WE ATTENDED NORFOLK SOUTHERN'S (ticker: NSC) investor day on June 3 and heard nothing that would cause us to question our favorable long-term view on the industry.
Though management did not offer guidance, the company reaffirmed our conviction in a number of themes that are likely to drive rail outperformance versus other freight transports over the coming years. Unfortunately, we continue to find it difficult to identify important near-term catalysts for the shares that could get investors excited, and thus, maintain our Equal-Weight rating on the shares.
One positive is that concerns about major negative rail legislation passing this year are likely overblown. Regulatory issues have been a major overhang on rails in recent months. We believe these issues are one reason why rails have not enjoyed the same level of multiple-expansion as other freight transports as the market shifted its focus on an economic recovery.
It has been our long-held view that overbearing regulatory/legislative actions with major negative implications for return on invested capital is an unlikely resolution to recent shipper-backed efforts in Congress. Moreover, we have increased conviction that such regulation is likely to face further delays in Congress. We think a compromise bill, a relative positive, is the most likely outcome. After attending the investor day, management appears to share our view, thus increasing our conviction on the issue.
A second positive is that productivity initiatives should drive margin improvements in years to come. Norfolk Southern detailed a number of key productivity initiatives such as Operating Plan Developer (OPD), a tool used to identify and execute the most efficient network/operating plans, Unified Train Control System (UTCS), which improves coordination among various work-groups, and Locomotive Engineer Assist Display and Event Recorder (Leader), a benchmarking and guidance tool for locomotive engineers for maximizing fuel efficiency (the "Golden Run").
Norfolk Southern is ahead of its peers on IT initiatives, we believe, and has a long pipeline of productivity-boosting projects. However, to be fair, while investment in a vast array of productivity initiatives likely has longer-term benefits for the company, management's reluctance to cut headcount as aggressively as peers during this downturn could continue to weigh on near-term results. Norfolk Southern strongly believes it will be better-positioned to handle the return of volume growth in an economic recovery. Indeed, we believe after posting the worst earnings-per-share trend in 2009, Norfolk Southern is likely to grow faster than peers in 2010 and beyond on volume recovery and realization of growth and productivity initiatives.
A third positive is that the rail-pricing story remains intact. Though pricing was not a focus at Norfolk Southern's investor day, we heard nothing that would suggest rail pricing is at risk. In fact, incremental data points we gathered suggested that the industry is maintaining discipline with respect to pricing. This is consistent with our view that the pricing story will be supported by service improvements, incremental pricing benefits through repricing of below market, legacy contracts, price cuts stimulate little-to-no incremental demand, and solid balance sheets/cash profiles give rail managements more confidence to wait for volume to return without resorting to price cuts to win market share to shore up cash. As a result, our experience at the investor day gave us more conviction in our current modeling assumption of 4% longer-term pricing growth.
One negative is that there are no signs of a volume rebound. Although management is anticipating a sequential rebound in volumes before the end of the year (consistent with our model), the company conceded that there are no signs of a rebound on the horizon. Recent trends have only vaguely shown signs of stabilization and Norfolk Southern continues to suffer relative to peers as a result of its outsized export coal, greater natural-gas competition in the east and heavy industrial portfolio -- trends which we expect to continue.
Another negative is that share repurchases are not on the horizon. In our view, current, depressed share prices offer management both an opportunity to leverage balance sheet strength to buy shares at an attractive price and average down from earlier share buybacks executed at much higher prices. However, we heard nothing during Norfolk Southern's investor day that would suggest management is embracing this view. In fact, its conservative approach to balance-sheet management suggests that share repurchases are very unlikely near term. As a result, we would be surprised to see the company leverage its balance sheet/cash flow strength to repurchase shares until a recovery is already well under way.
We aren't against owning Norfolk Southern -- especially for investors with a multi-year time frame. However, we prefer Overweight-rated Union Pacific (UNP) due to its larger legacy repricing opportunity and potential for near-term outperformance on productivity and volume recovery.