(The following story by Robert Wright appeared on the Financial Times website on November 12.)
OMAHA, Neb. — Just four years ago, an economic slowdown like that now under way in the US would have produced long faces and worried expressions at the headquarters of Union Pacific, the US’s largest railroad by annual revenue, or at Burlington Northern and Santa Fe, the number two.
This autumn, in spite of a slowdown of consumer demand – which drives railroads’ business carrying maritime containers – and of the housing market – which drives demand for building materials – executives at the two companies are positively buoyant.
Omaha, Nebraska-based UP’s third-quarter operating income was a record $1bn, 34 per cent up on the year before, on $4.2bn revenue. Fort Worth, Texas-based BNSF’s income, also $1bn, on $4.07bn revenue, was 9 per cent up on the previous year.
The robust performance results from a long-term surge in demand for nearly everything they deliver, from coal to shipping containers and from cars to wheat.
The traffic has filled all the spare capacity on many routes and allowed operators to withstand slowdowns like the present one without cutting their rates.
In previous economic cycles, the struggle to cover their high fixed costs meant railroads would often cut their rates in bad times to ensure truckers did not take too much of their business. This time the truckers are suffering.
The railroads’ revival has provoked interest from many different kinds of investors. Berkshire Hathaway, the investment company headed by Warren Buffett, has taken stakes in several companies, including 17.2 per cent of BNSF, seen as soundly managed.
The Children’s Investment Fund, a London-based hedge fund, and Carl Icahn, the activist investor, have concentrated on operators such as CSX, which they see as having the most turnround potential.
CSX and UP still have more to do to catch up with the best-performing of the four largest US railroads, Norfolk Southern and BNSF. Of the two largest, BNSF, which competes with UP on key routes in the western US, still enjoys better returns and higher profitability than UP, thanks to its managers’ early spotting of the looming capacity shortage.
BNSF had most of its key Los Angeles to Chicago line double-tracked before a sudden surge in container traffic in 2004 that overwhelmed UP’s systems and pushed traffic to BNSF.
“We are behind the capacity curve,” admits Jim Young, UP’s chief executive, who blames the problem partly on the former Southern Pacific, which UP took over in 1996 during a consolidation wave that also saw the then Burlington Northern take over the better-maintained Santa Fe.
UP is now rushing to double-track the Southern Pacific’s key Los Angeles to Texas Sunset Corridor, whose deficiencies lay behind many of its problems in 2004.
Even the better-performing operators face a challenge raising the funds needed to invest for continued growth. UP plans to invest about $3.2bn this year, while BNSF plans to spend $2.75bn.
Of the two, only BNSF consistently earns more than the roughly 10 per cent it and other railroads have to pay to raise capital.
Even its position would look less healthy if its returns were calculated against the replacement cost of its assets, not the unrealistically low historic cost.
Matthew Rose, BNSF’s chief executive, consequently concentrates investment on the core, strategic network, such as the Los Angeles-Chicago route, which is high-growth and low-risk for capital investment.
This approach has required freight rate rises, which have angered customers of BNSF and other railroads. “Quite frankly, if you’re a shipper in the US, you’ve been used to lower costs every year since motor carrier, railroad and airline deregulation [in 1980],” Mr Rose says. “So customers are frustrated because for the first time they’re seeing rates go up.”
The development is leading to “a lot of noise” from the marketplace saying the industry is making too much money, Mr Rose adds.
“When you look at the basic returns and compare that to the S&P 500, we’re still below the majority of the S&P 500. It’s puzzling how anyone can look at the industry and say we’re making excessive profits.”
As long as there is no serious re-regulation there is substantial evidence rates will keep increasing, helping to fund projects such as the UP’s double-tracking of the Sunset Corridor.
That is the hope at UP, whose financial performance is poorer largely because 25 per cent of its business is still conducted under long-term contracts signed in the industry’s fallow days.
The company, which earned 8.2 per cent on its invested capital last year, hopes to improve its performance as the contracts gradually come up for renewal.