THE BLANCHARD COMPANY

The Railroad Week in Review:
December 31, 1998


Week in Review got its start about three years ago when I was hosting the railroad message board at The Motley Fool's "Industry & Market Analysis" Area. One of the things we did to track the industry was to create a market basket of equal dollar values of stocks for each of 14 publicly traded railroad companies. Then we'd follow them for a calendar year.

The area still exists, and is now on the web (www.fool.com), however we've moved beyond the need for a host as a regular and lively bunch of posters keeps the threads moving. The market basket of railroads still resides (albeit on this machine) and it is that list which feeds the monthly win-lose commentary in WIR. One of the real-life values in following such a market basket and a main reason for including it here is so privately-held shortline railroad operators can track their own results against the broader universe.

Now, for the 1998 rail stock price appreciation winners, may I have the envelope please? The winners are KCS followed by Rail America, up 53% and 32% respectively with BNSF third (11%) and FEC fourth (10%). Note that of the four leaders, only one is a "pure" railroad. KCS has its Janus and Berger mutual funds. RAIL has its truck-making arm, and FEC is part of a larger paper and real estate company. CN and NS were the only other rails pure or otherwise -- posting stock price gains for the year.

Everybody else posted double-digit losses from EMON (off 19%) to GNWR (down 45%). The view from here is that a combination of the "Asian Contagion" and the UP/SP meltdown in the Texas Gulf kept everybody away. Even NS and CSX share prices are being held back by fears that their CR merger could run into Texas size difficulties (personally, I doubt it). As for 1999, the majors' earnings increases will be limited by the economy and their ability to win share from the trucks. Shortlines will have an opportunity to digest their most recent acquisitions and present some "same railroad" improvements, and we ought to see some double digit-gains beginning in the second half.

Investors with accounts at Charles Schwab have access to the "Analyst Center" which features various industries from time to time. This week, it's railroads, and the displays are enlightening. Their commentary is essentially that rails will be mediocre performers near term however the basic economic advantage of rail over truck will not go away. The Asian impact is largely gone and a robust economy at home will keep things humming. Nothing readers of this Letter don't know by heart already, however the statistical exhibits are worth a look to put the players class 1s, shortlines, and vendors in focus.

The STB has decreed that Union Pacific should keep what it has in Houston. The decision did not make happy campers out of many of the parties seeking adjustments to the merger, however the decision itself is invaluable in the way it shows how the STB thinks and decides. What follows is drawn nearly ver batim from the press release accompanying the decision. For the full flavor, go to www.stb.dot.gov, Decision 98-83.

Although the Houston/Gulf Coast Oversight proceeding was brought against a backdrop of the service emergency, the Board found that in many respects the case represented a continuation of the original merger proceeding. In the merger, UP paid a substantial purchase price for the entire SP system, which had a poor infrastructure but an attractive shipper base, particularly in the Houston area. In the merger proceeding, several parties had sought to open up access by having UP ordered to allow other railroads to serve shippers that were on its lines.

The Board adopted several conditions to preserve competition, but it did not open up access as some had sought. The STB did not adopt the "Consensus Plan" sponsored by a group of shippers, two affiliated railroads, and the Railroad Commission of Texas, saying that once the merger was implemented, it had helped to solve the emergency. The Board concluded that the Consensus Plan, which would effectively undo the merger in the Houston area, conflicts with its governing statute and with fundamental policies underlying it.

The essence of the Consensus Plan was essentially to open all possible shippers to more than one railroad, regardless of what services prevailed pre-merger. As in the NS-CSX-Conrail transaction, the board ruled that shippers served by a single line pre-merger would remain single line. Doing otherwise legislating one railroad access over the property of another to serve specific shippers constitutes open access, and that, friends, is beyond the scope of the STB's statute.

So, where does it all come out? The Board adopted a so-called "clear route" condition to enhance efficiency and facilitate the smooth movement of railcars through the Houston Terminal. Thus the joint UP/BNSF dispatching center at Spring, TX, will be able to route traffic through Houston over any available route, regardless of track ownership. A BNSF train may be permitted to operate over track of UP and vice versa. Tex Mex trains get to use both.

Additionally, the Board directed UP to report annually on how it is executing its infrastructure plan for the Houston/Gulf Coast region. Finally, the Board declined to rule one way or the other about any operational changes that UP might make in the future. Recall UP has committed to give advance notice of its operational changes and to make all necessary accommodations to preserve competitive operations over its lines.

Two bits of fall-out from the CN-IC merger. First, UP maintains, according to a report in the JOC, that the present merger package which includes a joint marketing agreement with KCS "skirts agency rules and would create a three-way merger." UP stands to lose about $150 mm if the deal goes through as planned, saying, "the entire application should be dismissed because it misrepresented the future commercial ties between alliance partners."Second, CP wants to buy out CN's half interest in the Detroit-to-Windsor rail tunnel which CN and CP now own jointly, arguing that each Canadian line ought to have its own tunnel. Back in 1995 CN completed a $155 mm double-stack cleared tunnel at Sarnia because the Windsor tunnel lacks the higher clearance required. The STB has said it will rule in May.

Norfolk Southern will spend $1.07 bn for capital improvements to its railroad operations in 1999, as compared with $903 mm in 1998. That's $651 mm for roadway projects (ROW) and $387 mm, both including some $300 mm for CR-merger specific items. ROW spending goes for roadbed (rail, ties, ballast, surfacing), bridges, signal and communications, intermodal facilities, and double tracking and siding extensions. Equipment vendors ought to be happy with orders for locomotives (all 6-axle), freight cars (including auto racks and coil steel cars), and the tools to get more mileage out of the present fleet. This includes the coal hopper rebody program, recertification auto racks, rebuilding hi cube boxcars and medium-cube covered hoppers, and modifying open top coil cars.

Frank Wilner's weekly "Rail Intelligence" newsletter reports that the Aussies are out to break the US' rice bowl for met coal. Three of the biggest will take an 18% price cut which could hurt US vendors and thus the railroads that serve them. And if US coal producers are expected to take a similar hit, guess who they'll be after to share in the hit. Elsewhere, Wilner says export grain shipments are off for the third year in a row, running about 60% of what they were in 1995. The PNW has been hit extra hard, while the Texas Gulf ports have actually seen some increase. Looks like BNSF and UNP will be the major losers on both counts.

Kansas City Southern stock is another one that can't seem to get going. The spin-off of the Financial Asset Management (FAM) arm continues to see just out of reach. The stock until this week has been trading in the low 40's and there are ten times as many puts as calls for Jan 45s. S&P now ranks the stock as ** (avoid) saying that stock market exposure of FAM could hurt. Mind you, this was written in Sep so should be taken cum grano salis. For myself, I continue to drive down my cost basis by selling covered calls out of the money. When it's called, it's called.

--Roy Blanchard


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