Norfolk Southern currently trades at $243.68 per share and has shown little upside over the past six months, posting a small loss of 2.6%. The stock also fell short of the S&P 500’s 5.1% gain during that period.

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We're swiping left on Norfolk Southern for now. Here are three reasons why you should be careful with NSC and a stock we'd rather own.

Why Do We Think Norfolk Southern Will Underperform?

Starting with a single route from Virginia to North Carolina, Norfolk Southern (NYSE:NSC) is a freight transportation company operating a major railroad network across the eastern United States.

1. Weak Sales Volumes Indicate Waning Demand

Revenue growth can be broken down into changes in price and volume (the number of units sold). While both are important, volume is the lifeblood of a successful Rail Transportation company because there’s a ceiling to what customers will pay.

Over the last two years, Norfolk Southern’s units sold averaged 1.7% year-on-year growth. This performance was underwhelming and suggests it might have to lower prices or invest in product improvements to accelerate growth, factors that can hinder near-term profitability.

2. EPS Barely Growing

Analyzing the long-term change in earnings per share (EPS) shows whether a company's incremental sales were profitable – for example, revenue could be inflated through excessive spending on advertising and promotions.

Norfolk Southern’s EPS grew at a weak 2.8% compounded annual growth rate over the last five years. On the bright side, this performance was better than its 1.4% annualized revenue growth and tells us the company became more profitable on a per-share basis as it expanded.

3. Free Cash Flow Margin Dropping

Free cash flow isn't a prominently featured metric in company financials and earnings releases, but we think it's telling because it accounts for all operating and capital expenses, making it tough to manipulate. Cash is king.

As you can see below, Norfolk Southern’s margin dropped by 7.9 percentage points over the last five years. It may have ticked higher more recently, but shareholders are likely hoping for its margin to at least revert to its historical level. If the longer-term trend returns, it could signal higher capital intensity. Norfolk Southern’s free cash flow margin for the trailing 12 months was 13.9%.

Final Judgment

Norfolk Southern falls short of our quality standards. With its shares trailing the market in recent months, the stock trades at 18.4× forward price-to-earnings (or $243.68 per share). At this valuation, there’s a lot of good news priced in - we think there are better investment opportunities out there. We’d suggest looking at an all-weather company that owns household favorite Taco Bell.

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