The Railroad Week in Review:
Week Ending October 16, 1999

The announced purchase of RailTex (Nasdaq: RTEX) by RailAmerica presents some very interesting ramifications. Looking at the 2Q99 results, RTEX has much the stronger North American presence, which RAIL offsets with the stronger offshore franchise. RTEX has a stronger balance sheet in terms of debt/equity and number of shareholders. Yet each has about the same revenues ($45mm RTEX, $41 mm RAIL), the same operating ratio (low 80s), and net margins (7%, plus or minus).

The essence of the transaction is that RAIL will pay $13.50 cash plus 2/3 of a RAIL share for every share of RTEX. Thus RAIL will pay $126mm for the shares plus another $61 mm for 2/3 of the shares at the 10/14 close of $9.75 per RAIL share. In addition all the RTEX debt will be retired, $123 mm, for a transaction value of $310 (the press release says "about $325 mm"). The cash price is $249 mm, 1.55 times RTEX 1998 revenues of $161 mm, certainly ballpark for a shortline deal.

The parties expect $10 mm in synergies achieved by eliminating duplicate facilities and combining admin functions, so combined gross margins should increase to provide an OR in the mid 70s, though net margins may not change much. Total debt will double to about $400mm, reasonable with a combined $208 mm going in and another $200 net new debt for the cash purchase. Interest expense will nearly double, even with anticipated savings of 200-300 basis points in the interest rate. Gary Marino said the equity base would be in the $130 mm range so the debt/equity ratio comes in at a highly-leveraged three to one. In the conference call they were talking debt/total cap of about 80%, which is about right at these levels. Look for interest coverage in the neighborhood of two times.

As a rail system, RAIL will operate more than 12,000 miles of track in four countries and three continents. Though Marino said none of the properties are contiguous, many are close enough to create some interesting routing alternatives. Bridging over other shortlines and using the Rail Industry Agreement negotiated with the class 1s (for new business only) come immediately to mind. Moreover, the new RAIL will have a total cap of about $225 mm (which will get Wall Street's attention) and Year One revenues of $450 mm. Maintaining a 7% net margin produces earnings of $32 mm or $1.60 a share. Give it a rail industry multiple of 15 and you begin to see some possibilities.

Last week's Review set off the expected affirmations and commentary, though there were none who denied my suggestion that class 1 market managers do not necessarily take every cost into consideration when making rates or deciding how to treat a shortline revenue requirement or allowance. In the case where shortline allowances are perceived as being too high it's often because in the course of rate negotiation there's money left on the table. The Four P's of marketing are Product, Price, Promotion, Placement -- the last of which is transportation among other things. If the market rate for a move is $3,000 and in the rate negotiation process there is $1,000 left on the table by the time the shortline gets to name its requirement, the SL will pick it up. I've seen it happen, and it happened because the class 1 rate negotiators did not understand the economics of the move and the shortline did.

Fellow rail observer Randy Gustafson puts the argument in a political framework, something I had not considered. He writes, "Local and state governments have a huge stake in these operations, from an invested capital/debt, jobs standpoint and for future economic development. For the class 1s to change their approach from growing shortline partnerships to an analysis of the revenue stream is fraught with implications that the sales managers usually aren't held responsible for their initial [partnership] analysis. The class 1s involved risk immense backlash from involved, powerful local representatives in local partnership with the shortlines, that can (and will) be felt through the political and regulatory process."

Jill Evans at JP Morgan has knocked her rating on Norfolk Southern (NYSE: NSC) down a peg to Long Term Buy from Buy. She cites "lingering eps impact from Conrail integration, less compelling valuation vs. peers." That's pretty accurate. I saw a report the other day that NSC incurred $100 mm in congestion costs and diversion in June alone.

Recall the NIT League survey did not give NSC exactly rave reviews for the last two months, so it would seem safe to say the same kinds of costs will reappear this quarter. To put $100 mm in perspective, NSC has 380 mm shares outstanding, so this hit comes to two bits a ticket. Coincidentally, the consensus estimate for 3Q99 has dropped to 95 cents from $1.27 in the last 60 days. Roughly two bits a ticket.

Elsewhere, NSC is following the lead of Florida East Coast (NYSE: FLA) by setting up a subsidiary company to sell fiber-optic and microwave capacity to telecommunications companies. With nearly 22,000 miles of right-of-way at its disposal it's a natural fit. The new firm, Thoroughbred Technology and Telecommunications Inc., doing businesses as "T-Cubed," will sell the bandwidth as a wholesaler to providers of telephone, Internet and cable TV service. Taking a page out of Bob Enestis' FLA book, NSC wants to use this asset for shipping the digital freight of an increasingly electronic economy.

FLA is making significant strides on the rail side. It has rounded out its management team by hiring Reggie Thompson away from privately-held Wheeling & Lake Erie to run the commercial aspects. The new interchange agreement with shortline South Central Florida Express allows it to tap into the lucrative sugar trade formerly the exclusive domain of CSX. On the operating side the NS haulage agreements and running a scheduled railroad keep equipment rents down and ROIC up.

There seem to be no published earnings estimates for FLA. However, we can get a sense of where this new management team is taking FLA by comparing last year and this. The company took one-time charges of $0.14 a share in 2Q99, reducing earnings to a dime vs. $0.36 in 2Q98. Absent accounting hits, earnings came to $0.24 a share vs. $0.36 a year ago. For this first six months, however, earnings were $0.70 vs. $0.55 last year, up 27%. Revenues quarter-to-quarter were flat at $62 mm, however YTY for the six months revenues were up 44%. We ought to see 3Q99 results week after next.

Wisconsin Central (Nasdaq: WCLX) made the news this week with these three tidbits. One, Tranzrail -- the New Zealand rail company of which WCLX is the majority owner -- is close to inking a new coal deal with its largest customer, Solid Energy. That business had been off 20% thanks to the Asian financial follies. Elsewhere, General Counsel Janet H. Gilbert has been appointed Vice President of Wisconsin Central's North American System. And Al Pierz was enticed over from Chicago's Metra to become Director of Purchasing.

Union Pacific (NYSE: UNP) will lease 1,000 new SD-70s from the Electro Motive Division of General Motors (NYSE: GM) over the next 3-4 years. As a result, the average age of the UNP loco fleet will drop by 5 years and the number of different loco models will drop to 18 from 33, considerably easing the parts management burden. Some 1,500 units will be freed up for sale or lease. Shortlines please take note.

Genesee & Wyoming (Nasdaq: GNWR) posted a 48% increase in its Sep North American carloadings YTY. This number includes GNWR's 95% stake in the Canadian Genesee Rail-One (GRO) network but not the Mexican operation which only started in Sep. Excluding GRO carloads were up 19% for the month with three quarters of the increase in coal. GNWR says coal was up thanks to stockpiles returning to normal following plant maintenance at its customers' plants and a switch to PRB coal at others. Australia traffic increased in the month of September by only 2.9% as increases in all other commodities offset the loss of coal business.

--Roy Blanchard

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