The Railroad Week in Review:
Week Ending July 24, 1999

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Burlington Northern Santa Fe (NYSE: BNI) was in town Tuesday and reported essentially flat sales, flat expenses, and a 7% drop in net income vs. 2Q98. The operating ratio remained constant at 76 and net margins decreased to 11.7% from 12.6%. Long Term debt is now $6.1 billion, up from $5.5 billion a year ago.

Ideally one looks for sales increasing faster than expenses, improved operating and net income, double-digit margins, and decreasing debt. BNI's quarter just ended wasn't much better than 2Q98, so positive trends may still be a bit away. EPS growth estimates for this year are thin, improving in 2000. The share repurchase program has kicked in again, dropping the shares outstanding by 7 mm shares or 1.4%. That's a start.

It was both educational and efficient to have Union Pacific (NYSE: UNP) and CSX (NYSE: CSX) not only in town the same day but also in the same room in back-to back sessions Thursday. Both had strong stories to tell and the parallels were quite striking. At the top of the list go the decisions of each to push operating decisions as close to where the wheel meets the rail as possible. The UNP cleanup in Houston clearly benefited, and Ron Conway, newly tapped CSXT Prexy, tells me he's making his Local Area Management (LAM) stick in the terminals. On to the results.

UNP was first up reporting four consecutive quarters of earnings increases, rebounding from the abyss of 2Q98. Matching that was four consecutive quarters of decreasing operating ratios, closing at a vastly improved 83, though that's still a dime north of where Chairman Dick Davidson would like it to be. The "cost of quality" metric stands at 15% YTD against a 1999 goal of 14% and 10% longer term. By way of review, the cost of quality is a measure of failure to do things right the first time: safety issues, poor car utilization, decreased car and train velocity. And to put that in perspective, every one MPH improvement in train speed will save $40 mm in car utilization.

Comparing 2Q99 with last year, revenues were up 6% to 2.8 billion while operating expenses decreased 16% to $2.3 billion. Car hire and fuel alone were down 13% and 10% respectively, thanks largely to running a more efficient railroad. Net income moved to a plus $189 mm from a $416 mm loss. There was a 212 basis point improvement in operating margin and the net margin was a modest 7% compared to 2Q98's unfortunate negative 16%. My only quibble from a Rule Maker standpoint would be the 16% increase in LTD, but, hey, if you're not making any money but you still have to spend it, it's gotta come from some place. I for one am encouraged (and remain long UNP).

CSX was up next, with the big news an agreement to sell essentially the water-borne parts of SeaLand to Maersk for $800 mm, retaining some US-only traffic in the Pacific (Guam, Hawaii, e.g.) plus some terminals (Hong Kong, e.g.). It was most gratifying to hear Head Marketeer Aden Adams expound on new single line moves from the former Conrail service area into the deep south, moves that never would have been possible under two-line haul economics. And it was a treat to listen to CSXT President Ron Conway on the benfits of Local Area Management as applied to CSX.

Turning to the numbers, revenues were up 5% to $2.6 billion, split about 60-40 between rail and water. Interestingly, CSX refers to its former Conrail Lines as "NYC" in the handouts, which fits with the split companies’ legal names: NYC LLC and PRR LLC. And NYC had second quarter operating revenue of $149 mm right out of the box while the original pre-merger CSX lines saw a $16 mm drop in revenue.

Operating expenses across the board rose 9% causing a 25% decrease in net income vs. 2Q98. The operating ratio actually went up three points to 89 while net margins, already thin at 6% a year ago, shrank further to 4% for the quarter. LTD increased slightly (2%) to $6.6 billion. The word from the dais was the "merger is done." If so, we should see a turn-around in these results in due course. Wall Street looks for a 40% improvement in earnings for FY 2000, and that would be impressive.

In a July 20 letter to the STB Conrail Transaction Council Walt Trollinger, AVP Marketing at Norfolk Southern (NYSE: NSC) writes, "At the last meeting of the Conrail Transaction Council there were a number of questions and concerns raised in connection with service on NS since June 1. In light of these questions and concerns, we thought it appropriate to prepare the attached Customer Service Report. Copies will be available from our Marketing and Sales personnel and we will post it on our web site as well. Any assistance you can provide in disseminating the Report is appreciated."

It is as thorough a reporting of the state of the merger and split as I've seen. Trollinger's summary pulls no punches: "The service plan for our new Northern Region (former Conrail) has been and will be straightforward. We expect most NS shippers will see a return to more normal rail operations by July 31 as cars on line decrease to 238,000. During August we will continue to work on reducing the number of cars on line by an additional 5,000. Our plan includes gearing up for the fall traffic peak, contains considerable flexibility and recognizes that much of the former Conrail system is a just-in-time network.” From here the report delves into causes, impacts, resources and solutions with tables and charts sprinkled liberally throughout. It is truly worth a close read by every shipper, shortline, shareholder, and any serious student of the industry. See

That being said, one of the most troubling aspects of the Conrail transaction remains data interchange with shortlines and regional carriers. More than a year ago both CSX and NS were advised that neither of them had anything to match the pipeline reporting system devised by Conrail. In that system, the moment a car is waybilled to any Conrail connection on any originating road that car shows up in the destination road's pipeline report.

To date attempts to duplicate the Conrail system have not worked. One approach was to bunch customers according to delivering road. This frequently fails because not all customers are keyed the same way all the time, nor do they always get the same station or station spelling. So any car not matching the originally keyed customer data is literally lost. And when that customer is Ford, Georgia Pacific, Allied Chemical, or any other of a thousand large company household names it reflects badly on all players. An early and effective fix is devoutly wished for.

RailTex (Nasdaq: RTEX) continues to gain favor among the eight houses following: A.G. Edwards, Credit Suisse, Deutsche Bank, Kerchville, Merrill Lynch, Morgan Keegan, Olde, and Schroder. The consensus recommendation stands at 1.63 (1 is a strong buy; 5 is sell) on a consensus eps estimate for FY99 of $1.36 and $1.52 for FY00, up 14.5% and 11.4% respectively.

RTEX currently trades at $14 1/2, just 9.5 times the furthest estimate. Divide the PE of 9.5 by Growth of 11.4 (this year is mostly discounted anyway, so be conservative and use next year's growth) for a PEG of 0.84. Recall from last week that a PEG of less than one is a potential buy signal if everything else fits. The Price-to-Book ratio is 0.92 and Price-to-Sales is but 0.80 (recall rails as going businesses fetch 1.5 to 2.0 times sales). The 52-week high was $15 5/8, so the current price is about 8% off that, another good sign. Let's wait and see what happens to LTD when results are announced next week. If it goes down, that's another plus.

All in all, an encouraging week. NSC reports next Wednesday, and I’ll be there.

--Roy Blanchard

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