New, potentially disruptive businesses

This is Jim Blaze, rail economist and teacher—sometimes a reporter; always one who questions. I’m concerned about how the “Big 7” railroads are going to address their next five to ten years of market position, taking the wealth they created, and turning it into an upgraded business model. Which one so far has laid out the best disruptive plan? Which one is struggling? And which one might simply be cashing out?

For most organizations, value-creating growth is the fundamental strategic challenge, for senior officers as well as the board of directors. In order to succeed, companies must be good at developing new, potentially disruptive businesses.

That is the essential conclusion about the dynamics of core business shifts as described in part by Clay Christensen and Michael Raynor in their book, “The Innovator’s Solution: Creating and Sustaining Successful Growth” (Harvard Business School Press, 2003). I stumbled upon this while doing teaching research. Here is the business theory as I understand how it might apply to the largest North American railroads.

Despite a slowdown in growth and margin erosion in rail freight’s aging core business, railroad management continues to focus on developing it at the expense of launching new growth businesses. In the process, management tries to swap asset ownership and downsize the asset scale. Nearly $3 of assets per annual dollar of revenue gets cut back toward the $2 range. That is often the only clear execution strategy. It’s financial, not marketing.

Eventually, investments in the railroad network core stop producing the previous growth in ton-miles and unit volume that investors have come to expect—which is why they bought and held the stock. To revitalize the stock price, management often announces a targeted growth rate that may be beyond what the core business can deliver, thus introducing a larger growth gap—and uncertainty.

Confronted with this gap and uncertainty, the railroad internally limits funding to projects that promise very large, very rapid growth. Often in real terms, my experience was that this seldom amounts to much more than about 15% of the marketing wish list.

The almost-200-year-old rail freight business has a culture of risk aversion. Decisions are nowhere near as easy as taking business away from horse-drawn wagons in the early 19th century. The effect internally is that the railroads often reject or stretch out riskier projects that might generate payback through new long-term services and customer-growth businesses.

Internally, rail managers often respond with overly optimistic projections to gain funding for initiatives. The one-million-trucks-diverted marketing theme for intermodal growth has been well-used since about 1988, as double-stack technology took hold—almost an annual recital of market growth potential, never really challenged as to the numerical goal, and aways seemingly taken for granted.

Now the theme is somewhere between another million to as high as between 7 and 11 million, depending upon what “expert” is talking. Are the boards and shareholders really convinced? How much time and patience do they have? Taking a logical 6 to 9 million intermodal diversions from the universe believed available might take five to eight years, maybe longer. No one seems to know or say.

What is the investment amount? It’s not going to be free.

Meeting a planned timetable for intermodal diversion is going to require more platform cars, more higher-speed rather than drag-freight locomotives, and more intermodal/logistics parks and terminals (or bigger terminals, like near Atlanta). It’s also going to require completion of links like CSX’s Washington-Baltimore-Philadelphia “I-95” corridor. That link is likely to take about eight years or more to finance and build.

Meanwhile, a tough decision needs to be made as to how to exit or sell off the lower-performing former core that requires switching, added boxcar acquisition, and a more-direct, less-transactional sales approach. This business model change has been discussed aggressively for about two years—with no sign, yet, of executing the change toward more short line efficiency management and operations roles, or possibly the creation of more Conrail Shared Assets-type business models in selected old-core business regions.

LOOKING FORWARD

As revenue increases fall short and operating ratio targets remain elusive, the market typically loses stock price confidence—and a new CEO is brought in to shore it up. It’s happened before. It will happen again. Hunter Harrison isn’t the only example. Stan Crane arrived at Conrail in 1981, and we grew traffic volume. He didn’t just cut costs, though he was good at that as well.

Meanwhile, policy writers and regulators remain somewhat paralyzed, because they don’t have a plan or are not in charge of shareholder assets. They can enable radical change or block it. Which will they do? What’s your level of confidence in what they will do? No one seems to know just yet.

The immediate risks as executives change chairs is that upon seeing that the new growth business pipeline is virtually empty, the incoming CEO often tries to quickly stem losses by approving only expenditures that bolster the mature core, and by cutting more costs, possibly creating a three- to four-year shareholder windfall. But will the culture and the company grow and survive? There is a level of long-term risk there.

SHORT-TERM CHANGES

Assets are sold. That’s relatively simple to execute. Cash flow is diverted from growth and R&D to dividends and stock buyback. Both acts are a dilution of cash that might otherwise go toward building the new core.

Short-run actions can often create a financial/accounting illusion as if “everything is okay.” Why? How?

Here’s why. The bulk of the typical company’s share price reflects expectations for the growth of current business. If companies meet those expectations, shareholders will earn only a normal return. But to deliver superior long-term returns—that is, to grow the share price faster than competitors’ share prices—management must either repeatedly exceed market expectations for its current business or develop new value-creating business, or strike out costs and balance sheet items.

Current 2017-toward-2020 growth expectations are look for leaders who don’t dwell on the market’s near-term expectations. Long-term investors don’t want to wait for the core to deteriorate further before they invest in new growth opportunities.

One or more railroads must eventually emerge as the first to move in a market and erect formidable barriers to entry through network scale or other favorable economics, in significant rail corridors where they have a competitive advantage. CN’s Prince Rupert corridor might be the best modern example.

Long-term investors want a railroad company that during tough times in the past has shown customers and investors that they become better and faster than their competitors at seizing opportunities to achieve a competitive advantage for both volume and top-line growth.

Being led by sharp cost-cutters in a declining-share and declining-volume market may be great for short-term current investors—until their market hits a critical step-function drop, leaving the most recent investors and debt financiers in a tough bind. That so often has been the economic cycle of railroading these past nearly 200 years.

Which railroad companies give the highest level of confidence that they are in it for long-term growth, something in the take-15%-market-share range? Which ones suggest another outcome with a much lower level of confidence at high top-line volume growth, more than just leveraging revenue rates up?

Since freight railroads form connected networks, does this mean that about four to six out of the Big 7 should execute together, to create network mass for new core growth? Or could as few as two seize market growth by somehow merging (uniting) “to pull it off,” with a critical-mass size?