THE BLANCHARD COMPANY

The Railroad Week in Review:
Week Ending December 4, 1999


SS Investor's J.P. Gulli now and then writes in the Analyst's Corner of multiplexinvestor.com. This week he says that many investors are so zeroed in on a penny or two eps they are missing the big picture. Continuing an ongoing Week in Review theme, he writes, "Long-term investors should pay strict attention to a company's overall returns on invested capital (net operating profits as a percentage of ALL the capital tied up in the company).

"For example, a company may grow earnings by 15% and still destroy shareholder value. Particularly if it must pour more and more capital into the business just to maintain this growth." And that's why we watch the debt/equity ratio very closely.

Because railroads are so capital intensive it takes a strong cash flow story to keep things humming. At one end of the spectrum we have Union Pacific (NYSE: UNP) laying out $2 bn a year on capital improvements, one-fifth of revenues. At the other end, a shortline with $8 mm operating income on $50 mm sales and $5 mm interest expense will have less cash to put into track and power. And we all know what scrimping on those critical two does to service, to revenue generation, to the operating revenue, to profits, and to shareholder returns.

The Financial Times (www.ft.com) reports the UK government plans for partial privatizing the London Underground were derailed. John Prescott, deputy Prime Minister, withdrew RailTrack's exclusive option to take over one of the three contracts. Says FT, "The timing of the announcement was particularly embarrassing for Mr Prescott, who will today unveil the government's long-awaited transport bill including plans for tighter control of the railways.

"Rail experts close to the negotiations said the decision was taken because of RailTrack's failure to come up with a viable plan to integrate the Underground line into the mainline network. This represents a further set-back for RailTrack's ambitions to become a key player in the government's plans for an integrated rail network and follows its mishandling of the 4bn West Coast main line upgrading project."

The article skillfully avoids making any link between RailTrack's safety performance on the surface lines and the Paddington wreck. Others have not been so squeamish. Writing in November's International Railway Journal, Editor Mike Knutton suggests that the Paddington accident and an earlier one like it shows that "lessons -- especially about trains passing signals at danger [stop indication] - have not been learned."

A preliminary report on the October 5 accident suggests that the critical fixed signal SN 109 is one of many with impaired visibility, in this case an overhead girder. This particular signal has been passed "at danger" eight times in the last ten years, so it's not like nobody knew it was hard to see. What's more, there are another two dozen or so such fixed signals across the RailTrack network that have been passed at danger on seven or more occasions. Reports IRJ, the worst have recorded 15 or 16 such events.

The same preliminary inquiry discovered that the engineer ["driver," to the Brits] of the offending train had acknowledged the audible warnings of the restricting signals passed before coming up on SN 109, and even acknowledged passing that. He then accelerated and about 800 yards later drove into the Up-bound (to London) train. The latter had a clear signal and it would appear the track was lined for him to take the straight route while the offending train came at him from what would have been the diverging route. The combined speed of the two trains at impact was estimated to be more than 110 mph.

It does seem strange that in a high speed interlocking like this trains are not required to come to a complete stop before passing a red home signal, or that diverging routes in terminal leads are protected by automatics and not home signals in the first place. This lapse has to be laid on both RailTrack and the train operating companies (TOCs). RailTrack is at fault for not providing the most restricting environment with clear signal sight lines in its terminal leads. And the TOCs for not insisting on it. The PRR for one and the NYC subways for another had all that in the 1920s.

It's already been noted here that neither CSX (NYSE: CSX) nor Norfolk Southern (NYSE: NSC) have begun to see positive results from the Conrail transaction. It's a bit early, to be sure, and we've been warned by the CFOs of both firms that merger effects won't be accretive till Year Two. But will they, at least as far as shareholders are concerned?

A page C1 story in Monday's WSJ says a new study by KPMG International analyzed 700 of the most expensive mergers in the last two years. They found that 83% didn't increase shareholder value and more than half actually reduced it. The study cites "executive hunch" about their merger's prospects, adding that a majority of CEOs had no formal review of the actual results when the dust had settled.

Conrail went for, I think, $115 a share when the final gavel came down in mid-1998. CSX was $45 and NSC was $30 (split-adjusted). So if you owned CR, took the cash, and then split the proceeds between the successor companies, you'd be less well off today. On the other hand, if you'd taken your $115 a share in mid-1998 and plunked it into, say, America Online (NYSE: AOL) it would be a different story.

One share of AOL sold for $13 and change (split-adjusted) in June 1998 and closed at $78 Friday, giving you a six-bagger. No wonder the tech and Internet stocks are walking away with all the marbles these days. Even in Friday's 247-point rally, up 2.24%, the 14-railroad market basket tracked here rose only 94 basis points. The S&P was up 1.7% and the Nasdaq 1.94%. So it's not that railroads are a bad investment today, it's just that there are so many better places to put your money if you don't want it languishing around waiting for something to happen.

In what has to be classified a very smart move, Emons Transportation (Nasdaq: EMON) Emons has folded two smallish Pennsylvania Properties into a new single entity. Gone will be the Maryland & Pennsylvania (affectionately known as the Ma and Pa) and Yorkrail. In their place will be the York Railway Company (YRC). The predecessors operated in the same geographic area in south-central Pennsylvania and actually met or crossed at several locations. Merging the two carriers into a new railroad will undoubtedly provide better service at lower cost, so EMON is to be congratulated on this excellent strategic repositioning.

Genesee & Wyoming (Nasdaq: GNWR) says its Australian subsidiary, Australia Southern Railroad (ASR) has signed a five-year service agreement with Broken Hill Proprietary Company Limited (BHP) for the management and operation of BHP Whyalla Steelworks' rail network. The five-year renewable agreement with BHP for the operation of two narrow gauge iron ore lines and in-plant switching operations at Whyalla is worth in excess of $US 19 mm over its first term.

This no small undertaking. ASR will obtain a five-year renewable lease over 190 km (120 miles) of track and a fleet of 113 ore cars. It will also purchase outright BHP's existing fleet of eight diesel locomotives for a total of $US1.5 mm and has committed to a $US2.2 mm track upgrade program over the period of the agreement.

It should be noted here that in June BHP set a world record for the heaviest and longest train with an electronically controlled pneumatic (ECP) braking system. The 240-car train was powered by five 4,000 HP Dash-8s from GE, was 7,000 feet long, and weighed in at 37,500 tons. One has to wonder how much that track maintenance bill comes to every year.

It's off to the CSX annual shortline meeting near Jacksonville on Sunday. It promises to be a rewarding experience.

--Roy Blanchard


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