How Realistic Is Norfolk Southern's Path To M&A?

• Following its third quarter print on October 28, Norfolk Southern Corp. NSC started to climb steadily in BMO Capital Markets’ list of preferred railroads.
• The stock has surged more than 23 percent since the report date, especially following Canadian Pacific Railway Limited (USA) CP's acquisition offer.
• Having attained most of the upside implied in BMO's fundamental thesis, analysts Fadi Chamoun and Devin Dodge decided to downgrade Norfolk's stock's rating from Outperform to Market Perform.

Norfolk's call provided improved visibility over a substantial cost reduction opportunity in 2016, "projected modest revenue growth in the merchandise and intermodal segments, moderating coal headwinds, and attractive valuation at a ~20% discount to the market prior to the flare-up of M&A activities on November 9, 2015."

In fact, the BMO analysts expect to see the company recuperate some of the lost share in intermodal rail service, reaccelerating domestic intermodal growth into 2016: "Intermodal growth tends to have attractive incremental profit contribution even in a modest pricing growth environment due to the network densification opportunities."

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However, the stock's outperformance following Canadian Pacific's acquisition offer has eaten into most of the upside provided by the firm's fundamental thesis. While the analysts can envision a situation where Norfolk could receive an offer above its current trading levels, they see "the overall path toward M&A being very long and fraught with regulatory risk. Moreover, if another round of railroad M&A does get under way, there would likely be other merger announcements."

Taking into account the substantial surge in the stock's valuation, the analysts believe the risk/reward profile is not as attractive as it was, neither as alluring as it is in other railroads "with little or no consolidation premium built into the current multiples," such as Union Pacific Corporation UNP and Canadian National Railway (USA) CNI, and to a lesser degree, CSX Corporation CSX.

An investment in Canadian Pacific might also prove an attractive option to Norfolk, "as it would allow for participation in the benefits of a potential merger but with stronger underlying fundamentals in the event that discussions don't proceed."

Disclosure: Javier Hasse holds no positions in any of the securities mentioned above.