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By Tony Hatch

I think RailTrends 2009 was our best summit yet, clearly showing the benefits of being lucky, in terms of timing — the perennial “rereg,” as well as positive train control (PTC), and strategy and capital in a changing world — as well as … well, putting together a good program.

I left the busy sessions (Oct. 6-7 at the Affinia Manhattan in New York City) with reasons to keep the faith in the “railroad renaissance,” helped by an outstanding presentation from Walmart Stores Inc. — Mssrs. Kelly Abney, vice president of corporate transportation, and Greg Forbis, senior director of general merchandise traffic — on the retailer’s future logistics plans. Those plans reinforce the opportunity — and the challenge of extremely high service standards — for pure domestic intermodal. And that opportunity was a topic of discussion among rail planners during the course of the event.

Short lines, too, are a scorching topic these days, and not just newly public again RailAmerica Inc. Joining us at RailTrends were Rick Webb, chief executive officer of The Watco Cos., and representatives from three carriers that work with Norfolk Southern Railway on the Empire Link corridor: Jim Howarth, vice president of business development for the New York Susquehanna and Western Railway; Reilly McCarren, owner and chairman of the Arkansas & Missouri Railroad; and Mike Smith, president of Finger Lakes Railway Corp.

Mr. Webb discussed his company’s diversification strength and, of course, the current economic weakness as it impacts his 22 railroads and other business units. (“Hopefully, it’s stabilizing,” he said.) But his underlying message was in sync with the aforementioned opportunities. “From a growth standpoint, we should grow faster than [our Class I partners] do — if not, then they have no business working with us.”) As for the Empire Link short-liners: They’re showing that local entrepreneurship can reap growth, particularly when a Class I partner is a class act, partnership wise (“I credit Norfolk Southern for providing real support,” said Finger Lakes Railway’s Smith. “These guys are making it happen. And it can be done all over the country.”)

Meanwhile, Mexico looks like it can be a big winner in the “new normal,” and Kansas City Southern Executive Vice President of Sales and Marketing Pat Ottensmeyer gave the NAFTA Railway’s best presentation yet on the opportunities there. He provided the most detail, by far, on specific Mexican industrial and consumer growth prospects, as well as Mexican and cross-border marketshare opportunities.

But I also was confronted by more challenges to my world view than I had expected during RT2009 — perhaps that is what epitomizes a great conference besides the quality of the fellowship: It made (and continues to make) me think. We also saw our first-ever “standing–o” as CN’s Hunter Harrison — joining us to receive Progressive Railroading’s first-ever “Railroad Innovator Award” — gave a valedictory-like address, demanding that we think. He also added that familiar refrain: From challenges come great opportunities for change.

Five of the challenges that framed this year’s event are particularly worth noting:

1. Domestic intermodal business is hard — the service levels are intense, as is the competition. The combination of better rail service (keeping the velocity gains from the recession into the recovery, for example), higher fuel prices, congested roads (someday again) and the increased attention to lower carbon footprints all create opportunity, but it won’t be easy, as presenter Jim McClellan (formerly of NS and now VP of Woodside Consulting Group) and many others pointed out.

2. Rereg — the perennial issue, it seems, may indeed be coming to some conclusion , or so many speakers and attendees thought. We heard from just about every side on this issue — from rails to labor to regulators to shippers to legislators — but truth be told, only the Senate Commerce Committee truly knows anything. We may see something soon — by late October or shortly thereafter. There is a huge potential downside to done wrong, balanced (the word du jour) regulation — not by inclusion of replacement cost, but by “cloud removal” and (a promised) access to future government funds. The fear here (and elsewhere in the investment community) is that railroads would compromise and agree to a less-than “balanced” legislation, perhaps in a split of western and eastern rail interests. Why would they do that? One possibility: They have a different set of priorities than their investors (owners) do. Another: Each railroad records differing results from different changes to, say, bottleneck rules — which, arguably, could split, at least slightly, their “united front.”

3. PTC is a much bigger topic of fear to rails than the Street realizes. In our annual “Wall Street” panel — which featured J.P. Morgan’s Tom Wadewitz, UBS’ Rick Paterson and yours truly — there was no (as in zero) mention of PTC, but to rail CEOs the possible $10 billion “unfunded mandate” is issue No. 1, or at least No. 1A. Two years ago, I recall discussions extolling the virtues of PTC (capacity, velocity, labor needs, etc.), and yet now the costs appear to well exceed those benefits in a changed world. Several RT2009 speakers discussed PTC’s implications and ramifications: Federal Railroad Administrator Joseph Szabo, Union Pacific Railroad AVP of Information Technology Jeff Young and Michigan State University Adjunct Professor Steven Ditmeyer.

4. “Climate change” looks more daunting than many of us had thought — from new natural gas technologies to a concerted effort to attack coal. Huge utility coal inventories will hurt intermediate-term coal results, as well. Meanwhile, rail efforts to receive compensation for the revenue loss from what in effect would be anti-coal legislation — given the assets they have built with the government’s encouragement — in the form, perhaps, of carbon credits, similar to what the utilities themselves would be getting. This is the other edge of the double-edged “green” sword for rails: Will domestic intermodal (and carload) gains compensate for coal declines?

5. Capex remains high, but meaningful government help (partnerships) are no guarantee. Even beyond the normal capital intensity (rails have averaged spending about 17 cents on the revenue dollar on capex), there looms PTC, as well as locomotive emissions controls — the latter of which will add a stunning 25 percent to the cost of new locomotives, plus higher maintenance costs sometime in the middle of the next decade, or so we learned from representatives of our locomotive manufacturer panel. Meanwhile, railroads will spread around tight-and-getting-tighter government funds to a lot of worthy causes. As NS EVP Planning and Chief Information Officer Deb Butler noted, there is unprecedented uncertainty out there. And for suppliers — those not tied to track and signaling, anyway — the drought looks to be a long, long one.

“And yet it moves” — or so said Galileo when his theory was questioned, and so say I: In the face of these challenges, as well as the overriding one (the pace and new directions of the economic recovery), I see an emerging rail story where the incremental margins in the recovery exceed those that have so far (positively) shocked in the recession.

That doesn’t make sense to some; rail group margins have held in the face of the amazing traffic volume decline (nearly 20 percent) because rails have increased the percentage of cost that is variable, which should mean incremental (not overall) margins actually will decline in the recovery and growth phase — but that assumes a static condition. And the rails, and their $8 billion in recent average annual (and more info-intensive) capex, are not static.

The test will be to hold off the D.C. threats while embracing the D.C. opportunities (railways as saviors), to hold or improve service metrics and system velocity (and, thus, asset turns) in the recovery. If railroads do that, productivity (and earnings) growth will be explosive, and market share opportunities in formerly medium and short lengths of haul, will be dramatic. It is hard work, but the rewards, public and private, are out there for the taking … or so we discerned, discussed and digested during RT 2009.

Tony Hatch is an independent transportation industry analyst and consultant who also serves as RailTrends’ program consultant. He can be reached via email at abh18@mindspring.com.