Equity research note on Norfolk Southern Railway with regulatory and tax outlook

rate, given its 37% current effective tax rate (at 30% adds $10 to valuation and at 20% adds $25 to valuation), as well as additional infrastructure spend (more aggregates, cement, rebar, etc...), focus on domestic manufacturing, and repatriation of capital, which could aid GDP growth. We target NSC to post sustained double-digit EPS growth and significantly improve free cash flow. Table 1: Norfolk Southern key stock data Industry Railroad Market Cap (mn) $33,393 Price $108.82 P/E (2017) 17.3x % of sell-side rated Buy 44.8% Short interest % of float 1.19% Source: Bloomberg and BofA Merrill Lynch Global Research estimates Deregulation/Gov’t Legislation: The Surface Transportation Board, an independent governing body, formerly under the Department of Transportation, is set for a significant turnover, with a Republican taking control of the chairmanship, and 2 new members being added to the 5-person Board (up to this year the STB was a 3 member Board). The potential for negative impacts from mandatory open access and rate of return calculation adjustments may be reduced given the change of administration, which would be a positive for the railroad group. Tax Policy: Given their domestic focus, Transportation companies are the highest effective tax payers in the Industrial and Basic Materials group, with the U.S.-based railroads averaging a 37% effective tax rate. At a 20% tax-rate, EPS would jump nearly 30% (though full capex expensing could reduce EBIT to offset a sizeable portion of the gain). Additionally, cross-border tax increasing cost of goods sold for manufacturing goods could slow GDP, impacting carload growth over time. Catalysts: Near term catalysts include accelerating carload growth, coal turning positive for the rail industry this week, after 90 consecutive down weeks, and NS’s upcoming January promise for additional details on its targeted efficiency gains. The company is set to post a sub-70% operating ratio for only the 2"¢ time in the past 20 years, a target we would expect to improve further in 2017 and beyond. Latest report: Raise estimates and PO to $122; Volumes trending above target October Upgrade report: Time to look at things differently; Raise to Buy 1Q risks: Norfolk Southern has posted 9 consecutive weeks of carload growth, indicating underlying economic growth, with relatively easy comps into 1H17. Thus, risk includes carload growth slowing or turning back negative, as well as increased concern on macro GDP growth rates given fear about new fiscal policies (cross-border tax, full capex expensing) which could compress EPS. Additionally, if the expected discussion on efficiency gain details in January is not provided as expected, investors could lose confidence that management will stick with and/or meet its 2020 target. Additionally, if corporate tax reform is not passed, multiples that have expanded on some reduced tax rate could re-compress. Company Description: Norfolk Southern Railway operates a 21,300 route mile railroad network in 22 eastern states, District of Columbia, and Ontario, Canada. We target it to generate $10 billion in 2016 revenues and a sub-70% operating ratio (hitting that target Bankof America <> Merrill Lynch Top 10 US Ideas Quarterly | 03 January 2017 —-11 HOUSE_OVERSIGHT_014632