Norfolk Southern’s weak Q4, deteriorating OR draw Wall Street criticism
Fourth-quarter 2023 earnings and a projection for its prospects in 2024 have led to at least a pair of Wall Street downgrades of the prospects for Norfolk Southern’s stock price.
The bottom-line numbers for Norfolk Southern (NYSE: NSC) were that it posted net income in the fourth quarter of $527 million versus $790 million in the corresponding quarter of 2022. Its operating ratio for the fourth quarter of 2023 was 73.7%, a significant deterioration from the 63.5% it posted a quarter earlier.
NS’ quarterly earnings report and the subsequent earnings call with analysts did not mollify Wall Street critics, two of whom took quick action: TD Cowen and Morgan Stanley (NYSE: MS) cut their ratings on the East Coast-focused railroad, Cowen to market perform from overperform, and Morgan Stanley to underweight from equal weight.
Bank of America Merrill Lynch kept its buy rating, but reduced its earnings-per-share estimates for this year and 2025.
NS stock was trading at about $242.50 at the close Thursday. Earnings were released Friday, and the stock price immediately plummeted to about $227. The intraday high Tuesday was $237.75.
The irony is that in the past three months, Norfolk Southern stock has had a good run, up about 26.8%, per Barchart data. But for both the last month and the full year, it’s essentially flat.
In its comments to analysts, Norfolk Southern CEO Alan Shaw said the company was targeting OR improvements of 100 to 150 basis points per year for the next three years. And the end result of that, according to several analysts clearly disappointed by that pace of change, is that NS would still have a lower OR than its peer Class 1 railroads.
On the earnings call Friday, Amit Mehrotra, the head of the transportation research team at Deutsche Bank, was blunt about the disappointment analysts felt about a projection they did not see as particularly aggressive.
“If we look at the three-year plan, I think if you ask every railroad in North America, they tell you that they also would expect to improve margins by 100 basis points to 150 basis points a year from where we are today,” Mehrotra told Shaw, according to a transcript of the call. “So, I guess the negative implication of that outlook is that you’re not actually narrowing the gap, you’re just improving your position from where you are, but the gap actually stays intact.”
In a similar vein, Bank of America Merrill Lynch analyst Ken Hoexter, discussing the three-year projection for reforms to have their full impact, said on the call: “I’m still surprised by that time frame. Should seem like there’s still moves that would get you that leverage a bit quicker, I guess, just compared to some moves we’ve seen on some other rails.”
Shaw, in response to an analyst question about the pace of change, said the three-year projection is “not an end point.”
“We have talked about continuous productivity improvement as one of the three components of our balanced strategy of safe service, continuous productivity improvement and smart growth,” Shaw said.
In the Morgan Stanley downgrade, the transportation research team led by Ravi Shanker noted that the Norfolk Southern earnings missed consensus forecasts. Adjusted EPS for the fourth quarter was $2.83, below a consensus forecast of $2.87.
Morgan Stanley said the shortfall “was similar to other rail prints in the quarter.” Guidance for 2024 on volume and cost inflation “was also consistent with what we have heard from other rails thus far.”
But as Morgan Stanley noted, given that NS was the worst-performing stock in 2023 of all the Class 1 railroads, analysts had hoped that Norfolk Southern would “drive the rail mean reversion trade going into 2024 (noting the big three-month surge in the price) given the easy comps once the February 2023 Ohio accident was lapped and given very negative sentiment on the Street around the name in 2023.”
Morgan Stanley’s report also focused on the OR gap with other railroads. As a point of comparison, Norfolk Southern’s OR north of 70% stands in stark contrast to the 60.9% posted by Union Pacific (NYSE: UNP) and the 64.1% at CSX (NASDAQ: CSX).
TD Cowen’s Jason Seidl was scathing in his review. “If they just hit … the high end (of the 100-150 points per annum) every year for the next three years, NSC’s OR would still be below where [CSX] was in 2023,” Seidl wrote. “We do not view new financial guidance as closing the gap with competitors as management suggested given both other Class 1s are expected to see margin improvement off a much lower (better) 2023 base.”
Investors “[have] been looking at NSC’s lagging OR as a potential for easier and better rate-of-change as well as stronger operating leverage when volumes returned,” the Morgan Stanley report said. “While all rails that have reported thus far likely disappointed on 4Q operating leverage (or lack thereof) despite improving volumes and implied constraints in 2024, the fact that NSC’s OR gap vs. peers actually grew, the more removed we have been from the Ohio accident, leaves the management team with more heavy lifting to do.”
NS did use the occasion of the earnings release and the analyst call to say it planned to cut management head count by 7% “to help offset increases in critical operating areas.” The railroad came under heavy criticism after the East Palestine, Ohio, derailment, with accusations that it had cut too deeply into operating and safety expenses; the head count cutbacks do not include any reductions in staff out on the railroad.
Shaw, in response to another analyst question, said the company was “entering the third year of a freight recession, and with the investments that we’ve made in safety and service that are delivering meaningful results, it’s clear that our cost structure is too high for our revenue base entering 2024.”
That view on costs was similar to what was expressed by TD Cowen in its downgrade of NS stock. “While the U.S. Class I rails struggle to find the next growth lever for top line growth, NSC’s cost structure should continue to notably underperform its peer group for this year,” TD Cowen wrote.
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