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March 2008
This management paradox is as old as the iron horse, but perhaps never has caused so much stress in the rail stakeholder community as it has in the 21st century. With capacity tight on a secular basis — yet loose on a cyclical basis — we have shippers (and regulators and legislators) concerned about under- capacity, and simultaneously (some) in the investment community worried (somehow) about over-capacity!
That the rails entered 2008 — possibly the most uncertain year in recent economic history — with essentially unchanged capex following the record spending year of 2007 offers commentary to the contrary: It’s a red-letter, amazing vote of confidence in the long-term future of the rail industry.
Railroads have tried to pacify the outcry in Washington over higher rates and, well, fair service by stating correctly that higher returns were necessary to justify capital expenditures, and that they were pouring more money into the rail network as rates and returns increased. Railroads have faced tougher shipper/government scrutiny since the system congestion that came with the volume wave of 2003-05 — a wave that, in turn, helped railroads capture pricing power for the first time in modern memory.
Given the outlook for an infrastructure crisis across all modes in the not-too-distant future, that re-regulation remains even a remote political possibility seems absurd. Ultimately, how capital is employed and balanced among operational, political and financial objectives will reveal a lot.
There remains an “old guard” in the investment community that looks at recessions as a time to batten down hatches, cut variable costs — and cut capex to prevent over-capacity and maintain free cash flow.
The recent series of fourth-quarter/year-end 2007 conference calls featured many questions of the “How fixed is your ‘08 capital plan?” and “Can you reduce capex should the economy worsen?” variety. To worry about rail over-capacity is to ignore that it took decades to eliminate over-capacity and, given the amounts of money and labor involved, decades to re-create it. Highway over-capacity exacerbates the issue on its cyclical edges, as it were, not at its secular core. To the old guard may be added some new investors, charging like the Light Brigade through the industry (hopefully with better results!).
This group, it’s been said, wants to cut capex, both on a cyclical, old-guard fashion, on a secular basis (the better, it’s been said, to fund buybacks, etc.) — or until the regulatory situation is resolved (a strategy diametrically opposed to the aforementioned rail response).
My guess: Given the expected returns on new capacity in the next cycle (and beyond), the supposed alliance between some traditional and some newer investors on the amounts and meaning of capex is fairly temporary.
Of the seven biggest railroads, four have increased their capital budgets over 2007’s, led by Norfolk Southern Railway’s 6 percent projected increase, with Union Pacific Railroad’s, CSX Transportation’s and BNSF Railway Co.’s budgets down slightly (the latter perhaps showing some of its cards to Washington).
But comparing this year’s plans to last year’s isn’t the best way to judge the railways’ change of character.
In the recession that started this century, rails reduced capex for several years — after several years of sharp increases as we saw this past cycle. The “if we build it they will come” mantra proved to be premature ... but not by too much. Those rails that too closely matched the poor short-term outlook with their capex budgets (combined, arguably, with historic underspending) found themselves in a “fluidity crisis” when that volume wave struck in 2003.
Although the more congested systems appear to have caught up after massive expenditures of capital and systems work, the rails surely left billions on the table in cash flow when they turned business away. That lesson certainly has been learned by the current management crop, if not by all rail stakeholders. They’re putting their money where their beliefs are.
Tony Hatch has been a senior transportation analyst on Wall Street for 19 years, and an independent analyst and consultant since 1998.
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