Norfolk Southern has had an impressive run over the past six months as its shares have beaten the S&P 500 by 7.5%. The stock now trades at $311.61, marking a 13.1% gain. This was partly thanks to its solid quarterly results, and the run-up might have investors contemplating their next move.

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Why Do We Think Norfolk Southern Will Underperform?

Despite the momentum, we're cautious about Norfolk Southern. Here are three reasons you should be careful with NSC and a stock we'd rather own.

1. Long-Term Revenue Growth Disappoints

A company’s long-term sales performance can indicate its overall quality. Any business can put up a good quarter or two, but the best consistently grow over the long haul. Over the last five years, Norfolk Southern grew its sales at a sluggish 4.5% compounded annual growth rate. This fell short of our benchmark for the industrials sector.

2. Shrinking Operating Margin

Operating margin is an important measure of profitability as it shows the portion of revenue left after accounting for all core expenses – everything from the cost of goods sold to advertising and wages. It’s also useful for comparing profitability across companies with different levels of debt and tax rates because it excludes interest and taxes.

Looking at the trend in its profitability, Norfolk Southern’s operating margin decreased by 4.1 percentage points over the last five years. This raises questions about the company’s expense base because its revenue growth should have given it leverage on its fixed costs, resulting in better economies of scale and profitability. Its operating margin for the trailing 12 months was 35.8%.

3. Free Cash Flow Margin Dropping

If you’ve followed StockStory for a while, you know we emphasize free cash flow. Why, you ask? We believe that in the end, cash is king, and you can’t use accounting profits to pay the bills.

As you can see below, Norfolk Southern’s margin dropped by 8.4 percentage points over the last five years. If its declines continue, it could signal increasing investment needs and capital intensity. Norfolk Southern’s free cash flow margin for the trailing 12 months was 18.1%.

Final Judgment

We cheer for all companies making their customers lives easier, but in the case of Norfolk Southern, we’ll be cheering from the sidelines. With its shares beating the market recently, the stock trades at 26.3× forward P/E (or $311.61 per share). At this valuation, there’s a lot of good news priced in - we think there are better opportunities elsewhere. We’d recommend looking at one of our all-time favorite software stocks.

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