Norfolk Southern (NYSE: NSC) is jumping aboard the cost-cutting strategy sweeping through the North American railroad industry. If the company can hit the targets it laid out during its investor day on Feb. 11, shareholders have a lot to be excited about.
Norfolk Southern's management said they are rolling out a new strategy, called Thoroughbred Operating Plan 21, or TOP 21, designed to bring down costs and to extract more productivity from the company's locomotives and other assets. The plan is based on precision scheduled railroading (PSR), an operating philosophy designed to make railroads more efficient that was pioneered in Canada and is now making its way to U.S. companies.
Image source: Norfolk Southern.
Norfolk Southern said that since 2015 it has trimmed its operating ratio -- a measure of total expenses relative to its revenue -- by more than 7% since 2015 to 65.4%. It now hopes to bring that measure below 60% by 2021.
Doing more with less
Norfolk Southern in recent years has focused its restructuring efforts on a system it called "clean sheeting," which emphasized starting from scratch in local markets to develop new operating plans in collaboration with key customers. The new push is much more of a companywide top-down approach; it emphasizes cost controls, prioritizing service to key customers, and using scheduling enhancements to minimize bottlenecks and better optimize locomotives and railcars.
As part of the plan, the company intends to reduce its non-union headcount by 500 before year's end, and reduce its total headcount by about 3,000, or 10% of total workers, by 2021. Norfolk Southern also expects to reduce the number of locomotives in its fleet by 500, or 11.9%, in the coming years.
Image source: Norfolk Southern presentation.
The railroad said it expects a compound annual growth rate of 5% through 2021, driven by strong performance in its bulk transport and intermodal segments. Management also backed its target 33% dividend payout ratio.
There will be higher levels of spending in the coming years as part of this push. Norfolk Southern said it expects to spend upwards of 18% of revenue on capital expenditures through 2021, including spending to convert its DC-powered locomotives to AC power. The conversion should reduce fuel consumption costs, because AC engines tend to have better traction and therefore need less energy to pull a train forward.
The railroad is also investing in new technologies to help speed traffic on the network, and on network improvement projects.
What it means for investors
Norfolk Southern, in embracing PSR, is following on the track of Eastern rival CSX, and borrowing heavily from techniques used by Canadian Pacific and Canadian National. All three of those railroads have seen their operating ratios fall to the near-60% level that Norfolk Southern is targeting, but those results didn't come without service disruptions during the transition.
PSR isn't universally beloved. Critics in the past have expressed concerns that railroads will cut too deep and risk frustrating customers. Eastern U.S. railroads like Norfolk Southern also tend to have shorter stage lengths, meaning it is harder to extract the sort of efficiencies you can on the open plains of central Canada, and must manage the challenge of increasing speeds and volumes over some of the nation's oldest and most congested rail lines.
The hope for Norfolk Southern investors is that the railroad, by starting with a localized approach, will be able to avoid some of the service disruptions that plagued CSX in 2017 and caused the U.S. industry's regulator, the Surface Transportation Board (STB), to hold hearings. The company has also brought in PSR experts to help it through the transition, in November naming one-time Canadian Pacific and Canadian National exec Michael A. Farrell as a senior vice president.
Image source: Norfolk Southern.
Norfolk Southern shares look attractive even without further cuts: The company boasts the second-highest dividend yields in the sector and, valued at 18.94 times earnings, trades at a 10% discount to industry leader Union Pacific. Barring a major derailment in implementing the TOP 21 plan, or a substantial drop in the U.S. economy, investors should do well owning this stock through the transition.
My bet is that management largely gets this right, and Norfolk Southern will be an outperformer over the years to come.
More From The Motley Fool
- 10 Best Stocks to Buy Today
- 3 Stocks That Are Absurdly Cheap Right Now
- 5 Warren Buffett Principles to Remember in a Volatile Stock Market
- The $16,728 Social Security Bonus You Cannot Afford to Miss
- The Must-Read Trump Quote on Social Security
- 10 Reasons Why I'm Selling All of My Apple Stock
Lou Whiteman has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Canadian National Railway. The Motley Fool recommends Union Pacific. The Motley Fool has a disclosure policy.