Working on the Dividend Railroad

04/01/2009 10:48 am EST


Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, says one well-run railroad should hold up well during the current recession and beyond.

Norfolk Southern (NYSE: NSC) is one of the best-run railroads in North America. The firm has one of the top operating ratios in the industry and produces around $1 billion of free cash per year—over 10% of revenue. We like Norfolk’s strong operations, defensive freight mix, and expansion plans.

North American railroads own assets that are practically impossible to reproduce. The costs and challenges of obtaining rights of way and building track erect an insurmountable barrier to entry. Despite this powerful competitive advantage, railroads have historically failed to earn returns on investment greater than their cost of capital. However, Norfolk Southern has generated attractive 15% returns on equity during the last three years.

A railroad’s competitive advantage is inseparable from the location of its track. Norfolk hauls coal directly from Illinois and Appalachian mines and also transfers Powder River Basin coal from Western rails. For some of its coal business, heavy-loaded cars run downhill to Norfolk’s East Coast coal-loading facilities, then return uphill when empty and light, leading to greater fuel efficiency.

Norfolk Southern has grown intermodal (more than one mode of transport—Editor) volume impressively during the past decade, though we’re not surprised to see volume decline during this recession.

Revenue contributed by this segment is second only to coal for Norfolk. Many of its current capacity and speed improvement projects are designed to enhance its intermodal franchise. For example, Norfolk has partnered with Kansas City Southern (NYSE: KSU) to improve the Meridian Speedway (in Mississippi and Louisiana)—a vital link for increasing the speed of intermodal traffic from Los Angeles to the growing Southeastern US.

Norfolk’s enhancement on the I-81 Crescent Corridor (from New Jersey to New Orleans) and raising overhead clearance in 28 tunnels in the Heartland Corridor (through the Ohio Valley) should improve speeds and help divert truck traffic to rail.

Norfolk Southern is in strong financial shape, consistently generating cash flows in excess of capital spending with which to fund dividend payments. Debt is only 41% of total capital, and the dividend has been running at one-third of earnings or less.

NSC has enjoyed pricing power during the last four years, and though volume will grow only modestly over the long run, we think its ability to increase rates will persist into the future. Though the current recession will reduce earnings, we think a 5% average growth rate for operating profit and 7%—9% for per-share earnings and dividends is attainable. We’re also encouraged by management’s return to dividend growth following a dividend cut in 2000.

Norfolk Southern’s current yield [of nearly] 4% and the potential for 7%—9% growth indicates total returns of 11%—13% from current price levels. (It closed Tuesday below $34—Editor.)

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