Rails Derailed? RBC Downgrades Norfolk Southern On 'Unappealing' Risk/Return

Although Norfolk Southern Corp. NSC has made material progress in its cost cutting initiatives in 2016, RBC Capital’s Walter Spracklin believes further efficiency gains would be much more difficult to achieve going forward.

The analyst downgraded the rating on the company from Sector Perform to Underperform, with a price target of $113.

Unappealing Risk/Reward

“With NSC valuations now hitting peak levels, we believe the risks to achieving those targets do not match the upside return,” Spracklin mentioned.

Norfolk Southern shares have appreciated 22 percent since November 2016, outpacing peers. However, with the 2018 earnings multiple having risen to the highest level among the majors, the analyst believes that it would be difficult for the company to achieve efficiency targets.

This would result in an unappealing risk/reward, Spracklin explained.

Less Transparency

The analyst pointed out that management had been “very forthcoming” regarding targets and underlying assumptions while providing the 2016 guidance. Norfolk Southern was, in fact, able to achieve efficiency savings of $250 million in 2016 through a 2,400-headcount reduction.

However, management was “far less transparent” while issuing the 2017 guidance in January, guiding to $100 million in productivity savings.

“Further, management noted that savings would come on the back of no change in headcount, a Comp & Benefit headwind of +5 percent and a 160bps increase in tax rate Y/Y. This suggests that further savings are very much contingent on top line growth, not cost reductions,” Spracklin stated.

The analyst expects Norfolk Southern’s earnings to come in below expectations in 2017, which would lead to the premium on the stock contracting.

Related Link:

Norfolk Southern's 2016 Annual Report highlights commitments met to lower costs, increase profitability, improve service, and enhance shareholder value

Which Rail Stock Should You Board? Breaking Down Wells Fargo's Initiations In The Sector