The Thoroughbred that got away

Cover story from the May 2016 issue of Railway Age: Norfolk Southern has been looking over its shoulder for almost a year. Now, it can focus its attention ahead.

The dust has settled, the smoke and mirrors have cleared. The Thoroughbred stands tall and proud, somewhat leaner, independent, surveying the landscape with a renewed sense of purpose, and a stronger feeling of confidence in its destiny. It has been put to the test. It has eluded a forced pairing with a strong, persistent, worthy suitor, albeit with assistance from those charged with guarding the stable.

For the foreseeable future, Norfolk Southern will remain Norfolk Southern, having outrun unwanted suitor Canadian Pacific. CP, in hot pursuit, abruptly slammed on the brakes before it collided with a mounting wall of resistance from the U.S. Departments of Justice and Defense, members of Congress, rail union leadership, railroad customers, and NS itself. The Surface Transportation Board can, for now, put aside dealing with merger petitions and declaratory orders. Railroad analysts and economists can continue to debate the pluses and minuses of a race to form a transcontinental railroad that never came close to leaving the starting gate.

The book closed on Monday, April 11, 2016, when CP terminated its efforts to merge with NS. This included, CP said, “withdrawal of a resolution asking NS shareholders to vote in favor of good-faith negotiations between the two companies. No further financial offers or overtures to meet with the NS board of directors are planned at this time.”

Norfolk Southern responded by saying the railroad’s board and management “are committed to enhancing value for shareholders. Since the company’s new management team was appointed, we have been focused on implementing a strategic plan to streamline operations, reduce expenses and maintain superior customer service levels. The NS team has made significant progress and is on track to achieve annual productivity savings of more than $650 million and an operating ratio below 65% by 2020. We are confident the continued execution of our plan will deliver superior value to all of the company’s stakeholders by best positioning NS to succeed. We thank our shareholders for their input and support throughout this process and our employees for their hard work and dedication to strengthening Norfolk Southern as a critical component of the nation’s transportation infrastructure.”

So, that appears to be it, for now. The hunter (no pun intended) and the hunted can take a break, assess the situation, and move on. Enough with the official corporate-speak, the usual rhetoric, filled with plain-vanilla-cookie-cutter phrases like “shareholder value” and “streamlining operations,” crafted by communications pros playing offense and defense, depending upon who signs their paychecks. Here are two outside observations worth noting:

• Cowen and Company Managing Director and Railway Age Wall Street Contributing Editor Jason Seidl: “Calling off the dogs: CP is walking away from a negotiating table that never really existed. Presumably it was the Department of Justice’s opinion that broke the camel’s back as the company feels there is no clear path to a friendly merger. Unless another party should take the issue up, shareholders will not be voting to urge NS management to speak with CP management. As we’ve been saying for some time, the likelihood of a deal getting done was a long shot. In recent weeks, many parties have expressed their opposition to a transaction, but the most significant deterrent came on April 8, when the DOJ said the voting trust proposal put forth by CP ‘makes no sense.’ Other recent letters of opposition came from the U.S. Army and Rep. Bill Shuster, the Chairman of the House Transportation and Infrastructure Committee. This followed several high-profile transportation companies coming out against the deal, such as UPS and FedEx.”

• A railroad president, speaking off the record: “NS was a potential acquisition victim—prey, really—that escaped. CP underestimated the heights of the external challenges, in particular the influence of the shipping community and government, that big money could not overcome. So there’s a lesson to be learned among the ‘Big Seven.’ The customer is king, with a captivating voice, and government does have the capability of non-regulatory influence. Combining the two makes it very clear: Do what you’ve committed to do when it comes to the customer and fulfill your regulatory requirements, without exception. It will afford nothing but upside in the way of customer growth and weaken the need for any further regulatory tightening. Customers and government are powerhouses to be respected, not fought, provided you perform to the expectations set forth before you.”

NS had been saying all along that it was making changes on its own to improve its performance, and didn’t need outside help. A few days after CP called off the chase, NS released its first-quarter 2015 financials. The results seem to indicate that it is indeed pulling out all the stops to follow through and deliver on its promises. NS reported “strong” first-quarter 2016 results that “demonstrate the significant progress we are making in line with our strategic plan,” in the words of chief executive Jim Squires.

On the minus side, NS’s railway operating revenues were $2.4 billion, 6% lower compared with first-quarter 2015, and volume declined 2%. Average revenue per unit decreased 3% as the effects of higher rates were more than offset by a $114 million, or 70%, decline in fuel surcharge revenues. On the plus side, railway operating expenses were $1.7 billion, down 13% year-over-year, and income from railway operations was $723 million, up 19%. Merchandise revenues were $1.5 billion, 2% higher than the same period last year. Led by an 18% increase in automotive traffic, volume grew in all business groups except chemicals, which was impacted by fewer crude oil shipments.

NS’s five merchandise commodity groups reported the following year-over-year revenue results:

• Chemicals: $419 million, down 3%.

• Agriculture: $386 million, up 3%.

• Metals/Construction: $300 million, down 3%.

• Automotive: $254 million, up 16%.

• Paper/Forest: $190 million, up 3%.

Intermodal revenues were $522 million, down 12% compared with first-quarter 2015. Volume was even for the quarter as lower domestic volumes offset growth in international volumes, due to the restructuring of NS’s Triple Crown Services subsidiary. In line with the rest of the industry, coal revenues were $349 million, 23% lower, due to mild winter temperatures, low natural gas prices and a weak global export market.

The final tally: Net income was $387 million, up 25% year-over-year, diluted earnings per share were $1.29, up 29%, and the railway operating ratio was 70.1%, an improvement of 8% over the prior year and an NS first-quarter record.

“Since I became CEO in June [2015], our team has been committed to streamlining operations, reducing expenses and maintaining superior customer service levels,” said Squires, who must be relieved that there’s no longer a target on his back. “Our focus on strengthening Norfolk Southern is yielding results, and the company is now on track to achieve productivity savings of about $200 million and an operating ratio below 70 in 2016. We are confident the continued execution of our strategic plan will deliver superior shareholder value by best positioning NS to succeed while ensuring the company is prepared to capture revenue and volume growth opportunities in 2016 and beyond.”

Beyond Expectations

“NS blew away our and consensus EPS estimates as the company’s operating ratio improved more than 600 basis points to a 1Q16 record of 70.1%,” noted Jason Seidl. “After CP’s attempt at an acquisition, NS has kicked its cost-cutting initiatives into high gear. NS has been streamlining operations and adjusting to not only a soft freight environment, but also toward a structurally better OR longer term. NS’s 1Q16 EPS of $1.29 blew away our above-consensus estimate of $0.99 driven by an OR that was 520 basis points better than our forecast. Despite revenue falling 6% year-over-year, the company grew operating profit by 19% and EPS by 29%. Share repurchases, a lack of weather-related costs, more-efficient handling of freight cars, 12% fewer locomotives and nearly 2,000 fewer employees were key reasons for the big earnings beat. The top line will continue to be a headwind as coal stockpiles are at 100 days (vs. a normalized 60) and intermodal competition from truckload carriers is unlikely to abate for another couple of quarters. Intermodal pricing gains are being restrained by a loose truckload market. Management also expects the auto business to slow on a year-over-year basis as well, something we’ve already heard from rival railroads and have modeled into our estimates.”

Seidl pointed out that NS is making more-aggressive changes than other Class I’s. “NS echoed themes similar to its peers,” he said. “Headcount reductions, stored locomotives, coal stockpiles, more favorable weather and better service have aided 1Q16 margins. However, NS has taken its productivity initiatives to another level. The company is now on pace for an additional $70 million of savings, or $200 million in total. That’s up 54% from prior guidance of $130 million. NS still expects to achieve $650 million in annual savings and a sub-65 OR by 2020. If management can keep posting results like 1Q16, it may have many people believing that will happen sooner rather than later. We think management’s guidance for a sub-70 OR in 2016 should be easily achievable, and we are now forecasting 68.1%—down from our prior estimate of 70.0%.”

In his first annual report letter to shareholders since becoming CEO in 2015, Jim Squires wrote that the company “has taken decisive and deliberate action to capitalize on significant growth opportunities within our unique network.” He pointed to several cost control initiatives and network improvements, among them:

• Closing the Roanoke, Va., office building and consolidating or relocating approximately 500 positions.

• Restructuring the company’s Triple Crown Services subsidiary.

• Reducing capital spending.

• Expanding track rationalization in the coalfields.

• Idling a major lake coal terminal.

• Consolidating two operating divisions.

While implementing these initiatives, NS “has maintained its commitment to providing superior customer service,” Squires said. “During this time, we achieved near all-time best service levels. In addition, we expanded our ability to serve markets in the Northeast by acquiring the Delaware & Hudson Railway Company’s line between Sunbury, Pa., and Schenectady, N.Y.”

What happens next? Observes Contributing Editor Frank Wilner in this issue’s Watching Washington (p. 15): “Pershing Square’s effort to place Hunter Harrison in charge of a merged CP-NS was called off, but a non-railroad investment consortium—similar to Berkshire Hathaway—could emerge to take CSX or NS private without regulatory approval, and install Harrison or the Harrison template. Curse Hunter Harrison and one may as well curse steam power that replaced wind, or internal combustion engines that replaced steam. Harrison embodies the economic concept of creative destruction, a disruptor of the status quo substituting the more efficient for the less efficient—the free market’s messy means of delivering progress.”

How much of a “mess” would have been created had circumstances been different and CP succeeded in capturing and corralling The Thoroughbred remains open to interpretation. Whether another attempt is made to form a transcontinental railroad, regardless of whether Norfolk Southern is part of that attempt, remains to be seen.