Obfuscation is Challenging. Clearing It Up? More So

Written by David Nahass, Financial Editor
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The late Hunter Harrison (both corporal and spiritual) had activist investors hand-in-hand or trailing in his wake, chasing the stock price momentum that could be generated by lowering operating ratio (specifically, the recent sale by Mantle Ridge of most of its $1 billion position in CSX stock for a rough gain of 100% since January 2017). Chris Goodney/Bloomberg via Getty Images

FINANCIAL EDGE, RAILWAY AGE NOVEMBER 2019 ISSUE: Recently, three events impacting the railroad community—shippers and carriers and regulators—rushed through the news wire:

Railway Age colleague Frank Wilner, Capitol Hill Contributing Editor, noted in his article “STB’s Cost of Capital Dilemma” that the Surface Transportation Board opened a review on railroad revenue adequacy and the calculation of railroad cost of capital: “The 12.2% computed by the STB for 2018 exceeds by more than five percentage points what is used by Wall Street. Additionally, shippers assert that the existing models, using historical growth rates dating to 1926, create distortions, and that the models artificially overstate growth by failing to adjust for stock buybacks.”

• On Oct. 1, 2019, more than two dozen railroad shippers filed lawsuits against four U.S. Class I railroads over their imposition of fuel surcharges.
• In September, as noted again by Wilner in his article “STB Takes ‘Bye’ on Fuel Surcharge Case,” the STB declined to review the same fuel surcharge issue.

These events suggest a changing approach to the business of railroads, to regulating railroads and to the overall manner in which railroads are viewed in the U.S. The railroads have been in the business headlines as the PSR (Precision Scheduled Railroading) movement came blasting into the room, with Hunter Harrison charging into the CEO office at three of the seven current Class I’s, and his ghost into three of the other four.
Harrison (both corporal and spiritual) had activist investors hand-in-hand or trailing in his wake, chasing the stock price momentum that could be generated by lowering operating ratio (specifically, the recent sale by Mantle Ridge of most of its $1 billion position in CSX stock for a rough gain of 100% since January 2017).

The railroads have been staging a delicate ballet: PSR-induced employee layoffs, a soft economy, freight loadings down year-over-year and increasing stock prices. It is not surprising that, as a result, the perception of the railroads and the service they provide is also evolving.

Why do these events matter? What could be the impact? Tariff rates (the published rate under which a railroad commits to moving a railcar) and rate disputes rely on the calculation of rail capital costs to ensure market fairness. It is one area where, in spite of deregulation, the railroad business remains under the government’s heel. The cost of capital, as any MBA will tell you, is the return required for a company to make a successful investment in a company. It represents the return necessary for investment in maintaining and expanding railroad infrastructure and expansion.

As Wilner notes, for many years after the Staggers Rail Act in 1980, railroads were not earning above their cost of capital. Then, the standards were revised, and it was determined that, since 2008 and 2009, some railroads were actually revenue-adequate. This validated and continues to validate a shipper perception that documented railroad capital costs are too high, and the shipper community is effectively subsidizing railroad profitability. This view is more firmly strengthened by the spate of stock buybacks by the railroads.

On Aug. 16, 2019, a federal appeals court rejected an initiative from shippers to be treated as a class (legally) for purposes of filing a lawsuit against the Class I’s for their use of fuel surcharges. This rejection led to the filing of more than 24 individual lawsuits. The “class” debate began in 2017. Although this issue has been around for some time, STB’s refusal to rule on this issue pushes the fight over what is or is not legitimate about fuel surcharges into the court system. If the decision on the issue of whether or not the shippers could actually be defined as a “class” took two years, the lawsuits themselves will be positively Dickensian.

Anthony “Tony” Hatch, industry insider, independent analyst and perennial Rail Equipment Finance Conference speaker, often notes that railroads “are not utilities.” He is 100% correct. That quasi circumstance (aka regulation) left the building with the implementation of the Staggers Rail Act.
Perhaps someone should tell the good people at Milton Bradley to update the Monopoly board.

Hatch notes that, post-Staggers, industry trade associations have been using their capital might and political strength to push back on issues on which shippers feel railroads have overstepped. He also notes that, since 1980, rail freight rates have not risen when adjusted on a constant-dollar basis (that information is publicly available). Additionally, Class I’s spend roughly 18% of revenue on capex—feeding the cost of capital debate. He does agree that the recent spate of news about railroad profitability and stock buybacks may be contributing to how the railroads are being viewed, and the political responses regarding what is happening between railroads and the shipper community.

As a culture, occasionally we enjoy seeing Goliaths reduced to Davids. For many shippers—Goliaths in their own right—as it relates to rail transportation, they feel like they are held at the mercy of railroad pricing, without rights and sometimes without clear paths to question the rates they need to pay.

Obfuscation in a business like the hauling of freight is very challenging. Clearing it up is likely to be more so.

Got questions? Set them free at [email protected].

Categories: Class I, Freight, Regulatory Tags: