Saturday, January 29, 2005


Workers are working in the coal mines. Australian workers and Appalachian workers are going down, down, down. China is now buying much of the Australian coal which means that Europe is now buying much of the Appalachian coal. Good news for Norfolk Southern Corporation (NSC) and bad news for Duke Power (DUK). Utilities are substituting coal for natural gas which is helping NSC's hauling business and hurting DUK in two ways. DUK needs high volumes of gas to earn profits on its pipeline business and it needs low coal prices to make good money on its power generation.

The past year was a very good year for NSC and it was a year of recovery for DUK. DUK lost a lot of money but was able to sell a lot of assets. DUK used the sale of assets to maintain its high dividend payment. Unfortunately some of the gas fired plants were sold for 20 cents on the dollar. DUK has outstanding convertible bonds that limit the up-side to the stock and the company has unfunded pension liabilities of around 386 million dollars.

DUK went up pretty good as the dividend looked better and better to bond buyers. Indeed since the bottom in February of 2003, the stock has moved from $12.50 to $26.00 per share. The turn-around specialist has sold 2.4 Billion dollars of assets to engineer the turn but the company still has under-performing assets that are up for sale.

NSC exploded in price as nationwide railroad car loadings were up 6% year over year and due to the heavy coal shipments NSC increased loadings by better than 12%. Of all the railroads, NSC has enjoyed the best operating ratios. The best thing about railroads is that no one is going to build a competing line to the same coal mines. If the demand is high, the railroads will haul the goods. When they wear the rails and equipment out, they will have to pay for the new but they really have no competition for much of their bulk shipments.

NSC sells at a discount based by most valuation measures. It has lots of sales, lots of cash flow, lots of assets, low PEG and an 8 year PEG payback. Buy the stock and you get a lot for your money. The operating leverage is outstanding. Revenues went up 16% this year and earnings grew by 50%.

At about the same point in the business cycle during the mid '90s, car loadings went up substantially three years in a row. In the mid '90s we did not have an energy problem feeding high utilization, prices and growth.

actually it is China that has the energy problem. China produces 400,000 megawatts of electricity, 300,000 by coal fired plants. It produces 9,000 by nuclear plants.

The China GDP is growing by leaps and bounds. According to Goldman Sachs, China will out-produce the UK this year, Germany by 2010, Japan by 2015 and the US by 2040. In addition to buying a lot of coal from Australia, the country has planned 27 new nuclear plants to open by 2020. The most recent to open boosted nuclear production from 7,000 to 9,000 megawatts and another plant will open in a few months. There is a five year gap before several more of the plants will open.

We can all speculate on how much the current price of oil is due to the current terrorist risk premium but no one really knows. We do know that after a major increase in the price of oil, it has always taken several years for supply and demand changes to take the spike off prices.

We also know that building power plants consumes a lot of capital and puts upward pressure on interest rates. Regardless of the nuclear plants, long-term interest rates normally rise as an economic expansion unfolds. This means the DUK dividend may need to go up to stay competitive with bonds. DUK will turn a profit from this year but not enough to justify a dividend increase. Therefore the only way the dividend can keep pace with a rising bond rate is for the stock price to go down. This is what happened back when nuclear plants were being built in the US. DUK and other utilities did extremely well after the rates finally peaked in the early '80s but it took several years of bad returns before that good streach hit.

I don't actually believe DUK will decline much in price but I believe NSC will go up a lot in the next 5 years. Although high demand for coal is good for NSC and bad for DUK, during the first four weeks of 2005, there has been a "flight to quality". Treasury bonds and Utilities have been among the beneficiaries. The threat of lower growth took a couple of dollars off the price of NSC. An opportunity presents itself. Investors can pick up a growing company cheaply and sell a contracting company at the best price in years. (I am down very slightly on the swaps I made earlier but I am confident the trade will look very good a year from now.)

Dr. Ed Yardeni expects railroad earnings increases of 22% in 2005 and 16% in 2006. Multiples, which are at discounts to the S&P may not expand but they are not likely to contract in this climate. In other words one might expect to make an average of 19% per year if earnings do grow at the forecasted rates. There are always ifs and buts. The weight of the evidence suggests that holders of DUK and other Utilities should consider NSC for a swap.


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