Stock Story: Norfolk Southern

October 2023

On 3 February 2023, a freight train operated by Norfolk Southern derailed in the quiet town of East Palestine, Ohio. The derailment resulted in the spillage of hazardous chemicals and a large fire that made international news. It was a significant amount of adverse publicity for a business that has otherwise largely stayed out of the headlines. Despite its low profile, Norfolk Southern’s rail network, along with the rest of North America’s freight railroads, represents a critical piece of infrastructure, responsible for transporting close to 30% of the freight moved in the region. 
  
The core of the North American freight rail network consists of six major (termed class one) rail networks, which are in turn supplemented by regional and short-line railroads. Norfolk Southern is one of the six major class one railroads. 

To provide some context around its sheer scale, the company’s network, which spans across the eastern states of the US, consists of approximately 19,100 route miles of track infrastructure and is responsible for moving 179 billion tonne-miles (weight x distance of the goods) of freight every year. Norfolk Southern generated over US$12.7 billion in revenue last year. 

We believe the adverse share price reaction to the derailment is unwarranted given the cash flow impact of the derailment is likely to be immaterial to the intrinsic value of the franchise. We predicate this view on the basis that: 1) the derailment did not result in any injuries, fatalities or material property damage; and 2) the rail car that was the primary driver of the derailment was not owned by the railroad, providing a potential opportunity for recovery of any damages. 

More importantly, the news about the derailment masks the long-term value of the franchise. We view Norfolk Southern as an attractive business to own given: 
1) the company operates in a favourable and sustainable duopoly industry structure – akin to its other class one peers; and 
2) rail is more cost efficient than truck – the other primary form of land-based freight movement.

The North American class one railroad industry is structured as three sets of duopolies with two covering Canada and the northern US states (Canadian National and Canadian Pacific), two covering the western US states (Union Pacific and BNSF) and two covering the eastern states (Norfolk Southern and CSX). We believe the duopoly between Norfolk Southern and CSX is sustainable due to high barriers to entry and strong network effects. The key barriers to entry are the cost and ability to build a rail network. For context on cost, the value of Norfolk Southern’s property, plant and equipment on its balance sheet is ~US$32 billion, albeit the replacement cost would likely be much higher than this. In terms of ability, building a network of tracks is difficult in practice because a new entrant would need to acquire or lease the land, and face potential NIMBY-ism dynamics. Norfolk Southern also benefits from network effects given the incremental cost of shipping a unit of freight is lower than the average cost.

The core reason rail is more cost efficient than truck is because trains are much longer than trucks on average. Most semi-trailers in the US are 20 metres long; by contrast, the typical length of a train is about 1.6 kilometres, with some trains in the US exceeding 4.3 kilometres in length. Longer trains lead to lower per-unit costs of transportation because the fixed cost of labour and fuel (typically 60-70% of operating costs for both trucks and rail) can be spread over more units of goods. In basic terms, the cost of labour for rails is splitting the cost of two train drivers over 1.6 kilometres worth of goods versus trucks splitting the cost of a single driver over 20 metres worth of goods.  In terms of fuel, the basic physics associated with how a train moves from point A to point B relative to a truck, means that trains can move three to four times more tonnes per gallon of fuel relative to trucks.”. This is also beneficial for the environment given freight rail’s carbon footprint is up to seven times more efficient than trucking.

These attractive characteristics are reflected in Norfolk Southern’s high returns on capital employed and strong pricing power, with rates increasing faster than inflation over the last 20 years.
The major change in Norfolk Southern’s operating model over the last decade has been the implementation of precision scheduled railroading (also known as PSR) in 2019. PSR is a railroad operating model pioneered by the late Hunter Harrison. Mr Harrison first implemented PSR at Illinois Central Railroad in 1993 and went on to implement PSR at several other class one railroads including Canadian National in 1998, Canadian Pacific in 2014 and CSX in 2017. 

The core objective of PSR is to reduce the average time it takes to move a customer’s rail car from origin to destination. As a result, PSR is a win-win for customers and shareholders. 
Customers win because PSR increases the reliability of rail as a transportation method; i.e., the goods arrive at the scheduled time. The proportion of CSX trains that arrived on time increased from 51% in 2015 (prior to PSR implementation) to 75% in 2018 (post implementation of PSR).

We believe the benefits to shareholders are both immediate and enduring. The significant improvements in asset utilisation driven by PSR (moving the same amount of goods with fewer people and locomotives) resulted in a rapid increase in margins over 24 months. CSX’s adjusted operating margins increased from 30% in 2015 to 40% in 2018. We believe Norfolk Southern’s margins will follow a similar trajectory given its network footprint is similar to that of CSX. The longer-term benefit is increased capture of volumes currently moving by truck as the reliability gap between truck and rail closes. Given these volumes are likely to be added at high incremental margins, we believe that this should lead to profits growing faster than revenues over the long term.

Yathavan Suthaharan, Investment Analyst

Source: Company filings