The Railroad Week in Review:
Week Ending June 6, 1998

The week was of to a great start with Merrill Lynch lynching the rails. CSX slipped to long-term accumulate from buy while kept as near-term neutral. BNI was lowered to long-term accumulate from buy while kept as near-term accumulate. NSC fell to long-term accumulate from buy while maintained as near-term neutral. And UNP got dropped to long-term accumulate from buy while kept at near-term neutral.

A related story in Reuters notes that all rail stocks took a drubbing as the STB nears closure on Conrail and folks are worried about what conditions are likely to be imposed. Having each of the four major rails take hits Tuesday pulled the Transportation Average down a full ten points.

Analysts see it different ways. Merill Lynch's Mike Lloyd thinks regulatory changes could eventually affect near-term earnings potential and railroads' ability to earn their cost of capital. Burton Strauss of Dominick & Dominick sees "some concerns about Union Pacific and its ability to turn itself around, and that's obviously going to influence that stock for a while," according to a Reuters story.

I'll say. Tuesday's news that UNP's long-time CFO White Matthews had suddenly resigned "to pursue other opportunities" may well have had something to do with UNP hitting an intra-day low of $44.50. In this regard, a regular correspondent notes, "When the CFO leaves the ship suddenly, your money ought to follow quickly."

Across the board equities of the four major US carriers seem to be approaching full price even now. Based on a combination of Zack's rankings (5 is BUY, 1 is sell NOW) and forward estimates, NSC carries a ten percent premium while CSX could still go another $15 or more. BNI and UNP fall in between. Business- wise, when considering balance sheet strength, equity appreciation, and railroad strength, BNI remains the clear winner with CSX in second place.

The other over-$5-a-share rails I follow are GNWR, RTEX, PWX, and WCLX. Omitted are KSU nor RAIL as each makes more money in non-railroad businesses than in our favorite activity. Looking at potential for price appreciation, all do better than the majors, though WCLX and CSX are about the same. GNWR remains Zack's Number One price pick among all rails. Oh the other hand, WCLX retains a handsome lead viewed from the perspective of total railroad enterprise.

The first shoe has been dropped in the Conrail merger process. For two days this week more than 80 witnesses trooped before the STB for their 5 minutes of fame, hoping to win approval for their individual requests for "conditions." (I'm reminded of the Jewish Mother in Bye Bye Birdie who said she suffered from a "condition." The line was, "And if there's one thing medical science can't cure, it's a condition." QED.) The other shoe drops Monday when the STB (all one or two of them) votes.

In testimony over the two days there were pleas from truckers who feared their loads might shift in intermodal service. Senator Al D'Amato (R-NY) wants to sue for more rail access in HIS state (never mind NY has done more to run off the rails than any other two states), and Linda Morgan is saying the STB might reconsider its position on monopoly preservation. Labor wants no vote till it gets a board it likes, and shippers are saying if government could make a monopoly in Conrail it can jolly well un-make it now. But above all, said one wag, "Be careful what you ask for. You might get it."

There's been an interesting thread off-list regarding dividends. Do you pay them or not? UNP last year paid 90% of cash flow in dividends; BNI paid 20%. GNWR and WCLX have said categorically they will not pay any dividends preferring instead to reinvest in the railroad. The view from here is that as long as the investor can do better in terms of equity appreciation leaving his dividends with the railroad than he can buying groceries with them the former is the more prudent course. After all, the prudent investor seeking income buys a bond, right?

Now comes Emons Transportation (EMON) which pays a third of income in preferred dividends and calculates common earnings per share -- which drives stock price -- by what's left. What would happen is EMON were somehow to convert the preferred shares to common without significantly increasing the present number of diluted shares?

EMON has the capability to increase its net by about 30% a year. Net income per common share for the FY ending 6/30/97 was $0.09. Restore what was taken for the preferred and common income becomes $0.12. Extend that out two years at 30% a year and get $0.20 a share for a 2-year PEG ratio of 16 based on today's share price of $3.00. Target price for any share is a PEG of 100, which gives us a target price for EMON of around $18.

For the fiscal third quarter ending 3/31/98, results were impressive: carloads, revenues, operating income and net income all up double digits, despite some weather-related obstacles in January. Without the preferred (above) income for three quarters would be 12 cents a share, and that projects nicely to the 16 cent estimate for the year ending 6/30/98.

Last week I remarked about the smaller (class 2 and 3) rails' sharper ability to "match the commitment to the capability, the service to the need." Long- time rail student and shortline General manager Bill Burt adds that the bigger a railroad gets the tougher it will be to manage. Burt, whose Livonia Avon & Lakeville serves an exponentially growing customer base southeast of Rochester, observes that as the merging class 1s of the 1980s grew in size they "devolved" marketing and service functions into easier-to-manage service lanes. See the "Florida Business Unit" of CSX and the BNSF's north and south operating units.

The end result, writes Burt, is that you now have semi-autonomous operating units that act like the smaller predecessor units yet which cannot compete with each other as parallel routes or lines between the same O-D pairs are rationalized. However prior to devolution the trend immediately post-merger will continue to be super-railroads that are "too slow to sense changes in the environment [and] too hidebound to react quickly."

Concluding the thread, Burt cites the work of Yale's Kent Healy, who 35 years ago wrote on the problems of scale in the railroad industry, noting that mid- sized railroads work best. A manager, said Healy, can only do so much in his span of control before things begin falling through the cracks. Places that worked well before time caught up with them include the Rio Grande, Lackawanna, NKP, and WP. Perhaps WC would fit the mold today.

The fact remains that present class 2 and 3 railroads have managers whose span of control is small enough things don't fall through the cracks and where the service can be tuned to fit the need from day to day. It's how you keep carload velocity up, locomotive idle time down, overtime under control, and track maintained. It's how you get stock price multiples that are closer to market averages than the substantial discount seen by rail stocks at the moment.

--Roy Blanchard

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