The Railroad Week in Review:
Week ending April 1, 2000

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The STB on Friday issued its Advance Notice of proposed Rule Making (ANPR) in major rail mergers (see Recall that at the end of the recent four-day marathon of Ex Parte 582 hearings the STB felt that it was time to take a fresh look at its merger policies. Ergo this ANPR.

The Board notes the present merger rules were adopted nearly 20 years ago in response to the Staggers Act when there were patently too many miles of redundant railroad in the land. "The merger regulations encouraged railroads to formulate proposals that would help rationalize excess capacity so long as competition, access to essential service, and other public interest goals were not degraded."

The ANPR notes further, "The goals of that merger policy have largely been achieved. It does not appear that there are significant public interest benefits to be realized from further downsizing or rationalizing of rail route systems, as there is little of that activity left to do. Looking forward, the key problem faced by railroads -- how to improve profitability through enhancing the service provided to their customers -- is linked to adding to insufficient infrastructure, not to eliminating excess capacity."

The issues are quite broad, ranging from shortline access to safety, from service continuity to enhancing competition. A significant observation is buried in Footnote 10: "Joint marketing arrangements, which enable railroads to offer joint-line service almost as seamless as single-line service, could be more practicable and more likely to be in the public interest when the carriers connect largely end-to-end, rather than competing over broad territories." Public comment is invited.

For the second week in a row class 1 rail stocks set no records, plus or minus a percent or two. Only CP showed any real strength, up 15% for the week, on no news we could see here. Shortlines fared somewhat better with EMON, GNWR and PWX up from 2% to 15% while RAIL lost 5%. Again, no news. The vendor side saw ho-hum results from the week's trading, further proof that investors are keeping rails at arm's length.

Hardly a surprise. The ANPR above is one shoe to drop. The outcome of the Board's deliberations will be another shoe with its decision likely to have significant impact on railroads of all sizes. Railroad suppliers are being squeezed by railroad purchasing departments' efforts to limit the number of vendors they deal with (see for March 2000). Moreover, Wall Street has roundly criticized the major rails for spending too much on capex.

RailAmerica vs. Amazon (WIR 3/25/2000) drew a surprising amount of commentary. From San Francisco an equipment lessor e-mails, "I am writing in response to your comparison of RAIL and AMZN. I don't have access to the data, but would hypothesize that rail stocks in the early days of the transcontinental railroads were getting multiples that were much larger than the rest of the market. Any ideas on how to get some historical data to see how the rails were valued in the early days of the industry? [Who can help here? Any of our investment analyst readers?]

"On the West Coast, we are watching all this from ground zero. There is a huge advantage to being the early player in a new market with paradigm shifts. The market is valuing certain stocks accordingly, and these stocks will trade at multiples of sales rather than earnings until the industry structure becomes more established."

Shortline CFOs found fault with our comparison, especially in terms of the relationships between debt and market capitalization. A friend in the midwest notes, "While your recent comparison of RAIL and AMZN makes some interesting points, your financial ratios are way off the mark. Amazon's $1.5 billion of debt represents only 6% of its market capitalization. This difference comes from the fact that the stock market values AMZN much greater than the sum of invested equity capital and historical earnings. I hope RAIL is successful with its strategy and the market eventually recognizes the value of railroads, but your analogy to AMZN is a real stretch."

Well said. The fact of the matter is AMZN has 200 times the market cap of RAIL and debt is consequently a much smaller part of the overall picture. Through September last year (the last period for which we have numbers for both) AMZN took on $1.2 bn in new debt, 5% of market cap; RAIL took on $159 mm of new debt, 127% of market cap. Debt service was 0.7% of AMZN market cap and 107% of RAIL market cap. And therein lies the rub. A huge market cap propelled by broad investor belief in forward earnings potential makes life challenging for a bunch of bright folks trying to do good things in an "old economy" industry.

From his desk in western NJ, a contributor sends this e-mail: "Apropos this week's WIR (3/25), and our conversation last week: I've been thinking about the problem of disaggregating the industry without doing a (UK) Railtrack (which does not seem to work). I sense that a government-owned common infrastructure would be such anathema to the railroaders (and to me, for that matter) that we need to find a private sector way of doing it without its having to tie up great amounts of new capital.

"The model could well be the terminal railroad, jointly owned, a giant BRC if you will. All the class 1s pool their r-o-w's, c&s, maintenance of way, and dispatching systems and then anyone can operate anywhere. There is a charge for it based on a formula, and anyone can bid to have certain tracks upgraded to meet their service requirements (including Amtrak). Short lines have a franchise to operate at a similar access charge within so many miles of their interchanges (including the ability to serve customers and interchange with other short lines), and customers can run their own trains, too (the UPS express?).

"Effectively, the non-rolling physical plant becomes a large-scale cooperative owned by the Class 1s and open to all, but securing the benefits of that openness back to those who put the assets into place to begin with. It could actually generate competition, and the service could conceivably be a lot better than it is now."

A bulk truck operator from Chicago, a friend and trusted source for over 15 years, adds, "I agree with you that there is a market for a $6,000 merchandise boxcar in a trans-con move. There is even a market for an $8,000 boxcar move. The Class 1's are tripping over their regionalized operational thinking, yard to yard operations, that was in vogue when you had to operate in this fashion over 50 years ago!

"Railroads are not too big to have scheduled and dependable operations. They need to hire people who are production flow oriented and trained, who can create a flow plan that results in scheduling and a service that a shipper can count on. You do this, and the truckers will have to become concerned!"

To conclude, a class 1 correspondent observes that there are economic bars to the concept of shortlines becoming the IMCs (Intermodal Management Companies) of the carload business. The point is well-taken that "There is too much money at stake for the class 1s to turn over all the pickup and delivery to local service providers." His employer's branchlines sport some of the highest revenue densities in the business - densities that are significant multiples of what we see on the typical shortline.

The economic realities of railroading in the 80's that spawned so many shortlines in the first place - high crew costs, high MOW repair and replacement costs, low equipment utilization - are gone. Two man train crews, letting track degrade to an FRA class appropriate to the service, and a focus on equipment velocity have rapidly ratcheted class 1 branchline costs downward. My correspondent continues, "With revenue densities as high as they are the amount of money we'd have to turn over to local players to do the branch work would run to the hundreds of $millions. And I dare say our expense reductions wouldn't approach a fraction of the shortline allowance paid." Food for some serious thought.

--Roy Blanchard

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