Norfolk Southern Corporation — Q3 2017 Form 10-Q
Business context and period. The unaudited filing covers the quarter and nine months ended September 30, 2017, compared with the same 2016 periods. Norfolk Southern operates a freight railroad across 22 states and the District of Columbia, with major intermodal, coal, automotive, and industrial businesses.
Financial performance
| Metric | Q3 2017 | Q3 2016 | First 9 months 2017 | First 9 months 2016 |
|---|---|---|---|---|
| Operating revenue | $2.670B | $2.524B | $7.882B | $7.398B |
| Income from railway operations | $911M | $820M | $2.572B | $2.313B |
| Net income | $506M | $460M | $1.436B | $1.252B |
| Diluted EPS | $1.75 | $1.55 | $4.93 | $4.21 |
| Operating ratio | 65.9% | 67.5% | 67.4% | 68.7% |
- Q3 revenue rose 6%, railway operating income 11%, net income 10%, and diluted EPS 13%. For the first nine months, the respective increases were 7%, 11%, 15%, and 17%.
- Operating ratio reached a company quarterly record in Q3; management also cited first-nine-month records for operating ratio and diluted EPS.
- Q3 traffic volume increased 4% and nine-month volume 5%. Revenue per unit increased 2% in both periods, reflecting pricing and fuel surcharge revenue.
- Q3 revenue growth was led by coal (+13%), intermodal (+8%), and metals/construction (+12%). Nine-month coal revenue grew 21% and intermodal 9%; automotive revenue declined 3%.
- Operating expenses increased 3% in Q3 and 4% year to date. Compensation and benefits rose 9% and 6%, respectively; fuel expense rose 9% and 19%, while materials and other expense fell 13% and 2%.
- Effective tax rates were 36.8% for Q3 and 35.7% year to date, versus 34.8% and 35.5% in 2016. Illinois legislation increased Q3 deferred tax expense by $12M.
Cash flow, balance sheet, and capital allocation
- Operating cash flow for the first nine months was $2.465B, versus $2.312B in 2016. Investing cash outflow was $1.174B, including $1.315B of property additions; financing cash outflow was $1.523B.
- Cash declined to $724M at September 30, 2017, from $956M at year-end 2016. Working capital deficit widened to $414M from $48M.
- Total debt, including current maturities, was $9.880B; the debt-to-total-capitalization ratio was 43.7%, down from 45.1% at year-end. The $750M credit agreement was undrawn; $100M was outstanding under the $350M receivables securitization program.
- Management said cash on hand and operating cash flow should be sufficient for ongoing obligations. The company paid $529M in dividends and repurchased 6.0M shares for $712M during the nine months.
- The board authorized repurchase of up to an additional 50M shares through December 31, 2022. Management said future purchases depend on market conditions and may use internally generated cash, cash on hand, or borrowings.
Management outlook and material developments
- For the remainder of 2017, management expected merchandise revenue to increase on pricing and higher volumes; intermodal revenue to increase on volume, pricing, and fuel surcharges; and coal revenue to be slightly above the prior year, primarily on export volumes, partly offset by unfavorable mix.
- Management said the railroad could support additional volume growth while managing volume-related costs and inflationary pressures through continued productivity improvement. It expected employment entering 2018 to be flat to slightly above Q3 2017 levels.
- Q3 included a debt exchange: $750M of 4.050% senior notes due 2052 were issued in exchange for $551M of older notes; no gain or loss was recorded. The company also issued $300M of 3.15% senior notes due 2027 in Q2.
- Export coal tonnage rose sharply (145% in Q3; 93% year to date), while utility coal tonnage fell 5% in Q3, attributed mainly to low natural-gas prices and plant outages. Management noted ongoing exposure to fuel prices, traffic mix, and commodity demand.
Risks, contingencies, and other items
- Railroad injury, occupational, third-party, and environmental claims involve estimation uncertainty; actual settlements and remediation costs may differ from recorded liabilities. Environmental liabilities were $62M at September 30, 2017, across 131 known locations and projects.
- The Sunbelt rate-reasonableness matter remained decided in Norfolk Southern’s favor but was subject to appeal. The company said any reasonably possible loss was not expected to materially affect its financial position, results, or liquidity.
- In October 2017, the District Court denied class certification in the fuel-surcharge antitrust litigation. Norfolk Southern disputed the allegations and did not expect the proceedings to have a material effect.
- National labor negotiations continued with two bargaining coalitions; a tentative agreement with a third coalition, representing about 60% of unionized employees, awaited ratification. A separate BLET agreement covers wages and work rules through 2019.
- The company expected adoption of the new revenue standard in 2018 to have no material financial effect. It was evaluating the potential balance-sheet impact of the 2019 lease standard.
Important facts for investors to verify
- Whether volume growth, pricing, fuel surcharges, and export coal demand persist, and how much expense inflation offsets operating gains.
- Cash generation and liquidity given the working capital deficit, planned capital spending, debt maturities, and expanded share-repurchase authorization.
- Developments in labor negotiations, the Sunbelt appeal, fuel-surcharge litigation, and injury and environmental claim estimates.
- Whether the stated remainder-of-year market outlook and management’s sufficiency-of-liquidity expectation are borne out by subsequent results.