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Letting Dividends Do Their Work

Norfolk & Southern: That Will Be Another $200, Please

George C. Fisher

Which is better to own? A) Broadway and Park Place, or B) B&O Railroad, Pennsylvania RR, Short Line RR, and Reading RR?

Whenever playing Monopoly, I tend to gravitate to the railroads due to their mundane but steady income. The strategy of owning railroad properties works well in both the game of Monopoly and in the real world of building a diversified portfolio.

Norfolk & Southern (NSC) has positioned itself as one of the largest rail and intermodal transportation companies. Intermodal transportation is comprised of hauling trucks or overseas containers to ocean-going shippers, which then ride on rail flat beds. Unlike its competitors which have carved up east-west routes criss-crossing the U.S., NSC has focused on north-south routes, mainly along the east coast. The old Conrail system in the Eastern U.S. was divided between Norfolk & Southern and CSX Corp (CSX). NSC has been investing heavily in expanding capacity, such as adding locomotives to improve its on-time performance, even as it digests Conrail. The integration of the Conrail system should strengthen NSC’s position in the north-south rail corridor.

In the past, there has been little competition for trucks in the northeast-southeast shipping corridor. Most rail lines and railroad mergers were focused on an east-west configuration, rather than north-south. With the addition of Conrail to its system, NSC now offers the first ever comprehensive rail system for this important corridor. Automobile transport is a large untapped rail market for this corridor, and NSC continues to divert shipments away from truckers with shorter transit times and lower cost. This strategy is working, as evident in their fourth quarter 2002 earnings and revenue gains.

The Conrail acquisition, along with a weak economy, has negatively impacted NSC’s earnings. However, the integration of Conrail should continue to offer cost savings going forward. These savings are due to the use of longer trains, more efficient routing of trains and cutting administration/overhead costs. In addition, the integration has allowed NSC to de-emphasize lower margin routes and customers. The acquisition of the Conrail system routes provides greater access to the northeastern markets of New York City, Baltimore and Philadelphia. It also provides better connections to western rail systems. With longer, single-system routes, NSC hopes to divert intermodal and auto shipments from motor carriers by offering shorter transit times between the northeast and southeast.

Coal, coke and iron ore is NSC’s largest commodity group as measured by revenues (25%). The merchandise traffic group consists of intermodal (18% of revenues) and general merchandise, which consists of automotive (14%), chemicals (12%), metals and construction (11%), paper, clay and forest products (10%), and agriculture, consumer products, and government (10%). Approximately 68% of total traffic tonnage originated online with direct NSC customers. The remainder is received from connecting carriers.

Over the past few years, earnings growth has not been good for NSC. EPS started a long slide in 1997 and seems to have bottomed out in 2001. Earnings peaked in 1996 at $2.03 per share and fell to $0.63 in 1999. Since then, EPS have been on a slow, but steady climb: $0.71 in 2000, $0.97 in 2001, and $1.18 in 2002. Earnings in 2003 are anticipated at $1.40 and $1.60 in 2004. Going forward, annual growth is expected to be in the 13% range.

In the fourth quarter 2002, NSC reported stronger than expected earnings of $0.33 a share, 10% above consensus. Coal revenues were down for the quarter, but were more than made up for by strength in their automotive and intermodal shipments. It seems the worst is behind NSC and management is beginning to realize the advantages of the Conrail acquisition.

Since 1999, NSC’s stock price has floundered between $15 and $25. NSC became what I call a "Missouri" stock – investors are saying, "Show me the money and I’ll invest". NSC is starting to show investors potential, and Wall Street is beginning to acknowledge it. As earnings continue to rise over the next 8 quarters, so should NSC’s stock price. At $19 a share, it is trading at the middle of its previous price range, and just above its 5-year PE lows. Based on 2004 earnings estimates, NSC has a forward PEG of 0.94 – not particularity undervalued, but an acceptable level nonetheless.

In 2000, management cut the annual dividend from $0.80 to $0.24 and raised it in 2002 to $0.28. If management maintains a 20% to 25% payout ratio, dividends could rise to $0.32 to $0.40 a share over the next few years. In the soon-to-be-world of at least partially tax-free dividends here in the U.S., this growth will add to investor’s interest.

To enroll in their DRIP program, investors must first become a registered shareholder of at least one share. Non-U.S. residents are invited to participate. NSC’s DRIP program charges $2.50 each for its OCP (Optional Cash Plan – Canadians call it SPP: Share Purchase Plan), so plan your investments accordingly.

For DRIP investors researching companies poised to benefit from the pending cyclical upturn of the U.S. economy, Norfolk & Southern is worth your time.

George Fisher, author of The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002) and All About DRIPs and DSPs (McGraw Hill, 2001), Sagamore Beach, MA

© Canadian MoneySaver, PO Box 370, Bath, ON K0H 1G0 613-352-7448 - Published March 2003

Copyright North Shore Associates 2003

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