Why Norfolk Southern Has Hit 2-Year Lows

Image: Norfolk Southern.

At the beginning of 2015, it appeared that the railroad industry would be in great shape. With the cost of fuel plunging, Norfolk Southern and its railroad peers would enjoy a big decline in one of their major costs of operation, and a strong U.S. economy seemed to bode well for shipping volumes. Yet as Norfolk Southern's second-quarter financial report highlighted, railroads haven't been able to move full speed ahead, and a host of operational challenges has held Norfolk Southern back and sent its stock to levels it hasn't seen since 2013. Let's take a closer look at the situation Norfolk Southern is in and why shareholders are nervous about the future.

Why Norfolk Southern investors didn't like its earnings reportNorfolk Southern's second-quarter results continued on a trend that we've seen in past quarters as well. Revenue plunged nearly 11% to $2.71 billion, falling more than $100 million short of the consensus forecast among investors following the railroad. Net income fell at more than double that pace, declining to $433 million and working out to earnings of $1.41 per share. That was only $0.02 per share less than what investors had expected, but it still underscored the difficulty that Norfolk Southern has had in keeping its profits up.

The two primary drivers of Norfolk Southern's weakness have been its coal and metals/construction segments. Coal revenues got cut by a third from the year-ago quarter, with the railroad blaming low natural gas prices and declining fuel surcharges for the drop in revenue. Volumes are down by more than a fifth, as demand both from domestic sources like utilities and from export-shipping dropped sharply. Meanwhile, revenue from metals and construction took a 16% hit, with falling steel transport volumes responsible for some of the decline.

The other issue that Norfolk Southern faces is that because it was able to pass through diesel costs in the form of fuel surcharges, its savings on fuel also resulted in a revenue hit. Norfolk paid $153 million less on fuel during the second quarter of 2015 than it did in last year's second quarter, but rising costs for compensation and benefits and other overhead expenses partially offset those savings, resulting in just a 6% fall in total operating expenses. Norfolk's operating ratio climbed to 70%, showing how cost-cutting isn't keeping up with falling sales.

How can Norfolk Southern rev up its engines?Norfolk Southern's areas of relative strength hold promise for future growth. Higher automotive production and strong demand for lumber and pulpboard helped support their respective divisions, and the chemicals segment continued to be the leader of the pack, with higher volume holding year-over-year revenue stable despite the fuel-surcharge headwinds. If those areas can keep prospering, then they'll inevitably help Norfolk Southern avoid the worst of downturns in the rest of its business.

Still, the coal segment remains a long-term trouble spot for Norfolk Southern. The future of the coal industry is increasingly in doubt, with even major producers having seen their share prices slide precipitously over the past few years. With even international demand for coal proving inadequate to support prices, bankruptcies of major coal companies could start happening in the near future, and that could jeopardize Norfolk's remaining business from coal.

Moreover, Norfolk Southern's attempts to support its stock through share repurchases has thus far been ineffective. Despite repurchases of $765 million during the first half of 2015 and authorization to buy as much as 27.8 million shares by the end of 2017, Norfolk investors now apparently see buyback activity as a given. Even worse, as profits fall, Norfolk Southern could have to consider unappetizing alternatives like borrowing money to finance buybacks, a leverage-boosting move that might backfire through lower share prices if the railroad doesn't bounce back convincingly.

Norfolk Southern's nearly 25% drop in its stock price so far this year comes as a huge disappointment to those who expected falling fuel prices to bolster its earnings. With Norfolk in particular still having considerable exposure to coal and other less-promising shipping areas, though, it's entirely possible that further declines in the railroad's shares could come before the industry hits bottom. Norfolk Southern needs to work hard to boost the positive impact of its more successful sources of business to offset any ongoing fallout from its weaker customers going forward.

The article Why Norfolk Southern Has Hit 2-Year Lows originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.