Discussion Points

“The key to the long economic expansion? Logistics!” /(former colleague) Andy Kessler, WSJ

· “It’s impossible for business to plan for the future in this type of environment”/National Retail Federation VP-Govt Affairs

· “The Age of Deglobalization is here”/FT

· “We have over-estimated the arrival of Autonomous Vehicles”/ Joe Hackett, CEO, Ford Motor Company

· “Trump, Capitol Hill Silent on Infrastructure Policy” / Transport Topics (the ATA) & “Infrastructure Bill Stalls on funding” (WSJ 9/3)

Greetings;

So as we all return from the beach the rail world has been active; so have and will I, having just returned from the excellent “Canada Moves by Rail” forum sponsored by the Railway Association of Canada in Ottawa (note the excellent CP overview from the event, attached). I will be off next week to the Intermodal Expo in Long Beach; the following week at the massive Railway (~10K attendees) Interchange operations convention in Minneapolis and the week after that at NEARS in….the Peoples’ Republic of Vermont. Before attempting to diagnose and analyze the recent events and pronouncements in the North American Freight World, how about a Holy Moly! Imagine my shock at opening the weekend WSJ to find a full-page (A-6!) ad by a law firm seeking shippers to initiate litigation against the rails for fuel surcharges 2003-08 (attached)! Wow….I wonder what the ROI of that expenditure will be? Also, I have hosted three distinguished railroaders in a series of calls and/or meetings, and what they had to say seriously challenged some of my conceptions of the rail world today (changing opinions noted in red)….and what further could be said on trade? The 21st C version of “ping pong diplomacy” is no friend to rails….

So – onto the discussion points, of which there are 6 of note:

1. Will Union Pacific’s cautionary volume guidance reduction set the tone for the quarter? You may recall that the Q1/19 rail earnings report theme was “reiteration” (“it was weather; we’ll make guidance”); Q2 was “capitulation” (“With 6 months - + - of weekly volume recorded we clearly will not make our January guidance”) – Q3 might be “freight recession”. That highlights both the volume struggle and the rails’ real Achilles heal – intermediate/long term market planning estimates. This can happen just as easily on the upside (BNSF 2014; CNI 2017, etc). UNP cited weak volume (Q3 down 7% YTD!), with coal down 17% (see below) and “Premium” (in this case intermodal) still down ~10%. Most operational targets (KPIs) are being improved (although velocity is still an issue. However, UNO still reiterated OR targets, pricing goals, and ~$500mm in productivity improvements for 2019. The message is that PSR is working at UNP but the volumes are not (yet) contributing….One thing to remember is that rails operate better in low volume environments, a simple fact that I had hoped over time and given the enormous 21st C CAPEX, wouldn’t be so pronounced (but I have – yet – to be proven correct on this). UNP reiterated their collaborative/deliberative approach (to the chagrin of some but hardly foolish given the anxiousness of the STB to “get involved”. UNP also reiterated their CAPEX policy, about which I am less enthusiastic….


2. One question is why is the volume so weak? The five buckets I have been ascribing to the problem are coming more into focus; in ascending estimated order of importance: the economy (note recent jobs and manufacturing numbers; earnings warnings from Home Depot, Deere, etc); the (related) trade weakness and irrational dispute; truck over-capacity; weather (the lingering impacts of flooding on systems – and Ag); PSR (both voluntary and involuntary traffic cuts).

a. The revamped AAR publication “Rail Time Indicators” (RTI) may have been the first to label today’s volumes a sign of a “freight recession”; as carloads in the USA declined 4.6% in August YOY, the 7th straight month of declines (as August was for intermodal, -5.4%), only 8 of 20 categories up.

b. Canada had been the saving grace for the rails – but for the first time in 5 months, its carload and intermodal volumes were down (0.9% and 2.6%, respectively). 10/20 categories showed increases.

c. Mexico (yes you heard that correctly – thank you RTI!) was flattish, but the slight (0.1% decline was its 7th straight; intermodal was down 4.3% and they scored 10/20 also….Mexico is continuing a study on a rail (land) bridge between the Pacific and Atlantic to compete with the Panama Canal. Also, AMLO released a 2020 budget suggesting 2% GDP growth (already attached as being too optimistic, supported by expectations of a “muted” – IHS – 2019 peak season).

3. The shortline boom continues! Recent deals – with more to come:

a. Mid-Rail gets on the board! Patriot, the short line holding company that was Gary Marino’s second such venture, was sold by Steel River to First State (of Australia) with partners that include Mid-Rail (& Gil Lamphere!). The management team, John Fenton et al, will stay intact and M-R will help provide Board experience and help in further deals….as with all of these the terms were undisclosed but we can well assume the multiples were full and not dissimilar to those publicly announced etc.

b. Omnitrax bought the Winchester & Washington (they seem to be on a roll)

c. CSX selling activity appears to be picking up the pace and it has changed selling tactics as well – and in a change of strategy, they are going about it much less publicly. The have changed leasing partners in a line near Savanah (GWR put; Watco in); sold the “Massena Line” in upstate NY to CN (more below) and are having folks high-railing in North Carolina, South Carolina, and mid-Ohio (all of that coming from shippers or potential bidders)….

d. The former CSX “Decatur Line”, now Watco’s Decatur & eastern Illinois RR, was featured in Trains Magazine. But remember that august publication is half foamer/half business, and the D&EI was definitely on the Latte side of the story, being featured in the magazine’s “Train Watching” (AKA “Train Spotting”) column, much to the delight of Watco’s strategy personnel….

e. Alpenglow, one of the Omnitrax offspring, announced that it had a new partner, CC&L Infrastructure of Toronto, which bought Alpenglow’s VIP Rail (a short line rail services operation near Sarnia) from Stonecourt Capital….

4. Bulk Blues

a. Coal – Moody’s downgraded the sector to negative as once again, bankruptcies begin to grow. But globally the situation, while poor, isn’t disastrous (75% of the expected growth will be Asian, enough to more than compensate for the USA). They followed up that report by noting that some $5B of further rail revenue could be lost sooner rather than later, on the order of -7%/year….

b. Ag – the annual Pro-Farmer tour suggested even the reduced USDA estimates for production were too high (for example its estimated corn crop is 8% below the government’s; soybeans 25%). To add to the China trade war woes, its looking like the “worst downturn in the ethanol industry’s history” according to their trade association, a political decision by the DoE that favors refiners over corn growers (over a third of the annual crop, normally). Along with Deere, fertilizer companies (Mosaic, Bayer) have issued earnings warnings. Just Monday it was reported that Japan’s corn bug issue wasn’t severe enough to warrant larger than-normal purchases of US corn, as the administration had suggested….

5) Shareholder news: Much has been made of the Business Roundtable’s decision to “downgrade” shareholder value from the to one of drivers of executive performance (the rest being stakeholders and the environment). This seems to fit the rail old-timers view that PSR was somehow destructive (the recent “Railway Age” editorial cited shareholder value not as over-emphasized but actually as a bad thing!). Belying the hullabaloo, as the WSJ points out, is the unchanged compensation plans – tied to SV, or components. It is worth noting that the Council of Institutional Investors instantly came out strongly against the move, and The Economist said such measures provide no measurable accountability for CEOs – and is, in fact, a “threat to long term prosperity”!

  • Meanwhile activists continue to make news – see Elliott and AT&T today – while some activists have actually seemingly targeted Pershing Square (noting, at the time, a ~30% gap to NAV in the PS portfolio; sounds familiar)! Also, recent documents and scuttlebutt suggest that activists directly or indirectly played a part in the big moves by GWR & UNP….

  • This is important not only for the issue of activism but as part of the struggle of longer term investing (capex) and short termism; actual studies of investing in general and rail investing in particular show a pretty good correlation between capex and ROIC (note the Canadian’s spending and return rates surpass that of the US Big 4); and that PSR 2.0 (or the PHR railway) shows a virtuous circle is possible linking stakeholders

6. Carrier news:

a. CNI – has shown a flurry of late summer activity, including the Massena line deal (above), and helping to channel significant Canadian government funding into capacity improvement projects in the BC ports, with the Prince Rupert announcement this week of ~$C150mm. The Massena deal, intended to drive IM business northward (vs trucking form northeastern ports tied into the new joint service offering with CSX announced in August), is another part of CNI’s back-to-the-future offline deal making, acquiring or partnering with companies off the network but with the purpose of “feeding the beast (the Railway)”. The first of this generation, TransX, may have added a point to the OR but also was cited as being key to already driving the Hudson Bay (domestic IM) contact win….Separately CNI announced contract extensions with internal steamship lines Evergreen & COSCO

b. NSC announced some personnel changes, giving SVP Ops (and Chief PSR Change Agent) Mike Farrell new responsibilities (mechanical), and hiring a new CFO, Mark George – from outside the company (UTX) as Cindy Earheart retires….that is (another) significant change from NS tradition….

c. CSX also announced a curious (not bad, just interesting) outside hire, Mark Longson, from Street energy trading & research, as new VP Energy….

d. CP also announced a flurry of promotions (Mark Redd, COO) and a new post, Chief Cultural Officer (Chad Rolstad)!

7. Recent contacts and meetings: In the last few weeks I have not only attended RAC (“Canada Moves by Rail” see CP slides attached; CN provided a similar excellent overview – and passed around a “Canapux”!)- but I also hosted a series of calls with existing or recently retired rail executives to give their inside-baseball opinions on the state of rail and the state of PSR transformation – one thing that was transformed by these meetings was some of my long held opinions on topics such as rail pricing strategies – the opinions are not mine, but I will indicate where they have caused at least a re-think in my own:

a. Regionals and short lines suffer form LOH comparisons to their Class One partners, but given densities, their lower “back office” costs can mean lower ORs as well

b. PSR changes in the field are not always as readily apparent to interline operators

c. Rail service is worse in the US west than any other region

d. Rail pricing is reflecting the weaker environment, and BNSF is indeed (as UNP has long claimed) a leader in using price to retain volumes (more vs the market than other rails?) Said one COO – “BNSF is by far the most aggressive on price”; said a CCO “all Class Ones are responding to the volume drop with some form of lower price”. I still think we will see reported price at “rail inflation – which has gone down YOY – plus”….

e. PSR transformation takes time even with some initial often spectacular success – “it took CN almost a full decade”

f. Rails in some cases are too lean – especially on the commercial side”. Note – the operating folks disagreed!

g. One of the PSR pioneers recently benchmarked one of the new US converts to the cause – and found that despite their reported success they still trailed the pioneer in operations-based metrics (car velocity, etc) and showed big margin gains through price, fuel cost and mix (mostly IM%). Not that those last three points aren’t positive in their own right….
h. That same pioneer operator didn’t believe in the US “collaborative approach” (I do) calling it, well, “BS!”

Miscellaneous:

  • Shell’s new plant near Pittsburgh will be a game-changer – but is it the high-water mark for plastics? The NY Times may think so: https://www.nytimes.com/2019/08/12/business/energy-environment/plastics-shell-pennsylvania-plant.html?searchResultPosition=2 ; there are worries that the plastics industry “has yet to come to terms with the growing backlash” (The Economist). Remember Clarence Gooden’s comments from SEARS this past spring: “The future Benjamin, is….paper!”

  • Aurizon reported good results, made progress on the regulatory front - and decided, after a study not to dis-integrate their Queensland coal operations (where they own the track – “Network” – and the railway, as in North America, versus either owning the track a la Brookfield’s ARC, or the above-rail operator, a la GWA). Given that North America’s integrated freight rail system is the global leader, I am not sure why they needed to….study that. But they did and came to the right decision. They also talk of using NA precision railroad principals…which just makes me think that the late Hunter Harrison would have loved Australia and the slogan from Breaker Morant – “God, Horses – Railroads – and Australia!

  • There were a few somewhat controversial articles in the interim”

    • The Times looking at the 6th anniversary of the tragedy of Lac Megantic, and blaming deregulation and crew size – instead of employee error compounded by extreme bad luck;

    • The FT arguing that Brookfield (BIP) had “achieved a state of quantum superposition” (really; they wrote that) or “regulatory arbitrage” by arguing to its investors that the pending GWR deal would be added to their global rail platform: while stating to US regulators that they were “not a rail carrier”- causing some arbitrageur heartburn. In reality they were only slightly disingenuous – their rail assets in Australia and Brazil are network, or “below rail” assets (in other words they own the track only – part of that dis-integrated system that provides few incentives for cooperation that is so….silly - see above); in North America GWR owns or controls both below and above rail assets (ie; an integrated rail carrier).

    • The WSJ argued that “Hunter Harrison’s Rail Overhaul Starts to Run Out of Steam” – now this was really silly. The article noted that PSR was producing operating and service metric benefits, but that volumes were down. Apparently Hunter hadn’t gotten around to reorganizing the economic cycle….

  • Seth Meyers on Trucking & the White Househttps://www.youtube.com/watch?v=iv-bbacVAA0 ; meanwhile can we believe the ATA stats? They say truckload tonnage jumped over 7% in July when anecdotal and other (CASS, etc) evidence suggests otherwise. But the overcapacity continues, with signs of some cooler heads (Class 8 truck orders were down 81% in July), and yet - They also report the driver shortage is continuing
    · Competitive Tech updates: we have “overestimated” the arrival of AV, it’s not going away, either: UPS bought a stake in AV-tech start-up TuSimple, for example….Other tech news includes Maersk and Ports America investing in a drayage load-matching technology (“LoadSmart”). Uber announced that Uber Freight was opening a Chicago HQ and being seeded with ~$2B over the next decade (which actually isn’t….an enormous amount of $). But another cautionary note: a McKinsey study from late last year reviewed 40 port automation projects globally, and while noting benefits, found that “automated ports were generally less productive than ‘normal’ ones” – is that even possible?!?

  • Logistics Management magazine’s annual “Quest for Quality” results were somewhat (positively) surprising – for example, in Information Technology the rails/intermodal category scored a 3.74 (out of 5), while truck-load scored a 3.44 (by contrast 3PLs scored 4.37). however, the Rails/IM category, for reasons I don’t understand, included only 4 carriers and they were BNSF, FEC, Swift and JB Hunt….

  • The IHS report that Intermodal price levels were higher than truck in some markets is at best only partially true (and they still place the ratio, 100 being equilibrium, at 107)– it counts the spot business, which is important for some IMCs but is a very small piece of the IM total and not necessarily indicative of future trends….we’ll learn more at the Intermodal Association of North America (IANA)/Intermodal Expo in Long Beach next week….

Anthony B. Hatch
abh consulting
http://www.abhatchconsulting.com
abh18@mindspring.com