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Driving growth and differential performance among Class I railroads

  1. February 15, 2022 Driving growth and differential performance among Class 1 railroads
  2. 2 Summary Building a precision-scheduled railroad generated substantial benefit for Class I railroads and their shareholders when compared to their prior performance. However, with nearly all railroads pursuing the same strategy, we see performance co-related with industrial production rather than strategic choices to grow top-line. Breaking away from the narrow range of industry peer performance will likely require more deliberate choices about the scope of operations and services that offer good prospects for returns on capital. Railroad executives should shift attention from operations to the configuration of commercial functions to help realize distinct competitive advantages and improved shareholder returns.
  3. 3 Over the past several decades, nearly every Class I railroad implemented practices associated with a Precision Scheduled Railroading (PSR) Nearly all class I railroads implemented PSR between 1998 and 2019 Harrison joins Canadian National and implements PSR – operating ratio (OR) fell from 89% to 61% 1998 Harrison joins Canadian Pacific. OR falls from the highest in industry at 83% to 60% by 2015 2012 Harrison appointed CEO of CSX; achieves 57% OR 2017 E. Hunter Harrison pioneers the concept of PSR 1993 Union Pacific achieves 60% OR through PSR 2018 Norfolk Southern and Kansas City Southern adopt PSR; BNSF the only Class 1 railroad to not adopt PSR 2019 Train lengths grew; operating routes and schedules became restrictive; workforce size reduced 2021 Source: Company Annual Reports, Deloitte Analysis
  4. 4 Over time operating ratios for all Class I operators migrated to a narrow 57–65% band, improving margins across the sector 71.6% 71.6% 70.8% 69.6% 67.0% 65.0% 64.8% 63.8% 63.2% 63.0% 61.5% 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Class I Operating Ratios1 CLASS I AVG Source: Company Annual Reports Notes: Grey trend lines indicate operating ratios of Class I operators including BNSF, CN, CP, CSX, KCS, NS and UP 64 – 77% 57 – 65% Operating ratio narrowed to 8 ppt range, increasing short term profits for the entire sector Operating ratio at 13 ppt range; only CN had adopted PSR principles 58 - 73%
  5. 5 Despite margin gains, ROC continues to be near-constant, pointing to revenue growth constraints in the industry 9.4% 10.1% 10.8% 11.0% 11.7% 11.0% 10.1% 10.4% 10.7% 10.6% 5% 10% 15% 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 BNSF CN CP CSX KCS NS UP Average Return on Capital Source: CapIQ financials (2010-2019) for Return on Capital; The Surface Transport Board reports for Railroad Industry’s Cost of Capital
  6. 6 $0 $10 $20 $30 $40 $50 $60 $70 $80 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Thousands Looking at the five years pre-COVID, rail freight ton-miles declined along with revenue growth Railroad Revenue ($B) Rail share of ton-miles has been declining, confirming cost reductions and efficiency gains did not lead to substitution among other modes of transportation In addition, restrictions on pricing further flattened the revenue growth (avg. rail rates are 44% lower today than in 1981) Source: Bureau of Transportation Statistics; United States only % Share of US Ton-Miles of Freight Freight Ton-miles (Millions of tons) Reduction in coal shipments 1.7 1.6 1.7 1.7 1.6 39% 41% 40% 39% 40% 34% 32% 33% 33% 31% 0% 10% 20% 30% 40% 50% 0 1 2 3 4 2015 2016 2017 2018 2019 Total Rail Ton-miles Trucking share of Freight Ton-Miles Rail share of Freight Ton-miles
  7. 7 Looking at the past five years, rail revenue growth significantly lagged Trucking and the overall Transportation sector, driven by sector-wide headwinds 5.2% 6.7% 0.4% 7.5% 7.2% 3.9% -2.2% 4.5% 1.5% 3.9% -3% -1% 1% 3% 5% 7% 9% Air Water Pipeline Rail Trucking Revenue CAGR 2010-2014 CAGR 2015-2019 CAGR Transportation CAGR (2014-19): 3.40% Industrial Production CAGR (2014-19): 0.64% Source: Bureau of Transportation Statistics (BTS) Notes: 2020 excluded due to covid implications; Air – BTS data includes revenue for both passenger and freight services; Water – only accounts for domestic water transportation; Pipeline – includes both Gas and Oil pipeline transportation, For projections, gas utilities CAGR was used as it is major component of pipeline industry; Railroad – consists of only Class 1 Railroad revenue Some of the factors that contributed to the growth were boom post 2008/09 recession and increased crude oil volumes Decline primarily driven by changes to the mix e.g., coal plants shut down, freight recession 2016/17
  8. 8 • What is beyond PSR for railroads? • What actions would meet investor expectations over the next five years? • What are the sources of revenue growth? What is your strategy? • How can railroads become more customer-centric? • What level of margin and growth trade-off are you willing to make? Can railroads grow their top line while maintaining a low operating ratio? What’s next?
  9. 9 IndustryAnalogs: Strategies employed by other transportation companies suggest a range of options as Class I railroads determine their next steps More Plausible Less Plausible BUSINESS STRATEGY FINANCIAL STRATEGY EXPAND INTERMODAL BUSINESS RECAPITALIZE WITH LONG TERM INVESTORS PURSUE EMPLOYEE OWNERSHIP MONETIZE INFORMATION ASSETS EXPAND OUTSIDE NORTH AMERICA PRIVATIZE RAIL ASSETS Public policy, regulatory, and industry structural factors narrow options for Class I railroads United airlines extended 55% equity to employees Jordan industries acquisition of Echo global logistics; Infrastructure funds buying into shortlines JOINT VENTURE Chicago sold city’s parking meters to a consortium of companies led by Morgan Stanley XPO Logistics acquisition of Norbert Dentressangle in Europe Forward Air acquisition of BarOle Trucking Air France, KLM, Delta and Virgin Atlantic joint venture FedEx Dataworks using Big Data to jointly plan customer demands/returns Source: Factiva, News Articles, Deloitte Research
  10. 10 Investments already being done by railroads, that should continue 1. Continue to apply PSR to enhance asset efficiency on the main line, where opportunity exists 2. Adopt new talent models, that are possible today with available technology (e.g., advanced analytics, automation, manage service for back-office functions) 3. Shape the public policy under Biden administration to support rail growth 1. Improve industrial development, attracting factories/ port facilities/ warehouses to adjacent real estate 2. Improve interface and collaboration with other modes – ports/ocean shipping/ trucking through technology 3. Yield Management – implementing day-of-week pricing and other levers to lower congestion and smooth operations Existing ideas in the industry Source: Biden Infrastructure plan announced on Mar 31, 2021 Table-staked
  11. 11 Talk to us Larry Hitchcock US National Transportation Industry Leader James Miller Canada Railroad Sector Leader Erich Fischer Strategy, Automotive & Transportation industry Yasir Mehboob Transportation | Restructuring and Value Creation Services
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