Tuesday, September 05, 2017

Hedge funds and good railroading don’t compute

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Hedge funds and good railroading don’t compute

Knee-jerks are part of business, one of the risks of doing business. As for knees, like most people, I have two of them, and as for jerks, I’ve been one, on occasion.

I remember my own knee-jerk after 1996 and FRA’s announcement that it would develop crashworthiness standards for locomotives. “Waste of money,” I knee-jerked, “Use the cash to develop crash-prevention systems,” which of course was undercut in 2008 when PTC was mandated and the industry knee-jerked “unfunded mandate.”

Knee-jerks are just that: reflex responses, formed and informed by habit, prejudice and vested interest. Before they are allowed to become policy, they need vetting. We need to be certain that we have identified a real issue, and a realistic response.

Which gets me to … where, exactly? CSX, exactly. Over the past several months, Hunter Harrison, described by some as a railroaders’ railroader, and by others as a hedge fund’s railroader, has roiled the waters, rattled the cages, and shaken, not stirred, things up over on CSX where he was brought in to work that old Hunter Harrison magic.

Magic doesn’t come cheap in this business, and I’ve seen estimates of the compensation awarded to Harrison ranging from $72 million to $300 million.

Too rich for my blood, that’s for sure. And besides, I don’t believe in magic.

Better railroading was, and is, grunt work, based on fundamental principles of safe train operations, driven forward by applying simple math to the problems of distance, time, velocity and available space. Those calculations give us the relations and the totality that make up capacity.

Hunter Harrison steps in at CSX and he closes down a significant number of hump yards, maybe 8 of 12 across the system, in favor of flat switching, and with predictable results. Elapsed time, the yard dwell time of cars on the system, soars. Overall network velocity declines. And, no magic to this, customers complain and seek relief.

OK, Hunter Harrison has been through this before, “transition pains”—schedules are altered, customers don’t like change, etc., etc. but Hunter Harrison has the vision—a vision where trains are built precisely, and blocked at the originating point precisely for the final destination of the cars in the train.

No magic there; it’s just the application of the first principle of good railroading. “Don’t make me handle the car twice!”

There are limits to the above. Has anybody ever worked a switching yard, flat or hump, anywhere, anytime and not “adiosed” a car short of its assigned destination? Maybe in the former Soviet Union, but look what happened to them.

If you get traffic in interchange, you might have to negotiate some special arrangement to share the benefit that will be derived from the extra work you’ve just sloughed off onto to your interchange partner. That’s not magic.

Certain policies Hunter Harrison instituted seem to speak more of knee-jerks than vision.

CSX recently decided to abolish the policy that authorized road crews to request, and be allowed, naps as long as certain requirements were met. Now, the napping policy is relatively new by railroad standards, much newer than the no-sleeping policy. Still, over the past 20 years railroads have allowed it, refined it, and specified the conditions under which it is permitted with no noticeable ill effects.

Maybe Hunter Harrison did away with that policy to demonstrate to train dispatchers, supervisors and T&E and yard employees that the default condition of the railroad is the movement of trains, not the non-movement of trains, but that’s a knee-jerk response. Naps were never allowed when it might interfere with the movement of that crew’s train, or another train’s movement.

Under actual operating conditions, over significant sections of single-track territory where trains have to operate or remain in a siding to meet or pass another train, or over other sections of track where trains cannot follow each other into the same block, there is no degradation of system operations, of network velocity, by allowing crews to formally request and receive permission for a 30-or 45-minute nap.

Harrison’s former railroad, Canadian Pacific, is a member of the group of railroads adopting and abiding by GCOR, the General Code of Operating Rules. Those operating rules include the following:

1.11.1: Napping is permitted by train crews, except crews in passenger, commuter or yard service under the following conditions …

… followed by the double handful reasonable conditions and restrictions for providing crew members to take rest while on duty. Did Canadian Pacific have a special instruction in its employee timetable stating that Rule 1.11.1 did not apply to CP employees, or to other railroads while performing service on the CP, when Harrison ran the railroad?

CSX now allows employees to get on and off moving freight cars in the performance of their duties. CSX has decided to break with the long-standing SOFA (Switching Operations Fatality Analysis) recommendations for “three-point protection” (brake applied, reverser centered or removed, and generator field off) before going between cars to align couplers, connect air hoses, etc.

Eliminating three-point protection is not going to reduced elapsed yard dwell time when the yards themselves are buried in cars that formerly went to those 8 shuttered hump yards.

Eliminating three-point protection is not going to improve system velocity by even 0.001 mph when the main line is backed up with trains waiting to enter yards.

These changes appear to be knee-jerks, twitches that bypass the rational decision-making processes and organs of a railroad.

The industry has continued to improve its safety performance over the past ten years. Between 2007 and 2016, the rate of total train accidents per million freight train-miles declined 30%. The number of accidents attributed to human factors (employee errors) declined 40%. (FRA safety data can be interpreted at this link.)

For yards and switching railroads, the overall rate of accidents per million freight train-miles declined 40%, with non-fatal employee on duty injuries declining 27%, despite an increase in employee working hours of approximately 7% over the period.

It’s difficult to prove that the SOFA recommendations are the cause for this improvement. I don’t know how many of the injuries that did occur are the result of “non-compliance” with SOFA recommendations, or if they occurred despite the proper execution of all the recommendations.

We can’t knee-jerk a “yes” or “no” here. However, we can draw warranted conclusions based on correlations, and correlations establish themselves in the trend—in the overall level of, and changes in, performance that give us an idea of the direction things are going. So I think we have to give credit to the SOFA recommendations, to the heightened awareness and vigilance as expressed in the requirement for three-point protection.

Hunter Harrison and CSX are on the wrong side of this trend. From 2008 through 2012, CSX total accidents on yard track trended downward. From 2013 through 2016, that trend reversed and the total number of yard accidents has trended upward. The rate of yard switching accidents (per million train-miles), declined significantly through 2012, but has trended upward through 2016. The total number of train accidents per million train-miles declined steadily through 2013, only to reverse direction and trend upward through 2016.

Yes, CSX was on the wrong side before Hunter Harrison arrived, but the recent changes don’t indicate that CSX has recognized that, and is acting to stop that trend.

Maybe it is part of the vision Hunter Harrison has for the railroad, and maybe it’s part of the vision the hedge funds have for railroads. Harrison has proclaimed that “coal is dead,” and if that’s truly the case, network velocity isn’t going to be a problem at all.

Coal accounts for 34% of carloadings on the Class I’s—up from last year’s dismal 30%, but down from the long-established ratio of 40%. The revenue contribution is less than the traffic ratio, but it’s still significant. If coal is dead, then railroads have a lot of excess locomotives, excess employees, excess track, excess track slots, excess equipment, excess yards, and excess railroad on their hands.

One solution to wringing that excess capacity out of the system requires an end-to-end, transcontinental merger.

Hedge funds don’t generally play a “long game” built on expanding the asset base of the business, and using that expanded asset base to achieve economies of scale, and increased revenue. They take positions, and they position themselves for the big payout. The big payouts are not derived from the accumulation of new customers, or increased volumes. The big payouts are dependent (usually) on merger, acquisition, takeover, and … liquidation.

Harrison went for the “big payout” when he was at Canadian Pacific, attempting an end-to-end merger with CSX and then Norfolk Southern, only to be rebuffed.

Closing yards, furloughing personnel and devaluing assets may make CSX a tempting target for takeover, to the benefit of the big institutional shareholders, hedge funds, etc. But no one should doubt the devastating impact it will have on an economy that has experienced the weakest recovery from the deepest recession in the post World War II period.

And no one should confuse knee-jerks with “vision,” or hedge funds with good railroading.

Capitol Hill Contributing Editor Frank N. Wilner adds the following commentary:

Successful dispute resolution first requires agreement on outcomes. Here, there appears mutual accord among stakeholders—shippers, railroads, investors, lawmakers and regulators—that railroads, in general, and CSX, in particular, have a duty to deliver freight to where it is wanted, when it is wanted, in the condition desired, and at a reasonable price.

In the marketplace of ideas, Hunter Harrison—backed by a hedge fund and encouraged with an outsized compensation package—intends to prove that his precision railroading model, widely celebrated in Canada, can be equally successful in the United States, and will outperform all other operating models. The implementation on CSX, so far, has been most rocky—so troubled, in fact, that in a recent blog we observed that “the luster is fading from Hunter Harrison’s ‘Dr. Fixit’ image faster than an old jalopy’s back-alley paint job.”

Perceptions are subjective, of course. What many CSX shippers, and some CSX connecting railroads (the latter perhaps more privately), currently view as unsettling and unacceptable, likely is seen by investors supporting Mr. Harrison as unjust premature interference with their chosen change agent; while Mr. Harrison presumably senses uninvited meddling impeding his effort to transform CSX to his brand of formularized precision railroading.

Whether events are ripe for regulatory intrusion, as some shippers—and even some lawmakers—seek, could be decided following a Surface Transportation Board “listening session” scheduled for Sept. 12 but now delayed to a date still to be set owing to Hurricane Irma.

. Shippers will reveal details of difficulties being experienced on CSX, while CSX will explain its new operating plan and respond to allegations of service problems. Expect questions as to the reasons for, and results of, Harrison’s cashiering of competent managers and their precious institutional knowledge in favor of those he considers more loyal to his brand of management; the logic of publicly blaming his workforce for what may well be managerial shortcomings born of unfamiliarity with the CSX network and culture; and other morale draining actions such as scrapping a relatively long-standing, industry-wide formalized and science-endorsed train-crew napping policy.

Yet, not to be unheeded in the instant unpleasantness is that under our economic system of capitalism—the worst except for all the others—private property rights are sacrosanct. Those owning an asset control that asset, absent very limited governmental intrusion, sanctioned, in the case of interstate railroad transportation, by the Constitution’s Commerce Clause.

The conundrum, then, is when, and just how much, regulatory intrusion is wise—and for how long. The STB toolbox, as authorized by Congress, is diverse, extending from mediation assistance to the extreme of directed service.

Investors could make a positive difference and serve as de facto economic regulators—at least those signed up for the long term. But activist hedge funds, such as the one currently exercising control at CSX, represent “hot money,” with a relatively short-term horizon. While activist investing is rightly defended for imposing greater economic efficiency, the short-term pain can arguably be intolerable, as the nation’s security and economic health are directly tied to an efficient, interconnected rail network—a point emphasized by Congress whenever a labor-management bargaining impasse looms. A counterpoint is that CSX historically has been considered as having a superior franchise to regional rival Norfolk Southern, but inferior financial results, begging for what economists call “creative destruction”—shorthand for internally reforming an organization through destruction of its inefficiencies and redeploying its assets to a higher valued and more productive use.

As for regulatory scrutiny of available evidence, the STB should be mindful of advice provided more than a generation ago by the late economist Herb Stein while chairman of the Council of Economic Advisers under Presidents Nixon and Ford. Stein warned that, too often, variables in economic models are purposely adjusted to influence outcomes more in line with expectations, and even desires. Similarly, metrics defensible for Canadian rail operations may be quite inappropriate for the U.S. rail network.

Perhaps in evaluating precision railroading, we should be mindful of German physicist Werner Heisenberg’s Principle of Uncertainty—that things have neither definite position, definite trajectory, nor definite momentum. Uncertainty looms. As Dave Schanoes pointed out in an email exchange, “Einstein thought, in partial response to Heisenberg, that God didn’t play dice with the universe. Hedge funders think that they are the god who does play dice with the universe.”

 

David Schanoes

David Schanoes is Principal of Ten90 Solutions LLC, a consulting firm he established upon retiring from MTA Metro-North Railroad in 2008. David began his railroad career in 1972 with the Chicago & North Western, as a brakeman in Chicago. He came to New York 1977, working for Conrail’s New Jersey Division. David joined Metro-North in 1985. He has spent his entire career in the operating division, working his way up from brakeman to conductor, block operator, dispatcher, supervisor of train operations, trainmaster, superintendent, and deputy chief of field operations. “Better railroading is ten percent planning plus ninety percent execution,” he says. “It’s simple math. Yet, we also know, or should know, that technology is no substitute for supervision, and supervision that doesn’t utilize technology isn’t going to do the job. That's not so simple.”

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