The Railroad Week in Review:
Week Ending May 29, 1999

A reader posts, "I understand that expanding intermodal traffic along the East Coast was a factor for the division of Conrail. Any opinions on the future of intermodal? Will we see truck traffic shift to rail?"

A truck driver (who is a regular and valued contributor) writes, "We should see more intermodal traffic, though whether it comes off trucks or is new business remains to be seen. My analysis is it will mostly be new business. I make this call because several of the major truck tractor manufacturers are predicting another record year of new truck sales, based on stronger orders so far this year compared to last year. Increased tractor sales will continue to demand more drivers, as there are more new tractors being ordered than there are used ones being traded in or sold outright. Unfortunately this results in more crowded roads and more accidents due to a higher proportion of inexperienced drivers."

Now segue from this observation to the Wall Street analysis that railroads have been overdoing it on capital expenditures. It stands to reason that if you're going to win business away from the highway haulers you will have to do a better job than the highway haulers as measured by the people who pay the transportation bills. Unfortunately, continued schedule delays and service disruptions are counterproductive. To eliminate these disruptive facts of life takes investment. Investment that is mandated by the years of neglect and "rationalization" of assets practiced by too many carriers over about 20 years.

CSX has put about $500 mm into double-tracking the old B&O main through Ohio. At one time that WAS a double track line. Here in Philadelphia the fourth track has been restored along the former Reading between Belmont Jct. and East Falls. In the North Jersey Shared Asset Area they want to re-double track the former CNJ Chemical Coast to avoid too much congestion on the former Lehigh Valley main from Newark to Bound Brook. Further west, look at what UP has done to re-double track bits of the old CNW in Iowa.

Since 1960 railroad industry revenues have grown (if you can call it that) at a compound annual growth rate (CAGR) of 3.8% per year while truck revenues grew at a 7.5% CAGR. Meanwhile US rail mileage has shrunk by 2.7% CAGR and operating ratios are down to the low 80s from the mid-90s. But in terms of market share, the rail/tuck ratio has dropped to 12/88 from 33/67. So how do you support continued capex at the rate of 8% a year over the past ten years?

Recall independent railroad analyst Tony Hatch warned of the "spiraling down" of railroad traffic-investment-traffic-investment in his recent White Paper. Paine Webber's Scott Fowler has sounded the same alarms in both Progressive Railroading and Traffic World. The argument is that you have to have the revenue growth to support these enormous capex programs, and absent the revenue you might as well buy back your own stock with the money you otherwise would have spend on track and locomotives.

The record shows that in 1998 alone revenue changes year-over-year ranged from a plus 6.8% (BNI) to a minus 4.7% (UNP) whereas operating income changes ran the gamut from a plus 3.0 (BNI) to a minus 11.9 (UNP). Which seems to fit: as revenues rise expenses rise proportionately and so operating income follows sales, and is as good a measure as you'll get about the core business of running a railroad. Trouble is, essentially flat revenues industry-wide make continued high levels of capex investment less justifiable than share buybacks at attractive (albeit depressed) prices.

So it's back to service again, a drum beat regularly in this space. Management guru Tom Peters writes in his classic tome, Thriving on Chaos, "The basic value-adding strategies include uniqueness, extraordinary responsiveness, superior service with an emphasis on intangibles, and providing top quality as perceived by the customer." Balance that with Scott Fowler's caveat, "while growth opportunities do exist, they must be balanced against the risks of creating excess capacity." In other words, use what you have to best advantage to add maximum customer value before putting more money into fixed plant than you need. It appears from the revenue and operating income growth rates we may not be maxed out in usable capacity quite yet. Now let's see some aggressive revenue growth.

If you want to see revenue growth in a railroad company, the sector to examine is the class 2 and class 3 railroads. By way of review, railroad class is a reflection of annual revenues as described by the Association of American Railroads (AAR). Class 1 railroads have sales exceeding $255.9 mm a year, class 2 roads have sales lower than that but more than $20.5 mm, and the class 3s are everybody else. It is precisely thclass 2s and 3s that can combine economies of scale with Tom Peters' customer value-drivers to generate YTY double-digit revenue gains.

The leaders in this group for 1998 are RailAmerica (Nasdaq: RAIL), up 62.6%, and Genesee & Wyoming (Nasdaq: GNWR), up 42.5%. And while it is true that RAIL generates nearly two-fifths of its operating income building specialty truck trailers, the rail side of its business is growing and will represent an increasing share of the pie going forward. A distant third place is RailTex (Nasdaq: RTEX) with revenues up 8.2% in 1998. The leaders' core businesses are doing nicely, with operating margins Wisconsin Central and Florida East Coast (NYSE: FLA) leading the pack at 26.7% and 23.3% respectively.

But here again, the rate of change in operating income continues to fall short. The best anybody could do was WCLX at a plus 3.4% followed by FLA at plus 2.5%. So while the big roads can't get the revenue train going but do keep operating expenses under control, the smaller railroads have the revenue-building ability but can't keep expenses down. And if anybody needs to spend money on track and power, it's the smaller roads. What's the answer?

Part of it lies in the so-called Railroad Industry Agreement (RIA) between large and small roads (see for a fuller explanation). Essentially, the RIA lets smaller roads increase franchises without adding significant cost by reaching out into cooperative agreements with the class 1s. And the class 1s get the revenues without incurring the gathering expense. Happily we are beginning to se the fruits of this labor in grain trains between shortlines and UNP and BNI. More work needs to be done, however, and the grain gathering business for one offers significant revenue increases to all without any capex at all.

The potential is there to provide superior service as measured by the customer with the plant capacity already in place. More operating income means more money for adding capacity. Yes, if you build it they will come. But only if you make it worth their while.

Washington is watching, too. Speaking before a group of New Jersey shortlines, STB Chair Linda Morgan cautioned, "Concerning re-regulation, if the class 1s merge and the shortlines are not providing an important role then the notion of open access will become more enticing as people see rail service going away. To stem this fate rail users start talking about adding competitors. Partnership between large and small railroads is critical.

"The more there is a sense of a level playing field the more members of Congress and the more customers will feel this new culture - a positive attitude toward the provision of rail service - is going to stay. The concept of partnership between large and small railroads has to stick. It's not just about shortlines finding new opportunities to work with the class 1s; the class 1s can look for more opportunities to work with the shortlines and that's the whole point." No capex required, either.

--Roy Blanchard

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