Is it time for a new business model?

Jay Frazier
Vice President-Origination,
GE Capital Rail Finance

Steven Ryder
Associate-Underwriting,
GE Capital Rail Finance

n today's sustained growth economy, a key question to ask is, why haven't railroads shown stronger performance? Twenty years after industry deregulation, railroads still find themselves immersed in a complex set of economic and operational issues. Freight prices, competition with trucking, capital expenditure levels, industry consolidation, and debt management are critical. Collectively, those concerns underscore the railroad industry's average stock performance over the last 5-10 years.

These market dynamics raise two critical questions: Should railroads change their business model? If so, what would the new model look like? Our analysis suggests that the rail industry will require a change in its game plan. We believe the railroads most successful in recasting their business models will benefit from a deep understanding of their constraints, their underlying strengths, and the changing landscape for their customers.

Railroads wrestle with four key issues. First, despite efficiency gains from industry consolidation, they have seen margins squeezed by falling freight prices. Second, consolidation and merger-related capital investment have come at the cost of weaker balance sheets. Headline mergers have been largely debt financed, and the average credit rating for Class I railroads has steadily declined from A1 in 1990 to Baa2 in 1999. Third, efficient asset utilization continues to pose a challenge. Average train speeds for Class I railroads hover around 20 mph, and more than 40% of railcars traveling on the rail system at a given time are empty. Fourth, railroads continue to find their market share challenged by the trucking industry.

Despite these industry challenges, railroads have reassessed their core strengths. Virtually all railroads have introduced efficiencies to strengthen their cost structures. Moreover, they remain low-cost service providers, even in the face of higher fuel costs. They are able to better manage their income statements through innovative financial structuring, using such tools as operating and synthetic leases as well as equipment trust certificates. Most have purged assets that are nonessential to their core business. Perhaps most important, they have begun to harness the potential benefits of technology.

Several changes in the industry suggest a new business model for railroads.

First, the Class I's need to expand their focus to include enhanced revenue growth. Most railroads now exhibit improved operating ratios, with diminished future gains from additional cost-cutting. Ultimately, we believe they will need to seek additional, value-added revenue streams to reap the full benefits of their successful cost-cutting efforts. Second, while the railroads' customer base has been largely stable, the needs of those customers have changed significantly. Just-in-time manufacturing operations have driven companies to demand ontime delivery performance from shippers.

Electronic commerce, enterprise resource planning, and business-to-business operations are quickly redefining the relationships between producers and suppliers. Railroads that provide segmented, value-added services in line with these changing demands can command increased profit margins. Conversely, railroads that choose to maintain the traditional business model run the risk of finding their growth levels squeezed by more progressive competitors.

Understanding and applying the strengths of the railroad sector will help direct a new business model. Railroads may not rival trucks in their ability to provide rapid delivery services, but they are a low-cost shipper that, with the assistance of selected technologies, can provide forecasted ontime delivery, asset efficiency, customer service, logistics management, and enhanced safety.

Additionally, railroads may seek to expand their value-added product offering to include inventory services. Manufacturing plants can keep inventory off their books and factory floors by outsourcing their inventory to railroads. Railroads can use underutilized yards to store this inventory for customers, and charge a premium for the service. They will need, however, to cultivate customer confidence through consistent, as-promised service and delivery.

The opportunity is ripe for railroads to reorient their businesses toward a new model of enhanced revenue growth. Successful models will reflect changes in supplier relationships and customer service as well as the underlying strengths of the railroad industry. Ultimately, the transformation of today's business world provides new opportunities, not threats, for railroads that choose to take advantage of them.