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Julian Close's Insights

InvestorsObserver
Financial Writer
Julian Close
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March 11 , 2013 - Norfolk Southern Still Strong Despite Coal Woes

Trains are, without a doubt, the world's most romanticized industrial equipment. Model train enthusiasts abound, musicians croon of lonesome whistles, and fantasy writers from C. S. Lewis to J. K. Rowling use train stations as gateways to other worlds. The early history of American industry and finance are likewise dominated by the railroads, but the railroad industry is far from what it was in that era. With so much activity in the information economy, it is hard to become excited about and industry so definitively old economy. Nevertheless, we believe nothing is more exciting than an opportunity to gain wealth, especially when one can do so based not on speculation, but on fundamental value.

Coal, however, should not be considered indicative of the overall demand for train transport, as the factors driving its decline do not apply to other industries. NSC is currently in the process of rotating into such industries, and non-coal transport now accounts for 80% of the company's business. While we believe that business from the coal industry will continue to decline, the decline is unlikely to be precipitous, and analysts believe NCS is adding enough revenue from other cargos to offset the loss. The current rate of revenue growth is not spectacular, but it should be enough to sustain the moderate PE of 13.63, particularly as Norfolk Southern is currently paying a dividend of 2.7%. So far this year, the market likes what it has seen from Norfolk Southern, and the stock has risen from $63.29 to $74. We expect that to level out a bit, but see no reason to fear a sharp drop, making conditions look good for a bull put-spread. The largest train company east of the Mississippi is Norfolk Southern (NSC), a mature company and one of the big four American railroads. Though a strong performer in the years leading up to the 2008 financial crisis, recent years have been a bit more up and down, and the reason is very clear: NSC's biggest customer, the coal industry, is in secular decline. Its ultimate end may be years or even decades away, but the decline is almost certainly irreversible.

Strategy

We believe the June 60/65 bull put spread offers an optimal risk/reward ratio. Sell a June 65 put for $1.00 and buy a June 60 put for $.50 netting a $0.50 credit. You will make an 11.1% return in 107 days on this trade, if nothing goes wrong, and the stock has to drop 11.3% or more to threaten the trade. That's a 38.5% annualized return (for comparison purposes only). As with all bull-put spread trades, we suggest this trade for investors with diverse holdings who can tolerate some risk in their portfolios.

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