Are the interests of shareholders and customers mutually exclusive? On the surface-yes. Fundamentally-not at all.

By Lawrence H Kaufman, Contributing Editor

Who do railroads answer to? Shareholders? Or customers? The answer is yes; they answer to both. Depending on whether one is taking a long-term or short-term view, the goals and agendas of customers and shareholders often appear to be different. Over the longer term, however, the interests of owners and customers coincide. Both have an interest in the railroad providing quality service at competitive prices-and profitably.

Wall Street in 1999 was turned off by railroads for a variety of reasons. Mergers have not performed as railroads promised when they were seeking government approval for their deals. Inconsistent-and downright poor-service has deterred customers from shifting freight from trucks to railroads. In addition, securities analysts see cost pressures ahead and a competitive environment in which it will be difficult to increase rates fast enough to cover rising expenses.

Customers want railroads to take a long view, with sufficient capital investment to ensure they will have improving service. After all, investment decisions made today will determine the line capacity a railroad will have 35 years from now and the nature of the locomotive fleet 15 to 20 years from now.

Shareowners, at least those represented by institutional owners, want to see rising earnings free cash flow that allows dividend increases and stock buybacks. They want ownership in companies that outperform and exceed broad averages.

Free cash flow can be generated in the short run by cutting back on capital spending. In the longer term, however, cutting back on capital spending ultimately results in poor service and declining revenues, an example of the common interests of customers and owners.

People who manage money for a living are measured by various performance indices. That means they have to beat, or at least equal, "the market" over time. When railroad stocks are rated "market perform" by analysts' that frequently is code for "you don't really need to own this."

Railroad managers must balance these seemingly disparate stakeholders. That job is compounded by the long life of rail capital investments. How do you look 35 years into the crystal ball and determine how much is the right amount of investment?

If one reads what securities analysts say about railroads these days, it would be easy to come to the conclusion that railroads have great potential-and always will.

That grim assessment certainly seems to be true from an investment standpoint. There are, however, some positive signs that potential may be closer to being realized than much of the investment world believes.

Just 25 years ago, 25% of Class I railroads were in bankruptcy proceedings. Customers received inadequate service from even the railroads that remained solvent. Stock prices were depressed and rail financial executives had a hard time raising capital for anything but the most essential of projects required to keep the railroads running.

After the Staggers Rail Act of 1980 was enacted, railroads embarked on a virtual crusade to cut their asset base-which had been artificially inflated by the heavy hand of government regulation-to more closely match the business that was available to them. Since 1980, employee head counts have been cut by more than half. U.S. railroads today produce record amounts of transportation service (measured in ton-miles) with 40% fewer locomotives and cars.

The asset reduction improved the return on investment, not because traffic and revenue increased, but because there was less investment. A federal tax law change in 1981 allowed railroads to write off the value of their fixed plant, further reducing the investment base.

With a better return on investment, railroad stocks outperformed the standard indices for several years in the early 1990s. But service performance didn't improve measurably, and railroads did not draw the traffic increases necessary to really leverage their fixed plant assets.

Slow traffic growth, coupled with an inability to raise rates, led to Wall Street's current disenchantment with railroad stocks. For the last few years, railroad stocks have languished, trailing the indices used by short term "sell-side" analysts who work for brokerages and investment banks and by longer term "buy-side" analysts who work for money management companies that own railroad stocks in their mutual, pension, and private funds.

What railroad management believes
Railroad executives understand these divergent and convergent interests and are doing everything they can to satisfy them. "We think there are more constituencies," says Matt Rose, Burlington Northern and Santa Fe president and chief operating officer. "They include shareholders, employees, communities, and customers."

"We do think both of those paths converge," Rose says. "The better service we provide our customers, the more they will want to ship on our railroad. This is a volume business. The railroad needs to grow to make money."

Some Wall Street analysts, seeing slow growth, have urged BNSF to cut back on its capital spending. "Certain analysts believe we have not balanced that well, and have made too much investment," Rose says. "The only issue is one of timing."

BNSF reduced its huge capital program beginning in 1999, when capital programs including operating leases were scaled back from $2.5 billion to $2.275 billion, $1.85 billion of that in cash outlays. This year, the capital budget is $1.8 billion, with $1.5 billion in cash outlays.

"As our railroad has become more fluid and as we have learned how to operate our franchise, quite frankly we don't need as much capital," Rose says. "We still have a strong locomotive program, we've committed $65 million for a new intermodal terminal at Stockton, Calif., we're still adding double track, and have a fairly significant signaling program on the Transcon (BNSF's line between Chicago and Los Angeles)."

BNSF identifies its capital in three categories: catch-up, replacement, and expansion. Huge locomotive purchases the last few years are an example of catch-up expenditures. The former Burlington Northern Railroad was underpowered for the business it had and BNSF has been making up for the shortfall.

"There still are significant monies going to expansion capital," Rose says, citing the start of a new North Texas locomotive maintenance facility. "It's more economical to perform repair work closer to where they're used."

Rose believes the railroad must answer to owners and customers at the same time. "You can't win with only one of them," he says. BNSF executives spend a lot of time educating both internal and external "customers" that when the railroad can achieve higher velocity levels, service goes up-which requires less capital.

Henry Wolf, Norfolk Southern vice chairman and chief financial officer, says, "The long-term interests of Wall Street and our customers are parallel. If there is an issue, it's a short-term conundrum, not short-term/long-term problems."

"Norfolk Southern's goals and vision always start with safety," Wolf says. "Employees are an important constituency along with owners, customers, and communities." Wolf explains that in trying to be customer-focused, the railroad faces the challenge of emphasizing customer service and reliability to employees, much as it has done with safety. "Then the bottom line will be successful," says Wolf. NS works hard at keeping owners informed and satisfied. Wolf and other top executives visit with the 25 largest stockholders-indexers not included-at least once a year and as many as four times. "We find a lot of interest in customer focus and quality," he says.

NS makes it a practice not to allow executives to say things that cannot be delivered. "We are deliberate in what we have said and promised to The Street," Wolf says. For 2000, NS trimmed its capital program to $750 million (compared to $1 billion in 1999), not including lease of 150 new locomotives.

What Wall Street sees
Securities analysts still talk about the time Conrail announced a five-year growth plan that called for $1 billion in new revenue. Shortly after the plan was presented to Wall Street, the growth target was cut back to $600 million. Other railroads have been known to announce synergy numbers in their merger deals, only to increase them before delivering any. That contributes to skepticism on Wall Street.

"Wall Street puts a lot of pressure on companies to deliver," Wolf says. Until its recent difficulties integrating 58% of Conrail operations into its system, NS rarely was off analysts' forecasts by more than one or two cents a share. "We were boring, but hope to get back to that," Wolf says. "We don't like to wink, pre-announce, or talk analysts down. We like to set an expectation without an actual forecast."

Commenting on the statement that NS has to dig itself out of the Conrail problem one car at a time, Wolf says, "We hope the rate of one at a time would accelerate."

James Higgins, rail analyst with Donaldson, Lufkin & Jenrette Securities Corp., agrees that customer and owner interests are the same. "By better serving customers railroads probably produce better returns for shareholders," he says. Higgins once questioned BNSF's large capital programs, but moderated his views. "BNSF capital was necessary to reinject fluidity into the system, which is a precursor to better overall operations, which in turn produces better, more consistent earnings."

Rail analyst James Valentine, a managing director at Morgan Stanley Dean Witter, says, "The real question is, can railroads earn their cost of capital? For the past 80 years that has been most difficult. It's to the point where you think maybe it's not the management, but the business model. Railroads continue to lose traffic, they're not able to get rates up, and can't cut costs much more." Valentine cites the long-lived assets of railroads. "Management today must live with the 'mistakes' of the past, decisions on capital investment made 20 years ago," he says.

"The interests of shareholders and customers are not mutually exclusive," says William E. Greenwood, a rail industry consultant and former president of Burlington Northern Railroad. "It is in the shareholders' interest that you are doing the right things in the right way for your customers."

Greenwood, an operating executive who became one of the top marketers in the railroad industry, says: "A good understanding of the marketplace is what leads to future opportunities to grow your business profitably. That gives you greater opportunities to get better utilization of your assets, and that leads to profitability. That situation comes about through cooperative arrangements with your customers. Good utilization of assets is essential to profitability. If you add one more turn a year, it contributes to leverage, and that takes good integration with your customers."

To Greenwood, this adds up to a common interest of owner and customer. "A good customer relationship is essential to improved profitability," he says. "That comes when you are able to design service and marketing packages with your customer."

So-called buy-side analysts tend to take a longer view than do the sell-side analysts. Gentry Lee, who analyzes railroads at Fayez Sarofim & Co., a Houston-based private investment counselor with $60 billion under management, says, "The interests of shareholders and customers are relatively aligned. In the long run the industry wouldn't exist without creating value for customers and allowing shareholders to capture some of that."

Lee points out that railroads need to earn a premium over their cost of capital. "In the long run you better earn your cost of capital or people won't provide it to you," he says. Railroads provide the lowest cost transportation service and their cost advantages are significant, but they need to get their service right. "When we make investments, we like to think of it as if we are buying the business," he adds. "We ask ourselves 'if we bought the entire railroad, would we be happy owning it?' We