Jump Aboard This Railroad
Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Warren Buffett's purchase of Burlington Northern Santa Fe has caused investors to take a second look at railroads. Railroads have benefited from enormous barriers to entry in the form of laid track and rights-of-way that make it nearly impossible for competing railroads to infringe on one another's franchise. However, high capital expenditures are necessary to replace worn-out equipment at a much faster pace than GAAP depreciation requires, which weighs on railroads' free cash return on invested capital. The only way to counteract the high capital expenditures is to operate as efficiently as possible.
Norfolk Southern (NYSE: NSC) is one of the most efficient railroads in North America. It has had one of the best operating ratios in its peer group over the last several years and produces lots of free cash flow. As with other railroads, its capital expenditures budget is necessarily a large chunk of revenues, but rising fuel costs should make railroads a more attractive option over the next decade relative to trucking.
As a result of running an efficient railroad operation, Norfolk Southern generates a lot of free cash flow. Although not the highest each year, Norfolk Southern's free cash flow margin is the most consistent in its peer group.
Norfolk Southern's free cash flow margin has averaged just over 10% since 2002. In comparison, Union Pacific (NYSE: UNP) averaged 10.92%, CSX (NYSE: CSX) averaged 5.35%, and Kansas City Southern (NYSE: KSU) averaged 2.56%. I could use statistics to mathematically prove that Norfolk Southern's free cash flow margin is more stable than the other three, but it should be clearly visible to all eyes that this is the case.
Norfolk Southern's stable free cash flow margins comes from the ability of one of its segments to absorb lost volume from another. For example, coal volumes -- the company's biggest segment by revenues, second by volume -- have fallen over the last few years. However, intermodal shipping volumes -- the company's second-biggest segment by revenues, largest by volume -- have made up for the decline in coal. Although coal is a higher-margin product, Norfolk Southern appears to have the diversification to ride out any further declines in the segment.
Over the last five years, Norfolk Southern has averaged a nearly 9% pre-tax return on invested capital. Of the three competitors mentioned above, only Union Pacific has done better (Union Pacific has averaged a 9.5% pre-tax return on invested capital over the last five years). It is not likely that Norfolk Southern will improve on its ROIC any time soon, as it already sports one of the better ones in the industry. However, a larger asset base will support a higher earnings figure, which makes this stock look cheap.
Norfolk Southern earned $2.9 billion pre-tax in 2011. However, that equates to a 10.33% return on invested capital, which is higher than the five-year average. As a result, $2.9 billion is probably not a 'normal' pre-tax earnings number for the company. If instead you apply a 9% return to the most recent quarter's invested assets, you get a normal pre-tax earnings figure of $2.622 billion.
At a 10-times multiple -- allowing for moderate growth and accounting for the high multiples the market places on railroads -- the company is worth $77 per share. At a recent price of $64.61 per share, Norfolk Southern looks like an attractive option for those wishing to get exposure to the railroad industry.
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