Railroads: Merger debate continues

As the Surface Transportation Board reviews the rules that govern rail mergers, shippers voice concerns about service.

By -- Logistics Management, 7/1/2000

When the Canadian National and Burlington Northern Santa Fe railroads announced their intention to merge late last year, it might have seemed at first blush like a normal event in an industry that had seen several waves of consolidations over the last decade or so.

But in a highly unusual move, the federal Surface Transportation Board called a halt to all merger activity while it caught its metaphorical breath and attempted to sort out the implications for North American railroads. The big question facing the board, which has regulatory oversight of rail mergers, is how the nation would be affected if the rail industry were reduced to two dominant transcontinental railroads.

Shippers are divided over whether the BNSF and CN merger proposal should proceed now or be kept on hold while the STB revisits its rules governing mergers. But they are largely united on a couple of goals: Whatever happens, some form of competition should be preserved, and, should further mergers be approved by the board, service issues must not go unaddressed.

Two of the last three consolidations have left shippers frustrated and angry. After the Union Pacific absorbed the Southern Pacific in 1997, there was a virtual service meltdown; likewise, major service problems arose last year when the Norfolk Southern and CSX Transportation divided the Conrail network between them.

Merger Woes

While railroads have struggled with the question of how to integrate disparate systems successfully, merger-related issues have taken their toll on the industry's financial health. Over much of the last decade, railroads have regularly reported operating margins that would be the envy of most truckers. Because the industry has such high capital costs, however, railroad management has not boasted about those returns: Few railroads, in fact, meet the cost of capital calculated each year by the STB. Making matters worse, railroads involved in high-profile consolidations have seen their margins suffer while service quality fell from levels that were already considered poor by the shipping public.

The Norfolk Southern Railroad is a case in point. In most years, it reports some of the best operating profits recorded by the railroads. Last year, however, its income from railway operations dropped 32 percent to $718 million and its operating ratio deteriorated to 86.2 percent from 75.1 percent. (An operating ratio represents the percentage of revenues spent on operations, so a lower number indicates a higher operating margin.) Net income fell to $239 million, a drop of 62 percent.

Analysts point to several merger-related reasons for this decline. For one thing, the railroad spent tens of millions of dollars to integrate its share of the Conrail network into its own operations, with significant financial ill effects. In addition, the service problems that resulted from the merger spurred many shippers to move their freight to motor carriers, costing the railroad even more. Certainly, the problems with absorbing the Conrail network were not the sole cause of the drop in profitability-the numbers were also affected by weak coal exports and high fuel costs-but the integration problems were the most serious problem during the year.

CSX Transportation, which divided the Conrail network with the Norfolk Southern, ran into similar problems. Its operating income fell by 25 percent to $770 million, and its operating ratio worsened to 86.3 percent from 79.2 percent. CSXT, an operating company of CSX Corp., does not report net income. But CSX Corp.'s earnings dropped by 21 percent to $339 million, and the company attributes the drop directly to the difficulties it had integrating the Conrail network into its operations.

By contrast, the Union Pacific, at present the largest railroad in North America, began to emerge from the chasm it dug for itself in 1997 and 1998 and saw profits rise last year. The railroad had major service problems beginning in mid-1997 and through much of 1998, following its acquisition of the Southern Pacific. But things took a turn for the better last year. Rail operations reported net income of $854 million, compared with net income of a paltry $27 million in 1998. The company attributed that rise to improvements in operations and service levels, increased revenues, and lower operating costs. The operating ratio improved markedly to 82.1 percent from 95.4 percent in 1998.

Similarly, the Burlington Northern Santa Fe, the other major railroad with a large network in the western United States, has shown steady growth in operating profits since 1995, when it absorbed the Santa Fe railway. Its 1999 operating income of $2.2 billion was 22 percent ahead of its operating income for 1998. The company boasts an operating ratio of 75.4 percent, only slightly better than the previous year's but a full 9 points better than its 1994 figure.

One railroad that appeared to have managed a merger without any major service disruptions was the Canadian National. Last year, it completed its merger with the Illinois Central Railroad but still improved its operating income by 15 percent to $1.5 billion. CN also improved its operating ratio to 72.0 percent from 75.1 percent. (For comparison purposes, those figures assume that the merger with Illinois Central had taken place at the beginning of 1998.) Before the merger, the Illinois Central had regularly reported one of the best profit margins in the business, a factor that undoubtedly made the integration easier.

Can Rails Make the Grade?

The entire railroad industry faces some important cost increases this year that could put pressure on margins and rates. Indeed, a survey of shippers conducted by Salomon Smith Barney financial analyst Scott Flower indicates that 85 percent of shippers expect rail rates to rise this year. Most of those shippers expect the increases to be relatively modest-in the range of 1 to 3 percent.

Morgan Stanley Dean Witter analysts James J. Valentine and William J. Greene, in a report published earlier this year, project that unionized railroad workers will see wages rise by an average of 5 percent this year. Labor costs represent about 30 percent of revenues, so the analysts expect that those increases will put pressure on railroad margins.

Fuel costs are a concern for the railroads, too, as they are for all transportation modes. Diesel fuel costs have risen by 30 percent or more from levels recorded in the spring of 1999, and there are no signs that they will abate much any time soon.

Despite those cost pressures, railroads have a decided cost advantage over truckers. But they are not likely to convert much additional traffic from the highways until they can demonstrate substantial improvements in reliability. In most shipper surveys, service reliability is the attribute respondents have ranked as most important. That's no surprise considering that fast cycle times and low inventories are key to many businesses' supply chain strategies. Yet the railroads are not meeting shippers' requirements. Shippers responding to the Salomon Smith Barney survey, which was conducted earlier this year, pegged the railroads' on-time performance at 70 percent or less. As a result, the railroad industry's share of the national freight dollar has fallen markedly. The Morgan Stanley Dean Witter analysts estimate that the railroads account for 9.4 percent of the nation's freight spending, down from 12.4 percent in 1990.

One final concern related to the mergers both completed and pending is whether Congress will reregulate the railroads, and if so, to what extent. Members of Congress have proposed a variety of bills that would impose new regulations on the railroads in the last two or three years. None of the bills have gone anywhere yet. But should the BNSF/CN merger be completed and if the Union Pacific moves to form an alliance with Norfolk Southern or CSX, as some analysts predict, pressure could mount for new rules. Any effort to push some form of reregulation would almost certainly be met by universal opposition from the railroads themselves.