The State of the Freight Rate with UP

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First, A Note on Wayside

I’ve had several conversations recently about wayside detectors that I thought would be good to share.? This comes up at times in relation to our Hum Boomerang wheelset condition monitoring sensor.

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The mission of Hum is to make rail safer and smarter.? For now, that means we’re going to deploy specialized sensors on railcars.? With the Hum Boomerang, we can provide car owners, shippers, and railroads, with the predictive condition of the railcar’s wheels and bearings.

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This device has led some to ask, “Are you trying to replace wayside detectors like hot box or acoustic bearing detectors?”? Not at all.? That is zero sum thinking.?

For whatever reason, I think railroads and others in the industry get stuck in cost savings mode where the only value attributed to a technology is based purely on eliminating some preceding technology.? It completely misses the value creation side and focuses purely on just doing what you're doing today, but better. Onboard railcar monitoring has the opportunity to vastly improve operations and service in a number of dimensions just beyond measuring a bearing's temperature.

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The value of the Boomerang is two-fold: Safety and Efficiency.? It accrues to railroads in the form of higher quality rolling stock on their infrastructure that reduces the risk of derailments, reduces the risk of damaging infrastructure, and reduces the risk of operational delays caused by emergency maintenance.? In fact, I believe there’s so much value in certain areas for railroads that they should be incentivizing car owners to put it on their cars.? Hazmat, especially.

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In our white paper, “Bearing Derailment Prevention,” we highlighted how BNSF increased adoption of DOT-117 cars in ethanol service on their railroad by offering rate discounts.? Railroads could use this same mechanism for car owners that equip sensors like the Hum Boomerang and adopt a predictive maintenance program.

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Returning to wayside detectors, yes, if every railcar were equipped with the Boomerang you could phase out the wayside detector system.? But if I was a railroad, I wouldn’t do it before that point which is a long time in the future.? Even if the mandate came down from on high that every railcar needed to be equipped with onboard bearing condition monitoring technology, it would still take more than a decade to outfit the entire North American fleet.?

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There’s no rush whatsoever to try to pull the plug on wayside, and no economic need either.

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Is the UP the Best of the Bunch?

Class 1 railroad earnings calls can generally be broken down into about four questions from Wall Street:

1. How well did you grow revenue?
2. Was it because of price or volume?
3. How well did you reduce expenses?
4. How are we going to get our money?

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There are a lot of exchanges like,

Wall Street: “Will you tell us what you expect to make?”

Management: “We’re not going to give guidance.”

Wall Street: “[Clever reframing of the same question]”

Management: “No. Stop asking.”

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That’s generally how these calls go.? The focus over the past several quarters has been on pricing.? Railroads aren’t growing volumes, especially in a freight recession, and I would say that we’ve pretty much hit the floor on how much more cost PSR is able to squeeze from the system. ?(NS is probably the last to find that floor).?

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Inflation has been driving up expenses which, in the absence of any real life from the freight market, have only compressed margins.? That leaves railroads with two options to grow earnings: Cut costs or increase prices.

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UP was an interesting case to follow on this behavior.? In terms of cutting costs or managing expenses at least, UP has been a smooth operator for two quarters.? I broke the Class 1 operating expenses into two general categories to examine how well each is controlling spending.? These are Discretionary and Non-Discretionary spend.? Discretionary spend would be things like Purchased Services and Equipment Rents.? Non-Discretionary spend would be things like Comp and Benefits, Fuel, and Depreciation.? These aren’t perfect groupings, but I think they’re a good approximation on what a railroad can control vs. what they can’t control when trying to reduce spend.

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The chart below shows five of the six Class 1’s and their year over year change in spending for the first quarter.? I left CPKC out of it because 23Q1 was the last quarter pre-merger and I didn’t have the time to go through the effort of rationalizing the data.

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You can see from the chart that UP had the largest decrease of discretionary spending (-6.6%) while BNSF had the largest increase (23.0%).? (BNSF spent an additional $358m y/y whereas UP spent $59m less).?

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To me, that’s the sign of a good operator – the ability to scale operations up and down based on market demand. ?Did UP cut too deep?? Did BNSF leave too much fat?? Really can’t say without a deeper dive.? I would assume that the reduced OPEX at UP indicates a lot of deferred maintenance.? Does this matter if volumes are down and track/equipment should require less incremental maintenance?? No idea, although you would expect to see something like increased CAPEX spending in the future if UP did cut too deep.

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Now, let’s look at pricing.? I don’t know if they have a Bible at these investor conferences where you have to swear on it that you’ll raise prices to the “Value of our service,” but my goodness would that make a great drinking game.? You’d be hammered within 10 minutes.

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Sticking with UP, I think there was a good exchange at a recent investor conference where they discussed pricing as a headwind vs a tailwind to earnings.? From the Wolfe Research conference,

Scott Group: I think, to me, one of the positive surprises from Q1 were some of the yield trends.?When I look at yield ex-fuel, Jennifer, up 3.5% in Q1, right??And I'm guessing there was some positive mix within that.

Jennifer Hamann: There was.

Scott Group: Your point about mix in Q2, should we assume some sort of deceleration relative to that 3.5%??Is that what you're trying to suggest?

Jennifer Hamann: I'm trying to suggest or just say, our mix is going to be negative in the second quarter.?I don't think hugely negative, but we're going to go from a positive mix to a negative mix, and that obviously flows through the yields.

Scott Group: And -- okay, that's helpful.?I want to think about underlying price for a little bit because I think it's -- for so many years, we've talked about rails' duopoly businesses with pricing power, and it was sort of a given, inflation plus pricing power.?And we -- and all the rails continue to say it, right??Jennifer and Jim, I'd love to get all your perspective on this, right??You now -- Jennifer, you now talk about inflation, pricing dollars, exceeding inflation dollars.?But you've also said?price/cost maybe is not a tailwind to margin this year.

I think that is one of the big keys for the rails broadly.?When do we get back to price/cost as a tailwind to margin??And it's been this, we've had this unprecedented price/cost headwind.?Is there -- do we have visibility to a catch up??Could it be a multiyear catch-up on price/cost??I'm -- I'd love to get all your perspective on this.

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Jennifer Hamann:? So a couple of things, Scott.?It does take us multi-years to price through our contract.?We do have, call it, 50% of our book of business is in multiyear deals.

And so there is going to be some catch-up as we work through those deals to be able to actively price them.?There are escalators on those, but then there are limits to some of those escalators that are prohibiting us from fully keeping up with the inflation we saw over the last couple of years.

So that's part of it.

The other part of it is what happens with inflation.?It's starting to come down, but we have another 4.5% wage increase that goes into effect July 1.

So if you look historically, we would say inflation was probably in the 1.5%, 2% kind of range.?The last couple of years, we've been 5% plus.

So there is a bit of a headwind there that's going to take us a bit.?I'm not going to give you a prediction of when we're going to turn that tide.?We're going to turn it as soon as possible.?But part of it is what we can control in terms of our ability to go out and price in the market.?And then part of it is that inflationary environment and what happens there, again, coming back a bit, but not still back to what I'll call more historical level.

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Jim Vena:? So if I -- Scott, if I could summarize it, one is every contract doesn't come up every year.

So we have some contracts that give some flexibility so that the people we partner with can react to market conditions.

“So those things as they come up, we'll have to deal with that.?But we are pricing, and we price to the value of what we deliver, and what we deliver is a valuable product that really on a cost per unit basis for the people that ship with us, makes sense for them to be on the railroad.?There's no other way that can give them that cost benefit.?And if we can have the service level high.

So when I -- the first time I was at UP in 2019, and I looked at the railroad and if 2024 was 2019, I'd set up here and say, "Don't worry about it.?We can outstrip costs faster than any inflationary pressure.

So that would take care of the issue directly.?But we don't have 1,500 locomotives we can park anymore.?We parked some more.?But -- so now it's taking it to the next level.?It's a lot of hard work, but we see that possibility using technology, using our infrastructure, training and teaching people and making sure we have the right processes.?And if you look underneath the numbers that you don't see every day, we get way more cars -- double-digit more car switched per employee.?We get a lot of things that are way better already…

I think we have pricing power because of the level of service and the value we give our customers.?If we were trying to price purely just because of inflation, I think that's -- you're going to lose that game.?Eventually, people will go somewhere else.?But the value we give our customers is high and it's worth what they pay us.?And we are going to price against that.?And I don't see anything slowing us down.”

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Maybe I’m just the cynical shipper and think that railroads like UP are going to jack up their prices to whatever they can get away with.? That’s not quite as romantic as the view the railroads have of themselves when they can achieve higher than inflationary prices “because of the level of service and the value [they] give [their] customers,” but hey, six to one, half dozen to the other.

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So, let’s see just how well UP has been able to re-price its business.? The chart below shows the year over year increase in ARPU (average revenue per unit) for each of its business units.? I included CPI (consumer price index) as one mark of inflation.? You saw Jennifer Hamann say labor comp was going up 4.5% on July 1.

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Any way you slice it, UP has not been able to outprice inflation from expenses.? In fact, with a really bad Q1 for coal and continued softness in the intermodal market, pricing power has actually decayed year over year.? On a weighted average of -0.21%, UP’s ability to price has remained flat.? I’ve included a chart on carload growth year over year just for kicks.

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I’m curious as to what the other Class 1’s look like, but I would venture it would be a similar story.

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There are a lot of nuggets in the exchange above that I’m not going to have the time to get into, but I think the questions around pricing as a tailwind/headwind are particularly interesting.? You wouldn’t bet against the railroads’ ability to increase prices to the extent that they are able to outpace inflation eventually, at least in non-competitive carload markets.? (Intermodal is still going to be a challenge for Class 1’s in more ways than one).

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I think this simple illustration is a good way to think about railroad margins at this point in time.

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In the short term, railroads are not able to outprice inflation because of their contract structure.? This becomes a tailwind that compresses margins.? That’s where we’re at right now.? In the mid to long-term, depending on what inflation does, you expect railroads to be able to increase prices above inflation and, therefore, expand margins.? Depending on when the freight market comes back, that would be another boost to earnings as new business would be coming on at a higher price than it left.

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However, if inflation remains at an elevated level and/or the freight market takes longer to come back, margins are going to remain compressed for some time.? If that happens, or if we remain in this “wait and see” type of market, Wall Street is going to get antsy and really push hard on railroads to reduce their cost structure.? That means more layoffs and more rationalization of the network.

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One crazy idea that I’m not going to be able to fully flesh out in this article is that someone (privately-owned BNSF cough cough) should lean into eating higher costs in the short term to really ride the market upside when it starts to come back. ?This would take some real conviction, but given the long delay between hiring crews and having them fully fit for service is 6+ months, I would start hiring at the “first sign of Spring” to have the network ready to handle capacity.? I would also lower prices, particularly for the competitive intermodal market, to go for share over margin.?

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You could say that’s what NS CEO Alan Shaw was trying to do, but timing is everything in business and his plan got derailed…by a derailment on top of the weak freight market.? Crazy idea, but there you go BNSF.? Why not?