Stock Bought: NSC

Today I bought shares of Norfolk Southern (NSC), a major North American railroad company. This is the third time I have added to my position in NSC this year, with previous purchases occurring in January and March.

NSC dropped over 9% today after the company lowered its Q3 earnings outlook (other railroad stocks also fell on the news). Continued declines in coal and merchandise shipments are expected to reduce revenues, although these effects will be partially offset by growth in intermodal volumes. While this news is disappointing, I consider it to be a short-term problem that will not dampen the company's long-term growth prospects. Coal volumes have been lower this year due to unusually warm winter weather, but this trend will likely flatten out or reverse once we return to more normal winter temperatures.

Despite the warning about earnings, I think management continues to have a positive view of the company's future. A strong indicator is the fact that NSC has increased its dividend twice this year, by 9.3% in January and by 6.4% in August. Note that the August dividend increase occurred after coal volumes had already been declining for several months. I think the company has responsible management and they would not grow the dividend in this manner if they were worried about future earnings.

From a valuation standpoint, I consider NSC to be undervalued with a P/E of 11.3 (its historic P/E is about 14.4), P/S of 1.9, and PEG of 0.88. Even if one were to lower future earnings expectations, the PEG would still likely be near 1. Today's drop in stock price pushed NSC over the 3% yield point ($66.67) and if you look at its historic yield over the past 10 years, it rarely stays above 3% for a long time. Using a Dividend Discount Model with a projected dividend growth rate of only 8% (which is well below historic averages) and a discount rate of 11%, I calculate a fair value of $72 for NSC, which I think is an extremely conservative estimate.

I bought 20 shares of NSC at the price of $65.98 per share, giving me a total of 70 shares at an average price of $70.25 per share and a 2.83% yield on cost. Note that I was able to average down from my previous cost basis of $71.96. At the current dividend rate, I can expect to receive quarterly dividends from NSC of $35.00, which is $10.00 more than what I was getting before this purchase. NSC will now contribute a total of $140.00 to my annual dividend income, which is $40.00 more than before. This purchase makes NSC the second-largest position in my portfolio, slightly behind MCD and slightly ahead of PM in market value.

It was nice to deploy some cash after a summertime lull. With the market near an all-time high, it has been difficult to find undervalued stocks. For that reason, it seemed appropriate to take advantage of the major drop in NSC today to lower my cost basis and increase my ownership of a great company. I still have enough cash on hand to make two more purchases, so hopefully Mr. Market gives me more good buying opportunities.