UP, Lemonade, and "Railnomics"
Jim Vena's appointment as CEO of UP last week highlighted, for me at least, the philosophical struggle within the rail industry of profitability vs. growth. (Yes, this is a dichotomy). So, why did the UP plant its flag where it did, how does that contrast with other approaches in the industry, and what, ultimately, should the railroads do to manage their businesses?
To better understand where things are going, it's helpful to look at some of the key drivers that got us to this point.
History
Post-Staggers, the rail industry was free to consolidate and consolidate it did. Mergers created increased economies of scale, but also excessive assets. Consolidating those assets, privatizing car ownership, and shedding low density lines (which in turn led to an explosion of shortlines) all reduced RR balance sheets and allowed them to invest in their business.
Freed from the shackles of rate regulation, the ICC, and passenger rail obligations, the RRs came off life support and were feeling great. Then they discovered pricing power followed by PSR. For the past 15-20 years, RRs have been on a steady path towards greater profitability by increasing prices while reducing their OPEX. Cash flow has been great and shareholders have reaped the benefits of a steady stream of dividends and share buybacks.
But while RR execs and Wall Street were busy patting each others backs, few seemed to acknowledge that the fox had found its way into the henhouse. After the mega mergers of the '90's, volume growth stagnated. Carloads peaked in 2006 before the long, slow decay to where it is today, a stunning decrease of 35% off the peak. Coal, with a 57% drop in volume from 2000 to 2020, still makes up the 2nd largest carload type by volume and all of that is going away. That's a huge hole. ORs are going down and RRs may be taking a bigger slice of the pie, but that pie just keeps getting smaller.
New Directions
Now that PSR has worked through the US RRs to make them lean and mean, a fresh direction was needed, or so the thinking seemed to go at the Class 1's. A new class of CEOs was brought in to make that happen. Maybe you can see a pattern from their work history:
BNSF - Katie Farmer: EVP Operations, VP Service Design and Transportation Support, Group VP Consumer Products, VP Domestic Intermodal and VP Industrial Products.
CN - Tracy Robinson: EVP and President, Canadian Natural Gas Pipelines. Prior to TC Energy, 27 years at CP in Commercial, Operations, and Finance. She was notably the VP of Sales & Marketing in 2012 when Hunter Harrison came to CP.
NS - Alan Shaw: EVP and Chief Marketing Officer, VP Intermodal Operations, Group VP Industrial Chemicals, Group VP Coal Marketing.
CSX - Joe Hinrichs: Ford Motor Company, President Global Automotive, President Global Operations, President Americas, President Asia Pacific and Africa, Chairman and CEO of Ford China, Chairman and CEO of Ford Canada.
Every one of these new CEOs came with extensive customer-facing experience. CSX even did one better by hiring from a customer (who also happened to have extensive labor and government relations experience).
Enter UP, who announced yesterday that Jim Vena, the former COO, would be replacing Lance Fritz as CEO in just a few weeks. Back in February, Soroban Capital, a hedge fund and large UP shareholder, made public their desire to see a leadership change at UP.
What did they want? An operator.
"Well-run operations are the enabling foundation for all other value creation levers of a railroad. Therefore, it is paramount the next leader of the Company has a proven track record of railroad operating excellence." (Soroban Capital presentation, Feb 2023).
And the board listened:
"'One of the most vital characteristics we considered as we conducted the search to identify the next CEO was extensive railroad operating experience,' said McCarthy, UP’s lead independent director, who was has been elected Chairman of the Board." (Railway Age report).
In contrast to UP, CN ignored their 2nd-largest shareholder, TCI, and chose to name a Commercial CEO in Robinson rather than TCI's preferred choice of, you guessed it, Jim Vena. (Trains report).
What was TCI's problem with CN's CEO, JJ Ruest? Mainly this quote from him which appears right at the start of their presentation to the CN board.
"We're not running the company for the OR, we're running the company for EPS growth..." (Q2 2021 Earnings Conference Call).
In fact, in the short 26 slide deck TCI published demanding the Ruest ouster, they did not mention anything related to top-line revenue, volume growth, or a customer-oriented focus. It was all about improving capital efficiency and lowering that OR.
In their published presentation, Soroban makes the same case that TCI did to CN. But the primary driver for their "best-in-class management" EPS projection isn't improving the OR. It's increasing volume!
PSR is like Lemonade
Herein lies the flawed assumption of PSR as it relates to growing carload volume: If rail operations are better, carloads will increase.
Let's look at this concept through the example of a lemonade stand. Say, for example, you wanted to set up a lemonade stand on a busy street. You're the only lemonade stand for miles around and anyone who wants to buy lemonade has to come to you. It's hot and potential customers line up around the block to buy a cold glass of lemonade. What a great business! Except you don't have enough lemons, and then you have 3 extra pitchers, and for some reason your customers think they should get a discount for bringing their own cups.
So, you manage to figure out how to get enough lemons, you get rid of the extra pitchers cluttering up your table, and you work out a deal with the customers who bring their own cups. Now you're making money hand over fist. You raise prices! People still keep coming!
Until, that is, it starts to snow. Now no one wants lemonade. So you get rid of your extra lemons (you can always get them back, right?) and you buy less cups. But it's still snowing and no one is coming. What then?
In economic terms, PSR is a supply-side action. It's assumed that demand has outstripped supply (rail network capacity, service) and if you figured out how to increase supply you could capture the pent up demand. If the PSR supply-side premise were true, shouldn't we have see an uptick in rail volumes now that all Class 1 RRs have embraced PSR in some form or fashion?
Instead, what the RRs have, largely, is a demand-side problem. The traffic isn't there and the demand that used to exist (coal, for example) isn't going to be there tomorrow. Some of that demand tore up its tracks and has converted to other modes. Sure, you can provide faster, more reliable lemonade, but what if your pool of potential customers is looking for hot cocoa?
Wall Street and the Growth Problem
This leaves the industry with two glaring issues:
First, Wall Street. As was apparent from the activist investor presentations cited above, the "cult of the OR" is alive and well. Class 1 CEOs are judged on their ability to eke out ever more cost savings and efficiency improvements. If you're a CEO who doesn't respect the OR, Wall Street is going to put a target on your back. How did Wall Street respond when Jim Vena was announced as the new UP CEO? They sent UP's stock up 10% in the first day.
Until the rail industry can either get Wall Street to buy into a shift from profitability to growth, it's hard to see any growth-oriented strategy going far with investors.
CPKC, which is dependent on growing volumes in support of its STB-granted merger, will be an interesting one to watch. So far, Wall Street seems willing to wait and see, even in the face of missed earnings and revenue. Much of the latest earnings call was spent stressing "long-term opportunities" and pounding the pavement for new business. How long will Wall Street give CPKC?
Second, how do RRs even grow? There are two fundamental levers a RR can pull to increase business: lower prices and/or offer new services to customers.
The contention from PSR advocates was always, "Hey, now that we've opened up capacity and lowered our operating basis, we can be more aggressive and go after traffic that's moving by truck instead of rail" (i.e., lower prices). Yet, the story from commercial folks in the Class 1's is a bit different.
After the implementation of PSR, pricing structures were rigidly frozen into place with increased approval levels and effort needed to provide customized schemes for individual customers. Sales people were often left frustrated with an inability to go after new business that deviated from published tariffs. "You can have any color so long as it's black," works great when reducing operational costs. However, it's unlikely to yield much in the way of attracting new business. You can have any drink so long as it's lemonade.
Additionally, many RRs often talk about "pricing discipline," which is corporate speak for "we aren't going to lower our prices." Why? Because that would hurt profitability. (See Wall Street, Issue #1).
Now, I can understand the lack of desire to go against a competitor that has an unending amount of capacity and is willing to price into the basement (owner-operators). However, some simple math shows that sacrificing the OR to take a bigger slice of the US freight market yields far more $$$. If the RRs can make that work, there's a lot more to gain from volume growth than from incremental OR improvement.
What about new services? RRs consistently talk about improving their "service product." Yet, in the same breath they acknowledge that they're incredibly difficult to do business with. Quotes can take 2 weeks. New rail-served sites can take 2 years. In an era of "one-click", digital freight brokers, and next day shipping, the RRs are looking increasingly out of step. The entire customer experience needs an overhaul and that's going to take some investment.
Credit where credit is due, however. UP has been very aggressive in building out its API library to help connect customers. (The underlying data quality those APIs rely on, however, is atrocious. Hence the need for onboard railcar monitoring, but that's a different subject). NS has named a first mile/last mile leader ("We've got to do different things if we want to grow" - Q2 Earnings Call). CSX and CPKC have partnered on a new service connecting the Southeast with Mexico that should be great for the autos. BNSF is investing $1.5 billion in a new intermodal facility in Barstow, CA to provide better port-to-rail access. These are promising signs, but still only scratch the surface if RRs are really serious about growth.
How should a RR manage its business?
RRs have been pulling hard on the profitability lever for a long time now and Wall Street appears more than happy to continue that merry ride. Cash flow is great, so let's keep the party going!
Except when the music stops - coal carloads dwindle to nothing, customers that can shift from rail to truck continue to do so, and the RRs can no longer merge to consolidate their dwindling modal share. With less traffic on such high cost infrastructure, expenses look worse and productivity drops. More fights with regulators, labor, and customers. Cash flow starts drying up and investors flee. Then we're back to a 1970s era of zombie railroads.
I don't know Jim Vena and certainly have nothing against him. I'm also an operator myself and probably have more in common with Jim than with the marketing folks. I'm more than happy to give him the benefit of the doubt and wish him and his team all the best in taking UP to the next level.
But after decades of consolidation and squeezing more cents out of every dollar, the rail industry needs to embrace growth. Spend money to make money. Grow headcounts on the sales and customer service side. Invest in technology to drive efficiency and new services. And, who knows, maybe try making some hot cocoa once in awhile?
Transportation Planner, Strategist & Analyst
1 年Byron Porter: You might appreciate much of this 1968 AARS report on the subject of operating ratios, especially in light of your cocktail napkin example: https://www.dhirubhai.net/posts/bill-freeto-18004a6_1968-aars-committe-report-on-operating-ratios-activity-7035704336680697856-uEAQ?utm_source=share&utm_medium=member_desktop Only the presenter went to much more of an extreme than you did, saying, "An operating ratio of 90 is better than one of 70, if net income for the owners is increased by $1 as a result of our increased expenses to secure additional income." Also worthy of note is the account of a railroad president reportedly having said, "Our net income depends upon our operating ratio. The size of the net varies inversely with the size of the ratio." I recall a C-level official from a US Class I railroad voicing the same fallacy within the last 12-18 months. In both cases, they are equating the OR with "profitability" or even net profit. You wrote of the dichotomy of profitability versus growth and getting "Wall Street to buy into a shift from profitability to growth." I see no such inherent conflict between the two. The seeming conflict comes from equating OR with net profit.
Observer of the Railroad Industry???? ??
1 年Great read especially concerning pricing power with captive shippers and OR. This is why UP enjoys such high profit compared to its peers. Example captive chemical traffic with reduced operating cost. Yet no top line growth and in many instances negative traffic growth.. Also keep in mind Soroban believes Vena can get the stock price to break $300/share. We can assume more asset conversion, and labor reductions for cash leading to dividend increases..
Mechanical Locomotive Engineer at CN
1 年Thanks for the invite, I look forward to the content!
For those unfamiliar with “Railnomics”, your “core pricing discipline” paragraphs were nicely revelatory, as was the growth v. OR pivot “napkin pie chart”. My issue is that maintaining higher prices are in conflict with a lower OR since in my view service generally suffers in the push to lower OR, which in turn pushes customers away (even if the rate quote etc experience is improved). Add that to the “high cost infrastructure” (self-financed and paid for, unlike the trucking competition) and the constraints are evident. What about the idea of reducing the cost of the infrastructure capex using tax credits and/or PPP financing tied to service improvement capex? Which might include opex reducers like electrification of key high volume corridors, ECP braking for the opex benefit as much as safety, and oh yeah onboard acoustic bearing monitoring and car tracking telematics?
Great job on this Byron.