2020 Freight Rail Outlook: Inflection Point

Photo by Bruce Kelly.

RAILWAY AGE, DECEMBER 2019 ISSUE: As the first two decades of the 21st century come to a close, the freight railroad industry looks very different from the struggling, inefficient, overweight group of carriers that had just received a massive shot of adrenaline from the Staggers Rail Act of 1980.

That was 40 years ago. What we have now is a healthy, efficient, productive, environmentally friendly, technologically advanced, safe and highly profitable industry—that, for whatever reason(s), cannot seem to grow market share (compared to the trucking industry) and is facing a big problem dealing with regulators looking to change the status quo (for example, the Surface Transportation Board’s consideration of modifying how Class I cost of capital is calculated, and how “revenue adequacy” is determined).

Rail freight traffic is in a major slump right now (some call it a “recession”), but it will recover. When it does, will this industry be positioned for growth? Will it be able to develop new lines of business? Will it feel less inclined to concentrate on over-used corporate-speak clichés like “shareholder value” and “customer-centric” and deliver?

Railway Age asked two of its expert Contributing Editors—Cowen and Company Managing Director Jason Seidl and long-time stalwart and consultant Roy Blanchard—to weigh in on the current state of railroad affairs.

Jason Seidl

2019 has been a year of financial gains from Precision Scheduled Railroading (PSR), of modal conversions to trucking, of a weakening industrial economy, of difficult end-of-year comparisons, and of uncertainty over ongoing trade wars. Indeed, with 4Q2019 volumes down 7%, the rail carriers are facing decisions to trade some volume for price, a practice in which they have been loath to partake during the past decade.

While we have heard of several carriers being selectively more lenient on pricing, it has clearly not been a wholesale change in their practices. Indeed, we still see the rails keeping pricing up above their cost of inflation but may end up at the lower end of their historic range (somewhere between 2.5%-3%).

All of this depends on where traffic volumes end up shaking out over the next year. We believe volumes will remain under pressure for the remainder of 2019 and into 1Q2020 as tariff pull forward impacts went on through early February 2019. While a resolution to the ongoing Chinese trade dispute would undoubtedly result in a spike in demand (as evidenced by responses in our Proprietary Railroad Shipper Survey), the ability for investors to predict such an event remains suspect at best. Hence, our view includes an economic backdrop of muted growth.

Given this backdrop, rail traffic numbers should improve as the year goes on with more favorable year-over-year comparisons and the likelihood of truck competition easing toward the back half of the year aiding optics for the rail group.

Indeed, truck capacity should play a prominent role in the ability for railroads to grow their intermodal traffic in 2020. 2019 has been beset by an overcapacity problem in the trucking space, which was created with record Class 8 orders from euphoric pricing gains in 2018. Capacity has been coming out of the market in 2019, but at a somewhat slow pace. This may change in 2020 as insurance companies are sending out notices of renewal rates that are up 30-40% for some carriers. With margins razor thin for some smaller carriers, such increases could prove fatal.

Additionally, the implementation of a National Drug & Alcohol Database for drivers should limit the number of acceptable candidates for trucking companies as it populates. The potential national legalization of marijuana could also have an impact on failed drug tests, as we highly doubt the underwriters who are left in the trucking space will allow such usage, even if legal.

We exit this year feeling cautious on the rail stock group, given its outperformance to the broader market year to date, weaker than anticipated 4Q volumes and lack of a near-term catalyst. Despite our near-term concerns, we still favor the group for longer-term investors. As the rails exit 2020, many should be well positioned to see the benefits from ongoing PSR implementation and ready to take on the challenge of automation. Automation may be the next step change in railroading but faces several obstacles including regulations, labor and technology.

Roy Blanchard

Can the railroads remain relevant? The Fall meeting of NEARS (Northeast Association of Rail Shippers) did little to dispel doubts about the ability of PSR to deliver additional supply chain value to customers and short lines alike. The single thread that ran through most of the presentations was that railroads are still difficult to do business with.

That isn’t to say PSR is a faulty process. It’s just that we haven’t conveyed its benefits very well to our customers, and much of the railroad performance to date—inconsistent transit times, trail annulments, steepened demurrage fees, etc.—aren’t doing any good.

Fact is, railroading is a derived-demand business. One doesn’t ask for an empty car with no freight to move. But once there is a derived demand to move product, beneficial owners want it moved with minimum hassles and maximum dependability. In other words, customers would like to see Freight Car Scheduling (FCS).

It’s not a new idea. The Missouri Pacific perfected it in the 1970s. The concept was first developed by the late Guerdon Sines, then Vice President Information and Control Systems for the railroad. He is fondly remembered by one MoPac alumnus as “the only IT guy I ever met who could talk down an operating guy.”

The purpose of FCS was to schedule each freight car, loaded and empty, on the series of trains that would carry it from origin to destination, just as an airline passenger is scheduled on a series of flights from origin to destination by the airline’s reservation system. The FCS system would give railroad customers—shippers and consignees—accurate estimates of when cars would arrive at destinations.

By the time MoPac was acquired by Union Pacific in 1982, FCS was operating its entire network. Shortly thereafter, UP closed down FCS. According to one railroader, “It didn’t work because the UP operating department was either unable or unwilling to run its freight trains on schedule, and, as a result, clerks had to reschedule every freight car on a new set of trains almost every time a car arrived at a yard.”

That’s why, rather than reworking its train schedules or implementing a train control system that could help keep trains on schedule, UP elected instead to shut down the FCS system, proving once again that if senior operating management doesn’t sincerely believe in a process and enforce it, it won’t happen.

Happily, there is a cadre of senior managers who got it early and nurtured a following. Fast-forward to the 2000s and Hunter Harrison was leading the way. He laid out what he called the five tenets of “Precision Scheduled Railroading,” and spelled them out in his book, How We Work and Why: Running a Precision Railroad. Switch customers at the same time every day. Control variable cost. Do it safely. Empower employees. Manage asset deployment.

Hunter ran the same local trains every day. He wanted power and crews at the other end of the run on plan so they’d be there to handle whatever came up on the return trip. He put everything he had in the yard that was headed for the same distant node on the next train out of town to minimize dwells.

Yes, it ruffled some customer feathers at first. But a railroad runs seven days a week, and it’s hard to keep cars moving if customers take off weekends and holidays. But there is a way to have both. I recall CN’s Claude Mongeau saying shortly after Hunter left that he wanted to use the Hunter methodology “to create a kinder, gentler railroad.” He certainly did that, and his successor JJ Ruest is following through. Moreover, Canadian Pacific’s Keith Creel—cut very much from the same cloth—is achieving the same results.

Yet, at NEARS, we had Penn State School of Business Administration professor Peter Swan, Ph.D., tell us, “The proponents of Precision Scheduled Railroading try to level the workload and asset base of internal railroad company yard movements and over-the-road train movements. It is not car-focused, though its advocates expect that it will eventually become more car-focused and on-time-schedule-delivery-efficient.” This is precisely part of the perception problem I mention above.

I fear what’s going on is that railroad managements, in their zeal to cut costs, take points out of the operating ratio and improve net income, have gone after costs first, then tried to run a low-cost railroad and then serve customers better. It hasn’t worked because you need assets to create customers, and without the assets you’ll have fewer customers.

At CSX, the charge is to find out what it will take to win more merchandise business and translate customer needs into product design. The successful scheme is one that creates fewer boutique products and more products with wider applications much the same way Apple has done.

In short, he’s seeking customer solutions (his term, not mine) that blur the lines between carload and intermodal product design, find ways to use operating resources that can serve both products simultaneously, and make it easier for customers to access these tools.

At Kansas City Southern, the economies of PSR are taking center stage. On KCS’s 3Q2019 earnings call, Sameh Fahmy, EVP for PSR, ticked off these results to date:

“We took out 14% of our locomotives. So now we have an active fleet of 903, when we started the PSR exercise it was 1,046. We also took out a lot of cars. When you look at the active car count, we now run at about 58,000 cars. We used to be at 64,000 cars online, this time last year. Car-miles went from 70 miles per day to 100 miles per day. We know that we can get to 150 and even higher than that. When you take out the least reliable assets, you improve reliability. So failures have reduced by 31%. When you have fewer foreign cars on the railroad, you end up with significant savings in equipment cost. We’re down by 24% in Q3. Crew costs have come down 9% in this quarter compared to the same quarter last year. We take every train that has a high horsepower/trailing ton ratio and ask, for example, why do we have five locomotives for 800 tons?

“In Mexico, we replaced two intermodal and one manifest train with one train that would combine the intermodal and manifest going to that area and will set out the blocks that will be combined, so if it’s Santa Maria, intermodal and manifest, it will all go together. Rojas is the same way. So you drop three or four actually, because you have four locations, so four set-outs instead of nine set-outs of blocks. Thus we’ve seen significant progress in reducing the work events, reducing train delays, improving velocity and reducing car dwell. That’s one example.

“We have about 68% trip plan compliance. We should be at 85% or 90%. Already 77% of our customers are seeing a significant or moderate improvement in our transit time and our service. Grain unit trains went from 1.20 to 1.42 trips/month. That means instead of doing a complete round-trip in 28 days, we do it in 21 days. Every day means $9 million increase annually in our revenue.”

This is exactly what Hunter Harrison did on the Illinois Central 20 years ago. KCS is truly a work in progress. These details show what can be done with a proper plan, and the process works on any railroad of any size, any place. Non-Class I roads, take note.

Finally, a friend whose railroad career goes back to the USRA in the 1980s says, “Trees don’t grow to the sky, and neither do margins keep improving. But the benefit of the improved margin is still there, creating an ongoing attraction.

“Obviously, to increase the buy-in bucket will then require an overall expansion. Right now, the opportunity for expansion in many parts of the U.S. railroad business is pretty obscure, and the coal business is creating considerable headwinds, but nothing is forever, and the industry is well-poised financially to handle any opportunities that might arise.

“Whether the individual members have the wisdom, the foresight and abilities, and the guts to do so is another matter. The answer lies outside the discussion of PSR, which has become rather boring.”

What’s It All About, Tony?

“A company must survive and thrive so that all of its workers can,” notes independent analyst Tony Hatch. “One can argue about strategy (which employees left, etc.) and whether PSR is only about OR. It’s not. Look at CN and CP, the goal line for all of these U.S. PSR experiments. Not all layoffs are good or smart, and all are painful (less so for railroads). But CSX, unfinished, is a better railroad than it was in 2016.

“Key point: Companies are not charities, and railroads are not utilities.”