Surprise Surprise, UP

An amusing highlight during UP’s call came when both UP COO Eric Gehringer and CEO Jim Vena discussed how they handled the increase in container volume coming through LA/LB.? From the call,

[Analyst]: So Eric, I had a question for you on the intermodal train speeds.?The data we're looking at from the outside looking in, those numbers are trending kind of as low as they've been.?We've seen some issues on dwell at the West Coast ports as well.

So how do I reconcile some of those external data points with the performance that you guys are driving in the results today in terms of talking about the best of the train length has ever improvement in intermodal customer service.?I'm just trying to square that circle because it's come up in a couple of client conversations.

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[Eric Gehringer]: Yes.?Thank you for the question, David.

Here's how I reconcile it.?It tells you that [a car velocity of] 220 is not as good as we can be.?Because to your point, we've seen dramatic improvements in both the manifest and bulk side.?And while we've seen improvements on some lanes and intermodal we've continued to work to be able to improve that.

Now let's be really frank,?33% increase in international Intermodal without much advanced notice if any advanced notice, I'm very proud of what the team has accomplished to be able to handle that.?.

Now what do we have to continue to do to build back that intermodal speed that you're talking about with the things we're doing right now.

So when we talk about deploying our buffer resources, that's taken the form of locomotives and cars into the L.A. Basin.?We've staged our trains across the system so that we take every train -- excuse me, every car that we can into the ports, and we take every car that they can give us back.?We work closely with the CSX and the NS to ensure that our interchange points remain fluid.?These are the things we need to continue to execute as we continue to capture that volume.?And I expect in short order that, that intermodal speed will turn the other way and that will continue to add on top of the excellent performance we have already.

[Jim Vena]:? So David, I need to just sort of add on a little bit from what Eric said.

So I followed up with both L.A. and Long Beach board beer earlier this week.?And we both came to the same conclusion.?No one told us first or second quarter that we were going to see a 33% increase and it was an event that happened because of East Coast ports issues, the Canadian issues.?The big question is how did we handle it??And you know that when something happens that is thrown on you, you start moving intermodal equipment and you don't get the same speed, then you don't get the same velocity.?And we knew we were not going to be able to maintain that.?But let's see where the success or failure by the supply chain.?Ships are not being held out at LA Long Beach.?They are arriving and going on the way they normally do with that kind of increase in business.

As far as the fluidity of our terminals, we're in great shape.?We've been able to turn the containers and the customers have done a fantastic job of pulling those containers off and delivering.?The only place that we'd love it if we have been able to plan it is we'd have faster velocity if we could have been told that it was coming and seen it a little sooner, so we could place cars in the right place work on the terminals we have at the West Coast a little differently and be able to speed it up.

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While it may be convenient for UP to blame a sudden increase in international intermodal as the problem, the data tell a different story.?

First, UP intermodal train speed has been dropping fairly steadily from its peak of 33.7 mph in Q4 of 2023.? As the chart below shows, intermodal speed has been declining all year, not just in Q3 as a result of the increased container volume coming into LA/LB. Manifest train speed hasn't been too hot either.

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Second, despite the acknowledgement of a need for buffer resources repeatedly by UP, intermodal train speed is now down below 2022 levels.? Now, I’m not an intermodal expert and I would have to dive deeper into the network to figure out where the bottlenecks are and get a better understanding of the system to know how much of this is due to UP or external factors.? However, if your current buffer regime can only net you performance that is poorer than even the bottom of the 2022 debacle, I wouldn’t call it much of a buffer.

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This is the fear that most shippers I talk with have about any positives in current rail performance: Once volumes comes back it won’t last.? This is the first time I’ve looked at any railroad’s operating metrics in probably a year or two because I don’t believe it means anything until volume comes back.?

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And it looks like that fear is justified.? Depending on how much demand was pulled forward this year, UP is on track to do comparable intermodal volumes to 2019.? Yet 2019 train speeds were some of the best since that time.? What changed?

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Additionally, did UP really not see higher intermodal volumes coming?? Or, again, did they just get caught with their pants down because they didn't keep enough resources in reserve to handle the higher volumes??

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We knew there were going to be larger volumes in 2024 than in 2023.? The ILA strike also shouldn’t have come as a surprise.? Now, maybe you didn’t think a strike would happen, but would you really not have a plan in place if it did?? Is railroad demand forecasting really this bad?? Does UP not have boots on the ground in Shanghai/Shenzen to track volumes headed to the US?? Where are their economists?? This is 2024.? There is so much data available and so many analytical forecasting tools for a company like UP.

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Maybe I’m being unfair.? No one has a crystal ball.? Maybe forecasted volume growth in international intermodal far surpassed expectations and they did the best they could.

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Or maybe Class 1 railroads are under pressure to trim costs, drive up prices, and continue to book low OR’s.? How much buffer do you really need?? A better question maybe is, “How much buffer will Wall Street let you get away with?”

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Overall, it seems that Wall Street was unimpressed by the Class 1’s performance.? Norfolk Southern was the only Class 1 to see any positive stock price movement after its earnings call.? Every other Class 1 dropped, even CN which narrowly beat its EPS expectations.? What did Wall Street see in NS that it didn’t in the others?

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Cost cutting.? NS parked another 200 locos and the crowd went wild.? Does NS have some fat to cut?? Maybe.? I always expected someone like a John Orr or Jamie Boychuk to be able to come in and drive some operational improvements.? But is this anything more than a one-time sugar high?

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Short-term vs Long-term

One of the questions that I’ve pursued almost since I started Hum was, “How should you run a railroad?”? I’ve been pretty vocal in my criticisms of current railroad management practices.? A quick summary of my thinking would be the following points:

• Railroads were on death’s doorstep before Staggers.? Staggers gave them the green light to shed unprofitable lines, control pricing, and consolidate.? The creation of Amtrak pre-Staggers was also important.
• By the early 2000’s, industry consolidation was complete and railroads exercised their newfound pricing power and scale economies to drive profitability.? PSR is just a name for a specific application of this reality.
• Focused profitability turned railroads into cash generating powerhouses allowing them to not only reinvest in their infrastructure, but also to return far more money to shareholders.
• After 20 years of increasing profitability yet declining volumes, railroads have hit diminishing returns in both cost cutting and raising prices.
• Despite these diminishing returns, Wall Street would prefer railroads to continue on the conservative path of doing the same thing rather than reward growth initiatives or any risk taking.
• A complete overhaul of Class 1 management strategy, culture, and organization is required to regain volume growth. An organization with 20 years of muscle memory to pursue A is going to struggle to pivot to B.

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There is a counterargument to the above.? What if the current strategy employed by railroads is the best way to run a railroad?? Maybe declining volume growth but healthy returns is the profit maximization outcome both in the short-term and in the long-term given the current realities of the North American freight market.? Here’s why that could be true.

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The railroads are faced with a tough economic environment, post-COVID.? ZIRP era financing coupled with a boom in truck-friendly freight from ecommerce caused truck capacity to balloon.? Additionally, declining coal demand domestically, falling commodity prices, and the missing 2023 retail inventory stocking peak all hit the railroads right where it hurts.? (See “BNSF in Trouble ”).??

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If you buy into the idea of commodity supercycles like I do (Jim Rogers wrote a good book on it that I read years ago), China drove the last commodity bull market from roughly 2000 to 2014-2015.? We’re now in the middle of a commodity bear market, which obviously is a drag on a lot of traditional rail businesses. If convention holds (a big IF), this bear market has at least another 4-7 years to run. That's a serious headwind to the near-term futures of traditional rail-favored commodities.

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The government just released the US Q3 GDP numbers this week which showed the economy grew at a rather robust 2.8% over the quarter shown in the chart below.

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GDP growth was driven by consumer spending, which has continued to surprise most, including yours truly, given inflation.? Part of the explanation for this behavior comes from rising asset prices and a split in spending, with higher income earners far outspending more cash-constrained lower income earners.? In other words, the rich have continued to get richer and have an increasing amount of disposable income to throw around, especially since the massive wealth transfer of COVID stimulus payments.

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And it’s really no surprise that higher income households are driving consumption.? Higher asset prices (homes, retirement accounts, equities, etc.) allow consumers to feel they’ve got more income to spend, while those who own fewer assets are counting on wages to rise faster than inflation to stay in the black.

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The dollar index shows another reason for this comfort level of US asset holders.? The chart below shows that the dollar is enjoying its strongest value recently since 2003, setting aside the narrow COVID-induced spike.

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A strong dollar makes US manufactured goods less competitive in the global marketplace and the GDP chart above showed that the US continued to expand its trade deficit to prove it. Here’s another chart from the great Brad Setser to make that even more clear.

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This brings up a quote from a recent Michael Pettis’ article that I posted a while back.

“...because U.S. trade and savings imbalances are partly, or even mostly, driven by industrial policies implemented abroad, this means that U.S. unemployment, debt levels, interest rates, the competitiveness of the U.S. manufacturing sector, and many other aspects of the U.S. economy are also affected by these policies implemented abroad. The idea that the United States controls these and other major aspects of its economy, in other words, is just a fantasy. In a hyperglobalized world, no country can control its domestic economy unless it controls its trade and capital accounts.”

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I’m becoming more convinced from what I’m reading that as long as the US continues to print dollars for the world economy and continues to run deficits to balance the surpluses of countries like China, US manufacturing will continue to face challenging headwinds.? To reverse this trend (higher income households with rising asset prices driven by foreign cashflows into the US, greater purchasing power for higher income household consumption of goods and services, lower income households with compressed wages and fewer blue collar job opportunities), will require dramatic social and economic changes.

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To spell all of this out more clearly as it relates to freight transportation: It is likely that we’ll see continued international imports (Amazon) driven by higher income consumer spending and a strong dollar at the expense of domestic manufacturing, at least in the short to mid term.?

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So how do you manage this reality if you’re a Class 1 CEO?? Two choices, continue to batten down the hatches, cut costs, cut headcount, and weather out the storm for US domestic manufacturing or pivot to focus on growing market share in the only sector that is growing appreciably: Intermodal.

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Class 1’s will do the first even as they pay homage to the second.? To really pursue the second, Class 1’s will need to drive up OR’s as they absorb a lower ARPUs and compete with a supply glut in the trucking industry.

There's a lot more dive into on what it would take to pivot to intermodal (like maybe pushing aside IMCs to regain the customer relationship and taking a greater share of margin), but that will have to wait until another time.