The third quarter earnings of railroads were down primarily due to falling coal volumes caused by a weak global economy. Of all the railroads, the slowdown hit Norfolk Southern (NSC) the hardest as the company's earnings per share fell 27% year-over-year.

However, despite the company's struggles in the third quarter, there are encouraging indicators that the world economy could be on the rebound. Specifically, there are indications that Chinese manufacturing and exports are on the mend. If this trend continues, it could have a positive impact on NSC's earnings over the next couple of quarters.

China is a big importer of coal

NSC's third quarter earnings revenue declined 7% due to a fall in coal and merchandise volumes. This decrease coincided with the slowdown in the Chinese economy, which is the largest consumer of coal in the world, consuming over 40% of the world's coal supply.

However, recent data out of China suggest that the economy could be rebounding. Retail sales in the country grew 15% in October compared with a 14% increase in September. Additionally, Chinese exports grew 12% during the month, an increase from 9.9% growth in September, Bloomberg reports. Another signal of a potential rebound in China is the sequential increase in its manufacturing indexes, as Reuters reports, which are correlated with greater coal usage.

Excess capacity can now help NSC when recovery begins

In our article on Norfolk Sourthern's third quarter earnings, we had expressed our concern on the company's high operating ratio of 72.9%, which increased by five percentage points compared to the same period in 2011. However, if coal volumes do pick up over the next few quarters, we think that NSC's operating leverage could pay huge dividends for the company.

NSC's management did not cut costs like we advocated, but the capacity that it kept during the third quarter will help keep up with volume increases if the Chinese rebound leads to an increase in coal volumes. However, we should note that coal volumes have a long way to go to reach their previous year levels and that, to maintain good profitability, NSC's management will likely need to mix revenue increases with cost cuts.

Conclusion

We think the new data coming out of China could be good news for the world economy and coal companies. These improvements are likely to cause an uptick in coal production, which will help railroads who ship coal freight. However, we think that caution is still warranted as this is only one quarter's worth of data and we need a continued run to see whether or not the decision by Norfolk Southern's management to not cut capacity was the right one.

We currently have a $63 price estimate for Norfolk Southern, which is approximately 10% above the current market price.