On February 3, 2023, a Norfolk Southern train including 149 cars derailed in East Palestine, OH. The derailment included 38 railcars, 11 of which were tank cars carrying hazardous materials. Toxic gases were released and burned after the accident to prevent an uncontrolled explosion. A 1-mile evacuation zone was implemented affecting up to 2,000 residents. There were no reported fatalities or injuries. The hazardous materials included vinyl chloride, used to make PVC, which is known to cause cancer.
There are many ways to analyze the accident. Of course, we have great sympathy for the nearby residents of the area; however, as portfolio managers we need to consider how this tragic accident affects the long-term investment case for Norfolk Southern Corp (NSC). From our perspective, if we do not sell a holding on any given day, we are effectively buying it. Therefore, we have continued to “buy” NSC through this accident.
The market’s initial reaction to the accident was relatively muted. The derailment happened after market close on a Friday. On the following Monday, NSC was down over 2% – more than the market but not drastically more. The stock was relatively flat the rest of the week but started to fall more the following week as the extent of the accident and NSC’s responsibility became more apparent. Two weeks post-accident, NSC is down about 11% while the overall market is down about 4%. The underperformance is material but does not indicate the damage to NSC is irreversible.
Insurance is part of the reason NSC will weather the financial burden of the accident. NSC is insured per incident up to $800M (up to $1.1B for specific perils) after paying $75M. Estimates of NSC’s total liability range, but it’s likely over $75M, which translates to a negative $0.25 in earnings per share (EPS). This compares to the $13.72 in EPS NSC is estimated to earn this year. Obviously, NSC’s liability could increase past their insurance limit, adding to the total cost. For perspective, a 2013 Lac-Megantic Rail accident resulting in an explosion, destruction of 40 buildings, and 47 deaths cost $500M to $1B.
If the accident may only cost NSC less than 2% of 2023 EPS, why is the stock down at all? NSC’s total liability, and the time it takes to settle that liability, is still unknown. There are also concerns about how the accident will affect rail volumes, future capital expenditures, and the competitive posture of Norfolk versus other alternatives. There are also reputational risks to the company.
We believe NSC will fully recover. This is partly due to the barriers to entry in the rail industry. NSC is one of only 7 remaining Class 1 rails left. NSC’s network is also particularly appealing as it serves 60% of the US population and 50% of manufacturing. NSC spends $1.5B to $2B per year on property and equipment to maintain this network. Another reason is NSC’s strong financial position. The company generated $2.3 billion in free cash flow in 2022, giving the company plenty of liquidity to cover its initial liability. The company has also behaved transparently following the accident. For example, NSC was testing air and water quality within an hour of the accident and has fully cooperated with the National Transportation Safety Board.
We believe in the long-term viability of rail transportation. Trains are demonstrably safer than trucks and up to 7 times more fuel efficient. Rail transport is considered the safest mode of transportation for carrying large amounts of hazardous material. The only alternative is trucks since many of these chemicals cannot be transported by pipeline. According to the Bureau of Transportation, from 1975 to 2021, there were 380 fatalities from hazardous materials incidents due to truck transport and 23 due to rail transport. Leaks and spills of hazardous materials happen with rail transport, but much less frequently than with planes and trucks. The USA Today found that, when compared to rail transport over the last 10 years, leaks from planes occurred twice as often and leaks from trucks occurred 67 times as often.
The East Palestine accident is tragic but by all accounts, NSC is acting responsibly. The thesis for investment in rail companies in general (barriers to entry), and NSC in particular (strong financials and a well-positioned network), remains intact.