Risk-Reward Balances Norfolk Southern

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Despite the gloomy economic outlook and dampened coal demand, Norfolk Southern Corp.’s (NSC) second quarter earnings were driven by strong operating performance and cost-control measures. Quarterly earnings surpassed the Zacks Consensus Estimate and also improved from the year-ago level.

We believe accelerated investments in new projects, coupled with business expansion, will likely result in strong growth. Further, the company remains committed to enhancing shareholders’ value in the form of dividend payments and share buybacks, and looks to further improve service offerings.

However, several headwinds such as the downturn in coal and crop markets will likely limit the potential upside over the near term. In addition, tightened railroad regulation and competitive pressure from other leading railroads such as Union Pacific Corporation (UNP) and CSX Corp. (CSX) also remain significant headwinds for the company’s growth. Consequently, we maintain our cautious stance on the company with a long-term Neutral recommendation.

We believe Norfolk Southern is poised to benefit from strong pricing momentum on the back of growing market demand and shortage in truckload transportation. We expect the company’s pricing improvements together with productivity gains to offset the current rail inflation. It is also expected to lead to continued margin improvement and earnings growth this year and beyond.

We believe the company will gain from its superior service and network capabilities, infrastructural investments, and accelerated growth in Intermodal and Merchandize segments, aided by strong freight pricing.

Norfolk Southern initiated adequate cost-control measures that bode well for growth targets. As a result, Norfolk Southern is replacing its older and less fuel-efficient locomotives with new machinery. We expect the new fuel-efficient locomotives to reduce average fleet age and result in lower maintenance expenses, driving further cost improvement. Further, lower fuel prices are also expected to enhance margins.

We remain highly optimistic on the company’s growth across most segments. In particular, the company’s Merchandize and Intermodal recorded significant revenue growth that offset lackluster performance of the Coal segment. Merchandize mainly benefited from automotive, which will continue to bode well on higher North American light vehicle production, along with business wins from Volkswagen and other manufacturers.

Steel shipments are also on the rise, with increased demand from Russia and Eastern Europe. New business wins in fracturing sand, mainly from Marcellus and Utica shale regions and products related to natural gas drilling will remain key growth drivers.

Additionally, higher shipments of crude oil and waste products such as ethanol will continue to drive growth for the segment. Further, Intermodal will continue to gain from highway conversions. International intermodal business is also expected to remain strong on capacity additions after completion of key intermodal terminal projects.

However, the near-term growth of Norfolk Southern is expected to be tempered by its aggressive outlook on accelerated crew capacity, increasing locomotive and freight car material expenses, and compensation benefit expenses.

Despite its consistent focus on reducing its operating ratio, the company plans to ramp up hiring for business growth. Although this is a significant strategic move for long-term gains, it is likely to remain detrimental to improving margins in the near term. Moreover, the current market conditions in utility coal remain unfavorable for the company in the near term.

Given the low prices of natural gas and declining electricity generation, utility coal revenues will remain headwinds for the company this year. In addition, the U.S. grain market also looks suppressed due to the drought in the U.S. Mid-West.

Going forward, the company also estimates subdued performance to affect its earnings for the third quarter of 2012. Recently the company provided its third quarter 2012 outlook, with earnings per share projected in the range $1.18 to $1.25. The company expects poor coal shipments and lower fuel surcharge to have an adverse impact on the company’s growth. The projections remain significantly below $1.59 per share earned in the third quarter of 2011.

For the short-term (1-3 months) the stock has a Zacks #3 Rank (Hold).

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