UP and KCS: A tale of two PSR interpretations — analysis by Tony Hatch

Last month, two western (well, west of the Mississippi) railroads reported above-consensus first-quarter earnings: Kansas City Southern, which grew year over year (YOY) by 18 percent (adjusted, versus Street estimates of around 10 percent); and Union Pacific Railroad, in its weather-dominated quarter, by 15 percent YOY (versus around 12 percent). KCS lowered its operating ratio by 160 basis points (bps) to (adjusted) 64.2, and UP lowered its OR by a point — having absorbed a 160bps weather impact — to 63.6. It was also noted that “at Union Pacific, we do not include real estate sales in our OR.” Zing! But more than the results — it was the differing tones and tenors of the earnings' webcasts that struck me.

Both carriers unveiled for the first full time their precision scheduled railroad (PSR) gurus: the high-profile big game Canadian prizes of Sameh Fahmy, chief PSR officer at KCS; and Jim “$8 Billion-Dollar Man” Vena, the chief operating officer at UP. But listen to KCS CEO Pat Ottensmeyer in response to the baying of the analyst members of the Cult of the OR (“Shame!  Shame!”): “Our focus here [is on] operating ratio improvement as a result of changing the way we operate and manage the network. ... [We are] primarily focused on service and growth.” That quote could have come from the book of Hunter Harrison himself.

Union Pacific: Summer is coming!

It’s not that UP strategists aren’t concerned with growth — they had to defend that accusation and did so with conviction — it's just that their presentation was more traditional PSR, if revolutions can have a tradition (it was cost and productivity and operations focused). 

For UP, specifically:

• That they reiterated their 2019 fiscal-year guidance (FYG) in the face of the 15 cents per share hit to earnings from the flood is remarkable in of itself. However, they faced their baying hounds on issues of OR and capex (asking if PSR would allow UP to spend well below 15 percent of revenues) with a different attitude — just as assured, of course, but focused on productivity. I have always said there are multiple ways to skin a raven. It is curious, however, that the financial community seems to be unsullied, as it were, by the PHR (Post Hunter Railroad) experience in Canada (growth pivot backed by spending and high return on invested capital), even as Vena was a big part of it.

• The fact that they reiterated FYG on volume (low single digit, after Q1/19 started out as down 2 percent), pricing (Q1/19 “core price” gains of +2.75 were a step forward for the railroad, although probably would rank in the bottom of the league tables) and OR (“sub-61 percent for 2019 and below 60 percent for ’20”) after the weather ravaged first quarter was attributed to a sign of PSR working and resiliency being built into the network. UP is almost entirely behind the operational and financial impacts of the storm and flooding. "We are moving traffic as presented," as Vena noted.

• The reiteration of the FY19 UP goal of $500 million-plus in net productivity gains (savings) was truly noteworthy, given that Q1/19 produced “only” $60 million in such savings (fleet size, train length, car hire, etc.) and was matched by $60 million in “operational challenges."

• Despite those challenges, four of the six key performance indicators Vena listed showed improvement (the best: dwell was down 19 percent), although safety, not highlighted, suffered (P/I were up 22 percent). It seems they are making quick progress, without straying form their “measured approach” politically…

• Hump removals! Give the people what they want. UP reversed its strategy (after one quarter of a new COO) and closed/repositioned two humps, will add a third (it sure seems like a Chicagoland intermodal yard) and — after saying they were committed — stopping construction on the Brazos, New Mexico, yard. As CEO Lance Fritz correctly noted, PSR (or UP2020/G55-0) is “evergreen” — as it should be.

• More bread for the masses. With locomotive productivity up 6 percent in this difficult quarter, the stored-power roster reached 1,900.

• The volume story was mixed ... and I sensed an increased concern about the economy, even if Chief Marketing Officer Kenny Rocker was questioned about being perhaps over-optimistic; only crude by rail, industrial products and international intermodal (“Tariff pull-ahead,” which may distort numbers until toward the end of Q2) looked good. But this quarter’s volumes, especially for UP, are hard to extrapolate from!

• Capex conundrum. While being asked if they were able to reduce their spend (on a percent/revenue basis), UP will take the “savings” from Brazos (etc.) and reallocate the funds to sidings on the Sunset (etc.) to accommodate longer trains (which are clearly coming — train length was up 7 percent in Q1). But I remain questioning — if not fully skeptical, given the known unknowns — about the long term, comparing UP’s PSR revolution to the ”Golden Companies.” the PSR 2.0 (or PHR) railroads up in the North, despite Vena’s claims of building a railway to last (“two, three, four and even five years out” — emphasis, of course, being my own). 

KCS reveals its PSR mantra: 'Service begets growth' 

The subset to the PSR code was four-part: customer focused; facilitate growth; improve asset utilization; and (fourth!) improve cost profile." And yet, despite that unusual (as in refreshing) PSR ordering, KCS shook off any doubts I might have had by going full bore on the concept (four full slides, as compared to just one in the January webcast) and having its chief PSR officer as a major component of the broadcast/Q&A.  

KCS also was impacted by the weather events sweeping through its largest interline partners, as well as those specific to its unique location — trade distortions and tariff fears, teacher strikes, etc. (there was little to no discussion of politics on the webcast). And with the exception of the 1 percent decline in units in Q1/19, reducing FYG for volume by a point (to +2 percent to 3 percent; 70 percent of the book still is classified as “favorable”), the remaining targets were unchanged. But my biggest takeaway was a bold view of PSR as a growth-driver (something Hunter always espoused) — of looking at change not to please the lowest common denominator (“Our approach is not to just close yards”), but to achieve their credo: service begets growth!

Mr. Fahmy noted there were “a lot of fruits still hanging,” presumably including some that are low-hanging. My only reservation was not his discussion, for I have a long-lived respect for Sameh; it was a lingering sense that a lot of the clear progress being made was coming more from him, and COO Jeff Songer (and team), and less from a systemic change. There was great stock taken in “exception reporting” (as there should be, I assume), but I think the market, having seen KCS rise, slump and rise again, would like to see changes that clearly could survive the loss of great PSR warriors.

For KCS, Q1/19 operating metrics improved sequentially and YOY — dwell by 5 percent/16 percent; gross velocity by 11 percent/13 percent (KCS changed its reporting of this from net); and car-miles/day by 5 percent YOY) ... and with it, they looked for net reduction of the locomotives (by about 100) and rail cars (“1,000 identified”). PSR initiatives so far have accounted for around $19 million in 2019 savings, which will grow to $25 million in annualized savings — at a cost of a Q1/19 charge of $67.5 million.

KCS had the usual non-value accounting issues; in this case, Mexican tax reform creating a GAAP change. KCS execs also effectively downplayed the Mexican government study on market dominance. In the face of numerous questions, Ottensmeyer strongly stated that there is one KCS  — not a U.S. and a Mexican system joined in Texas.

The KCS growth opportunities continue to show promise, despite all of the political haranguing. Cross-border volumes were up 13 percent (revenues were up 18 percent), while “energy reform” related volumes grew 188 percent (revenues 164 percent). Cross-border intermodal volumes grew a less robust 5 percent (revenues dropped 6 percent), but recent border disruptions and the long truck lines they engendered are seen as, in effect, a marketing opportunity for cross-border intermodal. Lazaro Cardenas was still dismal (down 26 percent).

Tony Hatch is an independent transportation analyst and consultant, and a program consultant for Progressive Railroading’s RailTrends® conference. Email him at abh18@mindspring.com.