Barron\'s - 16.09.2019

(backadmin) #1

24 BARRON’S September 16, 2019


ne of the hottest industrial


companiesisoneoftheoldest:


CSX,a 190-year-old freight


carrieronceknownastheBal-


timore and Ohio Railroad.


AstheEastCoastrailroad


cut costs and squeezed effi-


ciencies from a 21,000-mile network, its profits


surged in the past three years. So did its stock,


climbingmorethanfourfoldaheadoftheS&P500


index over that stretch.


North American railroads like CSX (ticker:


CSX)—andUnion Pacific(UNP) andCanadian


NationalRailway(CNI)—havebeenWallStreet


favorites,outperformingtheS&P500astheyap-


pliedproductivitygainsandpriceincreasestothe


rising freight volumes of an economic expansion.


Centraltotheindustry’ssuccesshasbeenitsem-


braceofanefficiencystrategyknownasprecision


scheduled railroading, or PSR.


Now, freight volumes are declining amid wor-


ries over an economic slowdown and a trade war.


Pricecompetitionfromtruckersispressuringrail


rates.Therailroads’lasthopeforcontinuedprofit


growth is efficiency gains.


Will they be enough?


That’s what an analyst wanted to know on a


Julyconferencecall,afterCSXreportedadropin


itslastquarter’srevenueandwarnedofadecline


in the year’s freight volumes.


“You’re killing me,” replied Jim Foote, CSX’s


chief executive. “I mean, we’re doing a fantastic


job,andthenyouwantmore.C’mon.”Hepromised


that his company would maintain its position as


“the most efficient railroad in North America.”


Rail-stock bulls hope that efficiency gains will


compensate for dragging volumes and prices, but


the industry may be close to the limit of the costs


that it can cut. Investors should think about hop-


ping off the freight train.


Precision railroading involves replacing a rail


network’s traditional hub-and-spoke routes with


straightruns,whilekeepingtrainstostrictsched-


ules.Bypullinglongertrainsusingfewerlocomo-


tives, workers, and switch yards, CSX expanded


its operating profit margin to 40% in 2018 from


30% in 2016.


There are limits to this efficiency strategy.


TheyhavealreadybeenevidentinCanada,where


precision scheduled railroading was pioneered a


decadeagoonthelong-haulrunsofCanadianNa-


tional andCanadian Pacific Railway(CP).


Railroaders measure efficiency by the ratio of


theiroperatingexpensestooperatingrevenue,and


this “operating ratio” has never fallen below the


mid-50 percentiles at these two railroads.


CanadianNational’soperatingratiowasunder


58% in its June quarter. The company told inves-


tors on the earnings call that the high 50s is the


railroad’s sweet spot. At Canadian Pacific, the


June-quarteroperatingratiowas58%.Itschiefex-


ecutive, Keith Creel, tellsBarron’sthat his team


aspires to reduce expenses to a mid-50s percent-


age of revenue.


O


U.S.railroadslikeCSX,UnionPacific,andNor-


folk Southern (NSC) followed the Canadians,


adoptingprecisionscheduledrailroadinginrecent


years. They drove their operating ratios down to


thelevelsattainedbytheirCanadiancounterparts—


and their profits widened. Precision railroading


worked, yet its impact has largely been felt.


“PSR rails like Union Pacific and Norfolk


Southern are missing or just meeting expecta-


tions,”MorganStanleyanalystRaviShanker wrote


aftertheJunequarter,“whichraisesthequestion


ofwhathappenslaterwhenthelow-hangingfruit


on cost is picked.”


Although CSX shares lost 20% after the com-


pany’sJulywarningaboutvolumes,itsshareshave


recoverednearlyhalfofthatlosssincethen,trading


atarecent$71.ThestocksofUnionPacificandNor-


folk Southern are returning to their spring peaks.


Railroad enthusiasts like Allison Landry of


CreditSuissehavehighexpectationsforprecision


railroading. Union Pacific has set its sights on


reachinga55%operatingratiofromitslatestlevel


of about 60%. Landry tells clients that the giant


railway is being too modest and may ultimately


achieve an operating ratio as low as 50%.


That would correspond to an operating profit


marginof50%.Yetthereisnoprecedentforthat


among railroads, however precise.


If the magic of precision scheduled railroading


hasonlyafewmorepercentagepointsofoperating


profittodelivertorailroadslikeUnionPacific,then


profitgrowthwillhavetocomefromincreasedship-


pingvolumesandpriceincreases.Andthosegrowth


drivers are not moving in the right direction.


After precision railroading has done its work,


thestocksofUnionPacific,KansasCitySouthern


(KSU),andtheirCanadianpeerscouldlosetheir


multiplesof19timesearningsandreverttothein-


dustry’s historical average of 16 times or less.


Theprophetofprecisionscheduledrailroading


wasE.HunterHarrison,anexecutivewhocameto


CanadianNationalwithits1998purchaseoftheIl-


linoisCentralRailroad.AshetookchargeofCN,


Harrison reshaped what had been a lumbering,


state-ownedbehemothintothemostefficientbusi-


ness in the industry.


CanadianNational’shub-and-spokerouteswere


replaced by straight runs. Scheduled departures


reducedthetimethattrainssatidle.Locomotives


pulledlongertrains.Asheadcountshrankandlo-


comotivesmovedmoretonnagewithlessfuel,CN


improved its operating ratio to 61% from 75%—


wideningprofits bya corresponding amount. Be-


fore Harrison retired in 2009, Canadian National


stock had risen sixfold.


Harrison’sachievementsatCNinspiredactivist


investors to call on other railroads to adopt his


precisionrailroadingstrategies.In2012,BillAck-


manofPershingSquareCapitalManagementwas


electedtotheboardofCanadianPacific.Inshort


order, Harrison was chief executive.


WhenHarrisonarrived,therailroad’soperating


ratio was 81%. By the time he left in 2017, he had


gottenCP’soperatingratiobelow59%andtripledits


earnings.Ackmanmorethantripledhismoney,too.


Harrison’slaststopwasCSX,whereactivistshad


beentryingtoshakeupmanagementforadecade.


In2017,aformerassociateofAckman’s,PaulHilal,


finallysucceeded,andthe72-year-oldHarrisontook


chargeoftheU.S.railway.Harrisonwasgravelyill,


however, and died before the year was out.


CSXwentontoadoptprecisionscheduledrail-


roadingandtookitsoperatingratiodowntoare-


markable57%from69%.Savingsonlaborandfuel


shrankoperatingexpensesbyalmost$1billionin


the three years ended in 2018, allowing profit to


surgeonevenamodestriseinrevenue.CSXstock


morethantripledinthethree-yearstretchleading


up to its July 2019 warning on volume.


Now,Harrison’snameisinvokedateveryrail-


RR


DO THE LOCOMOTION


HOW THE NORTH AMERICAN RAILROAD COMPANIES MEASURE UP.


Company/ Ticker


Recent


Price


3-Year Total


Return


Enterprise


Value (bil)


2019E


Revenue (bil)


2019E


EPS


2019E


P/E


Union Pacific/ UNP $167.71 91% $144 $22.5 $8.90 18.9


Canadian National Railway/ CNI 92.36 55 77 11.8 4.70 19.7


CSX/ CSX 71.55 161 72 12.1 4.15 17.3


Norfolk Southern/ NSC 178.56 105 59 11.6 10.58 16.9


Canadian Pacific Railway/ CP 230.03 58 39 6.0 12.59 18.3


Kansas City Southern/ KSU 132.48 46 16 2.9 6.74 19.7


E=Estimate Source: FactSet


“PSR rails like


Union Pacific


and Norfolk


Southern


are missing or


just meeting


expectations,


which raises


the question of


what happens


later when the


low-hanging


fruit on cost


is picked.”


Morgan


Stanley analyst


Ravi Shanker

Free download pdf