Get In On This Stock Before Buffett And Ackman Do

August 28, 2013

Billionaires Warren Buffett and Bill Ackman have helped make investors serious money in the railroad industry over the past couple of years. If you missed these opportunities while trying to navigate the financial crisis, never fear: There's still time to get in on the next great railroad investment.

Back in 2010, Buffett took market leader BNSF private at a roughly 30% premium. Ackman went into activist mode at Canadian Pacific Railway in 2011 after Canada's No. 2 rail company had grossly underperformed top peer Canadian National for a number of years. For the three years prior to Ackman's Canadian Pacific stake, the stock was down 5%, while Canadian National was up nearly 70%.

Since Ackman got involved during mid-2011, Canadian Pacific has outperformed Canadian National four times. There's definitely still money to be made in railways.

A similar opportunity is forming at Norfolk Southern (NSC). The company has been essentially flat over the past five years and is in dire need of some activist-style improvements. 

Norfolk's stock is up a mere 3% over the past five years. Compare this with top rival CSX, up 20%; Union Pacific (UNP) and Kansas City Southern (KSU), each up 100%; and Canadian National Railway (CNI), up 85%. Even the S&P 500 index has grossly outperformed Norfolk, returning 25%.

Ackman's key thesis at Canadian Pacific was that management issues were to blame for the company's underperformance. He was instrumental in ousting CEO Fred Green and getting former Canadian National CEO Hunter Harrison appointed to the top seat

A big positive for Norfolk of late has been its own management shakeup. In June, James Squires took over as president, essentially separating the CEO and president roles. Current CEO Charles Moorman will now focus solely on operations, while Squires will take over managing strategy and planning. Well-managed railroads are afforded higher valuations, and this is a first step toward a higher valuation for Norfolk.

One hot-button topic is pollution, which Norfolk is looking to tackle. Earlier this year, Norfolk laid out its initiatives, which includes fuel efficient engines, and turning to battery- and biofuel-powered engines. Its long-term goal includes lowering its greenhouse emissions by 10% per mile before 2014.

While the more efficient engines will no doubt help with emissions, there are company-specific benefits that are not to be ignored. As these engines come into play, the company should start seeing material improvement in lower operating expenses.

What makes Norfolk interesting is that with some slight improvements in the company, shareholders could easily be rewarded with share appreciation, and not just the industry-leading 2.7% dividend yield it pays.

Last quarter, Norfolk's operating ratio (operating expenses divided by net revenue) came in at 70.2%, compared with CSX's 68.6%. That might not seem like much, but it can be the difference of several million dollars over the course of a year. Norfolk and CSX have similar balance sheets, but CSX has a return on equity of 20%, while Norfolk is at 17%. Norfolk's move toward more efficient engines and operations is a first step for lowering its operating ratio and boosting returns on equity.

One of Norfolk's biggest initiatives for boosting its top line is to promote the move from trucks to trains, hence the gaining strength of its intermodal segment. The coming online of its Crescent Corridor, an intermodal corridor connecting Louisiana and New Jersey, should only further help drive the trading in of trucks for trains. Helping exacerbate the growth in intermodal should be the double-stacking that Norfolk is implementing. The majority of its intermodal shipments are now double-stacked, which allows Norfolk to move more cargo with fewer trips, leading to higher revenue per mile.

As natural gas prices tanked over the past few years, the trading in of coal for natural gas by the major power companies squeezed a number of major railroad operators, where coal transports have historically been a major part of revenues. Norfolk is mitigating this transition nicely, as revenues from intermodal should come close to passing coal this year as its top revenue generator. Intermodal volumes were up 8% in the past quarter, compared with coal being down 4%.

One of the real beauties of Norfolk is that the downside here is limited. The North American railroad system has one of the best-known legal economic moats in the world, as the railroad industry has infrastructure that just cannot be replicated. The amount of money that it would take to replicate such a network is unimaginable, not to mention the inability to access the land, where railroads hold age-old rights of way. 

Risks to Consider: Norfolk could fail to maintain its managerial and operational improvements and revert to being a subpar railroad operator. Railroads are also inherently tied to the economy, so any unexpected pullback in the recovery could be a big negative.

Action to take --> Investors can buy Norfolk now for roughly 70 cents per dollar of assets, which is well below any of the other major railroads. With the inherent moat that the railroad industry provides, there's not much room on the downside. With operational improvements, Norfolk should trade in line with the leading U.S. railroad operator, Union Pacific, at 17.5 times earnings. That price-to-earnings multiple on analysts' 2014 earnings per share estimates for Norfolk would yield a $110 price target.

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