Class I outlook: A gradual recovery's in the offing, CEOs say

By Jeff Stagl, Managing Editor

Late last year, Class I chief executives predicted 2009 would be a tough year because of the withering economy. But they also expected an upturn to occur in late 2009. They were certainly right on the first count and way off base on the second.

The lingering recession has kept Class Is' 2009 traffic levels about 20 percent below 2008 levels and a number of commodities — namely ores, coal, aggregates, lumber, paper, metals and autos — have tanked all year.

However, there were the smallest of signs that the economy bottomed out in the third quarter, when Class Is noted a slight traffic upturn.

"Our carloads were up 3 to 6 percent from the second quarter to the third quarter," said CSX Corp. Chairman, President and CEO Michael Ward. "The seasonal pattern usually shows traffic is 2 to 3 percent less from the second to the third quarter."

Norfolk Southern Corp. registered an 8 percent sequential traffic improvement from the second to third quarter, said Chairman, President and CEO Wick Moorman.

"The second quarter is usually our biggest traffic quarter," he said. "We saw stabilization in a lot of our traffic base."

The traffic upturn then carried over into the year's last quarter, during which U.S. railroads registered their highest weekly carload total of '09 at 287,087 units.

"Four of our six businesses — agriculture, automotive, chemicals and intermodal — were trending a little better in the fourth quarter compared to September year-to-date numbers," said Union Pacific Railroad Chairman, President and CEO Jim Young.

Needless to say, the economy and its direction heading into and through 2010 was top of mind last month among the six Class I CEOs Progressive Railroading interviewed, emailed or, in one case, quoted from a transportation conference presentation.

Although pending legislation, the positive train control mandate and Berkshire Hathaway Inc./BNSF Railway Co. deal also merited discussion, the chief executives had a lot to say about the economy's outlook, albeit without providing predictions on 2010 traffic or revenue levels. In addition, they mentioned the need to continue controlling what's primarily under their control: operating costs and service reliability.

The consensus on the economy: expect a very slow recovery — so slow it'll probably take longer than one year to occur.

"I think it will be several years before we're back to peak volumes," said BNSF Chairman, President and CEO Matt Rose during a Nov. 17 interview in Fort Worth, Texas. "This recession didn't come from over-expansion like before, it came from a disconnect of the credit markets."

A Pathfinding Mission

There's a lot of deleveraging that needs to take place over the next few years to support a rebound, said soon-to-be CN top exec Claude Mongeau at the Citi Industrial Manufacturing & Transportation Conference held Nov. 12 in New York City.

"We hope we are on the right path and are managing our business on the basis that this economy is on firm ground, but with a gradual recovery as opposed to a V-shaped type of business outlook," said Mongeau, who will succeed E. Hunter Harrison as CN's President and CEO on Jan. 1.

Based on revenue ton-miles — which is a better volume indicator than carloads, Mongeau believes — CN's Q3 volumes were up about 5 percent vs. Q2, and traffic was similarly increasing in Q4.

"The good news is that business is going up," said Mongeau. "In basically the last 30 weeks, we've seen sequential growth — not leaps and bounds, but sequential growth on a week-over-week basis."

The baby steps show the economy has at least reached "normalization" — or the "end of the hemorrhaging," said NS' Moorman during a Nov. 30 phone interview.

"The freefall has stopped," he said. "I think we'll see growth in a few segments; ag and chemicals are getting better, and metallurgical coal for export is getting very strong."

Although UP is planning for a slow recovery, the Class I is positioned to handle a faster rebound if one occurs, said Young in an email.

"We have the flexibility to bring back furloughed employees and put assets into service if volumes come back quickly," he said.

The key to any recovery will be consumer spending, which drives 70 percent of the U.S. Gross Domestic Product, said Young.

For most of 2009, consumers have been doing something quite "un-American," namely "saving money and putting off purchases of a house or car," said CSX's Ward during a Nov. 19 phone interview.

The CEOs are hoping that trend reverses next year.

"We will be watching for increased consumer confidence — to drive stronger demand in sectors such as housing, furniture, cars and clothes," said UP's Young in his email.

Canadian Pacific President and CEO Fred Green also will closely monitor consumer spending, which "influences our international intermodal and automotive franchises," he said in an email.

"Both of these areas remain well below 2008 levels and require consumer confidence to return before we will see a significant increase in volumes," said Green.

Because 45 percent of CP's business is "global in nature," Green also plans to keep tabs on international consumer patterns.

"We are less exposed to North American economic trending and therefore will follow global demand for items such as grain, steel and potash," he said.

Fear Not a Factor

NS' Moorman believes the "fear of the unknown" that was evident among U.S. consumers and financial markets in the first quarter isn't as prevalent now.

"The fear gripping the economic world has largely dissipated," he said.

Federal recovery programs such as Cash for Clunkers helped spur consumer spending in the third quarter. However, there might not be federal dollars available next year to implement similar measures, said CSX's Ward.

"The question is: Can we afford such programs in 2010?" he asked.

In addition to increased consumer spending, the creation of more jobs and a large reduction in furloughs would help drive the recovery.

"We need to break the back on unemployment," said BNSF's Rose.

The CEOs hope to do the same to legislation aimed at eliminating railroads' antitrust exemption. As of press time, Sen. John Rockefeller (D-W.Va.) continued to work on an anticipated bill that would reform the Surface Transportation Board (STB) and provide more federal oversight of rail rates — something shippers, specifically captive shippers, have been seeking for years.

"The legislation grew from shippers frustrated with either their rates or service from a railroad, and I can understand that. But the STB already has taken steps to improve processes for shipper complaints," said Rose. "As long as the bill doesn't affect our ability to make money and put money back in, and is efficient for shippers, that's fine."

However, the "re-regulation" bills as drafted so far would impede the Class Is' ability to earn their cost of capital and reinvest in their railroads, the CEOs say. In addition, the bills incorrectly paint the rail industry as one that has a high return on investment, said Rose.

"The industry only makes an 8 to 10 percent return on investment — would those be called excessive profits?" he asked. "If it was 18 percent, I could see that. So, how can this not be messed up? Don't impede or harm with onerous legislation."

UP is trying to ensure that doesn't happen by sharing "an important message" with legislators, said Young in his email.

"Private investment in new rail capacity can help alleviate the burden on America's infrastructure," he said. "For example, we can build five miles of rail for the same amount it costs taxpayers to pay for one urban highway mile."

If UP can't earn an adequate return on investments, shippers, workers and motorists will be affected, said Young.

"Ultimately, our customers will feel the impact of this through a smaller network," he said. "Instead of hiring, our unions will see employees lose jobs, and more freight traffic inevitably will move to an already overcrowded and poorly maintained highway system."

Recent discussions suggest a balanced legislative solution might be achievable, said CP's Green in his email, adding that such a bill wouldn't impede railroads' long-term investment needs.

"The largest issue facing the rail industry in 2010 and beyond is our ability to earn our cost of capital on a sustained basis," he said.

CSX's Ward believes the months it's taking Rockefeller to draft his bill bodes well for a balanced measure.

"I'm encouraged that he's taking this long to consider it and try to put good needle to thread," said Ward. "If both sides say the bill is sort of OK, that's what he's striving for."

Keep Coal in Fold

Any legislation that hinders coal from remaining the nation's leading energy-producing fuel source definitely isn't OK by the Class Is. The Obama Administration's proposed "climate" bill that favors wind, solar, nuclear, natural gas and other electricity-generating fuels over coal to reduce carbon emissions by 2020 poses long-term issues for both the rail industry and consumers, the CEOs say.

"You can't displace 50 percent of energy generated by coal in 10 years with wind or solar or nukes or natural gas," said Ward. "A lot of capacity would have to be brought online. And what does this do to electricity prices and manufacturing?"

Or to rail traffic — NS estimates the bill would decrease its coal business by 25 percent.

"There are some people that think coal is evil, but the public wants the lights to go on when they hit the switch," said NS' Moorman.

While a "re-reg" bill would have an immediate negative effect on the rail industry, the climate bill's impact would take much longer to be felt, he said.

"With the climate bill, we'd have time to adjust and work on a plan out of it," said Moorman.

Reducing carbon emissions obviously is good for the nation, and although the climate bill isn't a good one for the rail industry, railroads would likely survive while energy costs would soar, said Rose.

Pondering PTC

However, there's a cost all Class Is are facing that's difficult to endure. The billions of dollars needed to deploy positive train control (PTC) by 2015's end to comply with federal law will drain money away from other infrastructure needs, the CEOs say. (For more information on how the Class Is are dealing with the PTC mandate, see page 40.)

The implementation of PTC is the industry's biggest technological changeover since the conversion from steam to diesel locomotives, said Rose. Yet, the money spent on PTC is "inefficient capital," he said.

"You look at ties, rail, ballast, signals and other types of safety enhancements," said Rose. "What if we can't put in ties, rail, ballast and other things because of PTC?"

Another cost needs to be considered, as well, said UP's Young.

"There's an element to PTC that hasn't been widely discussed, and it is that higher prices will be required for at least some shippers due to this unfunded mandate," he said.

PTC costs far outweigh the safety benefits — by about 16 to one — and there's been no study conducted on ways to improve the safety of operations and hazardous-material moves that would cost less than PTC, said NS' Moorman.

"We need to do this in a rational manner, and the FRA can help bring rationality to the debate," he said. "This still needs to be played out."

So does any attempt to garner a tax credit, grant or other funding mechanism from the feds for PTC. Moorman believes there's a chance some form of legislation could be drafted in 2010.

"I think we can get a sympathetic ear in Congress next year to help pay for this," he said.

On Standby

Congressional hopes and aims aside, the Class Is won't be able to manage costs and increase income next year unless the economy provides at least a small assist. Because of high fuel prices and congested highways, railroads are poised to take advantage of a recovery if, and when, one arrives, said CN's Mongeau at the transportation conference.

"As business comes back, there's no question the ability — with the service levels we've achieved as an industry — to get sustained pricing discipline is there, perhaps not at the level of the last couple of years, but certainly at inflation-plus," he said. "We're very bullish about the economy recovering."

So is CSX, which needs to remain nimble for when volumes ramp back up, said Ward.

"We still have 600 locomotives and 25,000 cars in storage, but we only need a day or two to get them back online," he said.

Because of train design improvements and continuous-improvement processes, CP won't need to bring back resources on a one-to-one basis when volumes return, said Green in his email. He believes the railroad's ability to sustain operational performance will make CP stronger coming out of the recession.

Ditto for the other Class Is, CEOs say.

"The big unknown is where volumes will go," said Green. "But our ability to absorb volumes in current trains and to react quickly when train design changes are required will allow us to perform in any situation."