues and earnings were higher in 2014 than they are today, but the share price is trading in nearly the same place. Furthermore, we do not see a near term growth catalyst. Even if the new administration succeeds in passing their proposed economic and regulatory reforms, it will take the better part of this year to get the legislation written and we should not expect implementation until 2018 or 2019.
If you believe as we do that NSC has come too far too fast, and you are looking for a hedge against a portfolio that is net long the market, you might want to take a mildly bearish position in NSC. One way to do that is to sell a call-spread. By selecting out of the money calls, investors would profit if the share price trades sideways to down. With the stock trading at $109.26, one might consider following structure.
To initiate this trade, the investor will collect a nominal $185 up front per call spread. The Feb 2017 (standard monthly) expiration seems appropriate as extending the expirations does not generate enough additional premium to make doing so worthwhile. Better to work with shorter expirations and rolling them if appropriate. The breakeven level is $111.85, which is 2% above the current price. The efficient market hypothesis suggests there is a 63% chance of success on this trade, which is consistent with our view. The maximum amount one can lose is $315, which would occur if the share price trades at $115 or higher at expiration, which is about 5% above the current price.