Growth (Part 1)

Sometimes I go back and read my articles after publishing.? I did that for last week’s article, “BNSF in Trouble," and, in my haste just to get it done, I realized there was a lot I wanted to write about that didn’t get mentioned.? I’m going to try and elaborate a bit more on what I started last week and, hopefully, spend much more time on what BNSF can do about it.

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What the Rail Industry Doesn’t Understand About Growth

The industry has the wrong strategy.? Even those who are trying to embrace more growth-oriented principles, haven’t figured it out, or at least Wall Street won’t allow them to figure it out. ?Before I can explain why the industry has been lost in the wilderness, we need to start with dispelling common beliefs about growth in order to understand exactly what growth looks like.

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To begin, let’s look at some business strategy principles as illustrated through a few basic examples.? Every business strategy can generally fit into one of three buckets: growth, profitability, or both/neither (stagnation).? Dress it up however you’d like, but you’re either focused on growing sales (volume, not just through pricing), expanding margins, or pretending to do it all while (likely) doing very little of either.? Focus is important.

Amazon is a great example of going all in on growth rather than focusing on short-term profitability. I wrote about this way back in "What's in a RR's DNA?"

Jeff Bezos famously pushed aside investors repeated calls for profitability for years. He laid out the original strategy of growth to market leadership by reinvesting every penny into the business rather than return it to shareholders. From the 1997 letter to Amazon shareholders:

"We believe that a fundamental measure of our success will be the shareholder value we create over the long term. This value will be a direct result of our ability to extend and solidify our current market leadership position...We will continue to make investment decisions in light of long-term market leadership considerations rather than short-term profitability considerations or short-term Wall Street reactions." (Amazon Letter to Shareholders, 1997).

Like the chart above shows, Amazon didn't ease off the growth lever until 20 years(!) after it started.

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Most public companies are stuck in bucket number three.? Their leaders were trained to be managers, to grow in safe, steady, incremental ways.? This is fine, except many markets do not maintain a “steady as she goes” path.? External factors – war, weather, technology, to name a few – disrupt “business as usual.”? And when that disruption occurs, the underlying fundamentals of a business can change quickly, leading to deteriorating results.?

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Suddenly everyone’s shocked and the business tanks.? Southwest, Boeing, GE, NS even, you could name a hundred examples.? If a business isn’t prepared for what’s next, it suffers. ?Waiting until the disruption occurs is like waiting to put your seat belt on after you’ve rolled the car.? (Or like relying on hot box detectors to alert an engineer once a bearing has already failed).

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Let’s look at a hypothetical business to see what the three different strategies (growth, profitability, stagnation/decline) look like.

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Making Widgets

Widget Co. makes widgets.? Recently, Widget Co.’s widgets became an integral part of Hot Product, a massively popular consumer product.? Sales are through the roof and Widget Co. can’t make enough widgets to meet demand.? Widget Co.’s management decides to open up new manufacturing lines, distribution centers, and hiring anyone who’s able to pass a drug test.? Business is great!? Widget Co. is making money hand over fist and Hot Product sales are through the roof.? This is the growth stage.

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In order to maximize profits, Widget Co.’s management decides to pour every dollar back into the business through investing in capacity/yield increases.? Time is of the essence, so it doesn’t matter how much new equipment/land/labor costs.? Just buy it all and get as much product out the door because you’re going to make more money simply on volume.

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Times are great and Widget Co.’s founders love it.? They file an IPO (initial public offering) and take the company public, ringing the bell at the NYSE, etc.? Then the business starts to slow up and the buzz of sleeping on the factory floor starts to fade.? Now sales are harder to come by and the market matures.? The existing Widget Co. leadership team starts to check out and a different type of person is brought in, “the manager.”

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Shareholders want the switch flipped from growth to profitability.? There’s a lot of profit to be harvested from a hastily put together business.? Manufacturing lines are only running at 40% efficiency, there’s duplicate parts and materials everywhere, pricing is all over the place – the professional managers excel at the snip tuck motions needed to harvest more dollars from the business.

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This works great!? Profits increase even as sales decrease.? The company is much more efficient.? Better systems and processes are put in place.? Lots of good things happen.

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But there’s only so much juice you can squeeze out of an orange.? As a capitalist, the focus is always profit maximization.? Eventually a profitability strategy will hit diminishing returns, just like a growth strategy can only mine so many dollars out of an existing market.? A company’s board of directors should be flipping the switch back and forth between growth and profitability in order to find the best course that maximizes profits.

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This is where the rail industry is today.? The simple illustration below shows the spectrum of growth vs profitability in business strategy.? I’ve plotted the history of the industry on where I think it has been on the spectrum.? I’m glossing over a lot of nuance here, but hopefully it conveys the concept.

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PSR Isn’t Growth

Since I started writing Rail Stuff, I’ve targeted what I’ve felt are the flaws in PSR that have fooled the industry for years.? PSR is a profitability strategy, not a growth strategy.? One of the biggest issues over the past 10 years for the industry has been confusing the two.

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To be clear, I do believe there are very good, smart elements of PSR.? Focusing on lean-based operating principles like reducing train starts, increasing train lengths, reducing handling/switching, etc. are exactly what any rail operator should be pursuing.

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However, there are also many issues with the PSR-mentality, primarily focused on the commercial element.? Speaking as an ops person, PSR is largely what happens when the operators have run the company for too long.? You can become so focused on your corner of the world (operations) and trying to run the process better, faster, stronger that you don’t realize what’s on the other side of the fence.

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In fact, after my last article, which highlighted the structural flaws in BNSF’s core business, I got a comment that I was wrong because BNSF was really good at running a lot of trains.? I don’t fault the guy for his perspective, (BNSF is really good at running a lot of trains) but it highlights an operations-first, customer-second mindset that is so prevalent when operators are in power in a company.?

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I know because I was there!!? At ADM, when we were asked to run harder to take advantage of a market opportunity, the first thought was, “Can’t do that because these machines need maintenance to run well,” or “Don’t make me go up in rate because I just got this process lined out and yields are really good right now.”? The operator wants to run better and that comes by reducing variation and complexity.? “Any color so long as it’s black.”? The problem is what the operator wants doesn’t always align with what the customer wants.

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The best leaders in industrial companies, generally speaking, are those who have hands-on operational experience but also have an above average understanding of the commercial constraints of running a business.? See Keith Creel.

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My biggest issue with PSR is that it’s a profitability strategy being stretched and sold as a growth strategy.? Nothing could be further from the truth.?

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To summarize my arguments from the many previous articles I’ve written on the subject, I would state it this way:

• PSR is, first and foremost, a profitability strategy.? Profitability strategies will unlock earnings growth through OPEX reduction and pricing increases; they will not unlock earnings growth by growing volumes because the mindset, personnel, skills, etc. that make someone successful at being profitable are at odds with what it takes to drive volume growth.
• A profitability strategy is best implemented when volume growth is slowed or slowing in an effort to increase earnings growth absent organic market growth.? PSR in a post-90’s mega merger time period was the right time for implementation.
• The basic economic law of supply and demand shows that increasing prices and reduced OPEX through cuts to sales and services (i.e. decreasing customer welfare), reduces customer volumes.? ?This bears out in the data as volumes have dropped while prices have steadily climbed since 2004-2006.
• These actions are fine and even correct in the pursuit of continuous earnings growth that isn’t supported by volume growth from the market.? However, an inability to switch back towards volume growth once all the profits have been squeezed out of the existing business is just as devastating to earnings as is an unwillingness to raise prices/cut costs.
• The notion that PSR increases customer volumes through improved service, neglects to recognize that ever increasing prices and reduced customer welfare (fewer customer service reps, fewer days of service, fewer lanes, disruptive schedule changes) counteract any additional customer welfare attributed to improved service.? At best, it’s a wash.? At worst…further modal share erosion to the trucks.?
• Improved service, in and of itself, does not beget growth.? You can’t put a dollar in your customer’s pocket with one hand, pick his pocket with the other, and then complain when he stops handing you dollars.
• Existing Class 1 sales folks I’ve heard from are largely demoralized, frustrated, and handcuffed.? They can’t lower prices to capture a market opportunity.? Most are siloed and are disincentivized to work collaboratively across commodity groups/customers to enhance organic sales.? Lots of complaints about bureaucracy.? Many are looking for their next opportunity elsewhere or just hanging on until retirement. (I’ve gotten a lot of messages in my inbox to prove it).

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There are two types of growth: organic and inorganic.? Organic growth comes from generating sales within the bounds of the company’s existing business units, its R&D unit, capturing a greater share of wallet from existing customers, or prospecting new customers.? Inorganic growth comes through mergers and acquisitions.

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(Sidenote: M&A is the easy path when growth slows.? As a market grows, many new companies enter and profits are competed away.? From a profit perspective, markets should consolidate as they contract until there’s a balance between available profits and companies to service those profits).

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So how do BNSF and the other Class 1’s flip the switch to growth?? Stay tuned for Part 2 with a return to our friends at Widget Co.