ATLANTA — The strategy shift that Norfolk Southern announced yesterday — focusing on providing consistent service and volume growth rather than on costs and the operating ratio — received a generally positive reception from Wall Street analysts.
But they also said that to win over skeptical investors NS will have to prove that it can restore service to 2019 levels — and then keep it there.
To break the cycle of railroad service problems that occur every few years, NS will maintain its train crew levels during downturns, CEO Alan Shaw said during the railroad’s investor day on Tuesday. As a result, NS will be able to handle volume rebounds, prevent disruptions, and provide resilient service that will convince shippers to build their supply chains around rail, Shaw says.
Wall Street has traditionally expected railroads to cut costs and shed workers as traffic declines during a recession. Recently, however, some analysts have begun asking how railroads can become more resilient in the wake of widespread service problems related to crew shortages at the big four U.S. railroads.
Maintaining crew levels will create a short-term hit to profits during downturns, Shaw says, but will allow NS to provide consistent service and gain volume, boost revenue, and increase profits over the long term.
“We agree with the strategy to invest in resiliency and service to drive growth and believe CEO Alan Shaw has a real opportunity to drive culture change that benefits … investors over time,” Susquehanna Financial Group analyst Bascome Majors wrote in a note to clients.
Baird Equity Research analyst Garrett Holland noted that NS’s train crew approach will hurt profit margins during downturns. “The cumulative benefits (examples: more robust volume recovery, lower turnover/training costs, reliable service) outweigh the short-term impacts,” he wrote.
“We completely endorse this approach even if investors who historically have relied on rails for earnings stability in a recession may raise an eyebrow,” Morgan Stanley analyst Ravi Shanker wrote in a note to clients.
“This is a pivot we believe is needed,” BMO Capital Markets analyst Fadi Chamoun wrote, noting that railroad earnings are becoming more dependent on volume growth.
“The medium term volume growth opportunity has the potential to be attractive and, more importantly, is better than the stagnant growth alternative that could bring a negative regulatory response,” Chamoun wrote.
Surface Transportation Board Chairman Martin J. Oberman has been highly critical of the big four railroads’ inability to meet freight demand this year. He places the blame on a wave of employment cutbacks that began in 2017, which was followed by deep furloughs as rail traffic tanked at the onset of the pandemic. Oberman has urged railroads to dig out of their current service hole, return to growth mode, and commit to maintaining adequate resources.
Congress, meanwhile, is considering bills that would give the STB more regulatory power over railroads.
“Railroads have little choice in terms of pivoting to enhanced service … It is a requirement for the rails to reduce regulatory risk,” Chamoun wrote.
NS’s new strategy may get tested in 2023, when many analysts expect an economic slowdown that would reduce freight volume.
“We firmly agree with the themes of service improvement, network resiliency, and customer-centrism as the rational path forward for Class I railroads from here, despite the near-term operating cost of building that resiliency by continuing to invest in headcount,” Majors wrote. “That said, we also expect investors to adopt show-me skepticism toward pivot to growth strategies.”
The reason for skepticism? Over the past decade, railroad volume has not kept pace with economic growth while truck tonnage has risen sharply.
NS’s volumes are down 4% over the past decade, Wolfe Research analyst Scott Group notes. Coal volumes have declined 52% over that period, he says, while the rest of NS volume is up 8%.
“The [NS] long-term plan hinges on a U-turn in a 15-year trend of declining rail volumes and the 5-year trend of industry share loss to truck in intermodal,” Shanker wrote.
NS will have to prove to shareholders that its plan works, analysts said. “Consistency in execution over time will be needed to convince investors,” Holland wrote.
Independent analyst Anthony B. Hatch says NS’s service-and-growth strategy is “another setback to the Cult of the Operating Ratio,” his term for Wall Street’s hyperfocus on the key efficiency metric.
Shanker said it was clear from investor day that “this is not the O.R.-driven, PSR-focused” Norfolk Southern of 2019, when the railroad announced it would adopt an operating model based on Precision Scheduled Railroading principles.
NS executives say several trends favor a shift of freight from highway to rail, including environmental benefits and cost savings compared to truck, the rise of e-commerce, retailers wanting to keep more inventory closer to consumers, and manufacturers returning some production to the U.S.
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