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