Dr. William Huneke, Consulting Economist, offered his opinion in the Railway Age report STB “Whack a Mole.” As he pointed out, the Surface Transportation Board in the past rarely had time or staff to do more than react to the latest rate case, stakeholder petition or Congressional request. He described a sense of Whack a Mole in the flurry of STB regulatory reform proposals, particularly STB’s tinkering with the industry cost of capital calculation.
Yes, STB has periodically developed and argued about the rail freight industry’s cost of capital. It combined both debt and calculated costs of equity in its reviews. Yes, normally the debt estimate is straightforward. After all, as Dr. Huneke points out, debt is simply the weighted average interest rate of all outstanding industry debt. Pretty simple.
The argument then states, “Equity might be tougher because it is not observable and depends on investor expectations of future stock prices and dividend payouts.” Hmmm …
My first point-of-order comeback is that equity is in fact advertised in the stock market trade prices every business day. What is complicated is that, for some reason, STB chooses to academically troll for an equity risk value that just ignores the everyday at risk trading prices (costs).
Let’s be clear on one definition: Risk value is the simple theory that while debt might be covered during a future “possible” bankruptcy or reorganization, the equity value might go “poof.”
Translation: As in “convert to near-zero trading value on The Street.” Equity investors can potentially get wiped out. How often does that “poof” happen? Not very.
As Dr. Huneke wrote, STB has repeatedly embarked on the use of two complicated financial models to estimate what these risks expectations “might be,” not what they are. Instead, they estimate what they under certain future scenarios “might end up being.”
First up, the MSDCF (Multi-Stage Discounted Cash Flow) model estimates the value of an investment today based on predictions of how much money it will generate in the future, and then adjusts (discounts) that cash flow to its present dollar value to show its future worth today. It uses a made-up set of assumptions to then calculate, in multi-stages, a short-term, five-year growth period, a transition period over the next “X” years, and a long-term growth period continuing into perpetuity.
Made Up? Yes. There are no real customer/rail company outlook failure projections as evidence of the future. Are there?
Even worse academically, this is kind of a fairyland tale, since to economists like me, “forever” usually is about 50 years out. And, there is no way to calculate perpetuity—not reasonably.
The CAPM (Capital Asset Pricing Model) adds to the intellectual “airs” by introducing the return on a risk-free government bond with a return accounting for risk. In some ways, it’s a beta test.
Now let’s be fair. These are not Dr. Huneke’s models. He is merely explaining the choices made in the past by previous STB leadership.
I think we can all agree that risk is an important consideration in any investment analysis. The riskier an investment, i.e., the more volatile, the higher the return required by investors. This is often known as the risk premium. All true.
MSDCF and CAPM have different orientations. CAPM uses past data to develop its estimates. It is backward-looking. MSDCF, because it uses analysts’ forecasts, is forward-looking. But it is speculating about future traffic outcomes.
STB 2020 SOLUTIONS UNDER CONSIDERATION
In response to shipper criticism, STB proposes to tweak the second stage of MSDCF. According to STB, the tweak will (might) slightly reduce MSDCF’s estimate and its volatility. Dr. Huneke says that the question is whether this is the right mole to whack, or whether STB should step back and look much more broadly at the industry’s condition and prospects when reforming its Cost of Capital calculation.
He points out the industry’s new risk from a loss of its coal business: “Loss of coal is a major blow to industry prospects. Coal was a great business for rail. It was largely independent of the business cycle and was predictable” for a variety of reasons.
That is true. Also true is that: “The remaining railroad traffic base is not so tied to rail. It is more subject to intermodal competition. That increases uncertainty and risk for the industry’s future.”
However, is the future of the U.S. Class I railroad industry thus “more uncertain,” therefore requiring investors to expect an increased risk premium, and justifying an expected higher industry cost of capital?
This is where Dr. Huneke and I part ways. I don’t see that anyone one on Wall Street has great fears of impending rail freight equity doom and gloom.
Coal traffic decline by some like Conrail and Norfolk Southern was foreseen in the executive suites back in about 1994-96. This coal decline is not news. It’s actually history seen coming for quite some time. That’s why NS sought a mixed railroad cargo merger with Conrail. NS wanted to diversify.
How has the market reacted to railroad equities since the actual coal drops stated hitting Income Statements after the Great Recession? Stock values have soared. That soaring market doesn’t support the risk premium assumption. It is true that railroads make large investments that, once made, are often sunk. Meaning? Such investments cannot be repurposed or sold to others.
But in fact, Stanley Crane and others four decades ago demonstrated that track assets are in large part “portable” from corridor to corridor. Transfers of assets reduces the so-called stranded asset risks. Why is this evidence being ignored?
The other STB-high risk argument suggest that the so-called “real options theory” demonstrates that the expected return for a sunk investment must exceed that of fixed investment by a factor typically around 2.0 or higher.” I find that assertion unproved. It is a theory. Where is the data to prove it?
There is then a calculatable argument made that perhaps a real options analysis might result in a cost of equity that is twice the 2018 STB estimate of 13.86%.
Say what? Say about 27.72% under one formula reported Dr Huneke. He suggested that discounting that with either STB formula (MSDCF or CAPM) might then result in about an 18.5% cost of equity. That is contrast to the than STB’s pro forma calculation of 12.22%.
Would that, as he seemed to imply, be absolutely appropriate as the industry watches its coal franchise dry up and transitions into a riskier and more uncertain future? The market prices in the daily stock sheets say no. The free trade of U.S. and Canadian railroad equities is signaling no such 16% to ~19% risk because of a failure premium.
WHERE IS THERE SUCH RAILROAD EQUITY AND DEBT RISK?
First hand, I’ll tell you where. It is found in place like Mongolia, Senegal, Mali, Ivory Coast and Nigeria. When? Whenever private equity investment is sought. Why? Because there is such a low initial railway freight market volume that a clear and evident risk premium is required. I know because I spent the better part of 17 years working on rail projects in those countries.
Based upon the above logic, I conclude that there is no such risk of business collapse evident in anyone’s current long-term U.S. rail traffic projections. Traffic may be down, but there is no Penn Central-like crisis in the cards, is there? Who postulates such a financial fear?
I cannot find a single railroad company financial analyst that is making such conditional warnings to its audiences. Defending 12.2% is, on a global open access to capital basis, difficult at best.
STEP UP ACTION
The STB, please, needs to get real. Protecting investors with extreme risk premium regulatory oversight isn’t part of the free enterprise system, is it? This is just my opinion as an “old railroad guy.” What, colleagues, is your retort?
Independent railway economist, Railway Age Contributing Editor and FreightWaves author Jim Blaze has been in the railroad industry for more than 40 years. Trained in logistics, he served seven years with the Illinois DOT as a Chicago long-range freight planner and almost two years with the USRA technical staff in Washington, D.C. Jim then spent 21 years with Conrail in cross-functional strategic roles from branch line economics to mergers, IT, logistics, and corporate change. He followed this with 20 years of international consulting at rail engineering firm Zeta-Tech Associated. Jim is a Magna cum Laude Graduate of St Anselm’s College with a master’s degree from the University of Chicago. Married with six children, he lives outside of Philadelphia. “This column reflects my continued passion for the future of railroading as a competitive industry,” says Jim. “Only by occasionally challenging our institutions can we probe for better quality and performance. My opinions are my own, independent of Railway Age and Freightwaves. As always, contrary business opinions are welcome.”