By many measures, North American railroads are extremely successful. They generate enormous revenues and, from the perspective of other modes, relatively healthy returns. Their operations are the envy of railroad managers from other parts of the world, who visit here often in hopes of learning more about how to run a railroad.

But the rails are at a crossroads. By their measures, rail rates in real dollars have declined steadily since the Staggers Act partially deregulated the industry in 1980. In fact, rates are down 20 percent on an adjusted basis since 1994, according to Burlington Northern Santa Fe (BNSF). Mergers during the last decade created enormous service problems that still gall shippers, who threaten to shift freight back to the highways. New rules from the Surface Transportation Board could make future mergers more difficult. And what may be the industry's most successful offering from a service standpoint—intermodal transport—continues to deliver some of its lowest margins.

Then there's the conflict between pleasing their customers and pleasing their shareholders. Railroads have invested heavily in the last 20 years to improve rail beds and add crucial locomotive power. Although those capital investments are essential to providing the service shippers demand, Wall Street analysts question whether the industry can ever earn decent returns on them.

"Deriving value above the cost of capital is the name of the game," says Scott D. Flower, managing director for Salomon Smith Barney and a seasoned analyst of the railroad industry. "We don't think all capital spending is bad spending. But huge spending is not what analysts are looking for in relatively mature industries," he told shippers attending the Monterey Seminar last month. Sponsored by the National Industrial Transportation League (NITL) and the Transportation Club of San Francisco, that seminar is an annual meeting of railroad and ocean carrier executives and major shippers.

Though one rail executive told seminar participants that capital spending represented a crucial part of the railroad industry's financial equation, eating up 22 percent of revenue, Flower expressed skepticism. "If you are not a cost-of-capital business, you're really telling the market that you are not a viable business," he charged. "You are going out of business slowly. ... You can't spend your way to prosperity or growth without adequate returns."

Flower told the meeting that railroads have essentially two levers with which to improve returns: pricing and asset utilization. If the industry cannot improve its yields, he said, it faces severe problems. And because asset costs now account for a higher percentage of rail costs than labor does, asset utilization must improve, he contends. "The message to railroads and the message to shippers is the same—assets aren't free."

The issue of improving asset utilization has been one that railroads have confronted for years. Though post-merger integration woes have sidetracked those efforts, railroad executives understand all too well how necessary they are. They also understand that winning higher prices from shippers who have a choice of modes requires substantial and sustained improvements in service reliability.

They have made progress. A survey of NITL members conducted by Flower shows that most shippers believe that CSX Transportation and Norfolk Southern, the two large Eastern carriers, have shown some improvement but that their service still lags behind levels reached prior to their purchase and division of Conrail. Out West, Burlington Northern Santa Fe and Union Pacific won high marks for service that is better than it was before their major acquisitions of the past decade.

If you listen to the rails, operations have become decidedly more efficient in the past year. Paul R. Goodwin, vice chairman and chief financial officer of CSX Corp., told an analysts' meeting conducted by investment house Bear Stearns this spring, "The main thing [where cost is concerned] is that we have more fluid operations. Our velocity is up, dwell time is down, car inventories are quite low. Crew costs, the big driver on the expense side of the house, are down big time. We place the emphasis on service. We've also engaged in a significant price program. Though customers never like to hear about prices, with the improvement in service quality, we're getting relatively little pushback."

Henry Wolf, vice chairman and chief financial officer at Norfolk Southern Corp., had a similar story for the analysts. He said the railroad had overcome the problems related to the Conrail acquisition and now had "a smoothly functioning transportation system." Norfolk Southern, he added, was making further efforts to improve service reliability and consistency. "We understand that service variability deters customers from using the railroad. Consistency and reliability allow customers to plan their supply chains."

But echoing other executives of major railroads, he added, "We have a lot of room to improve." The railroad's goal, he said, was to improve service consistency and to add new services and facilities in order to win a greater share of customers' business. In addition, he said, the railroad is focused on top-line growth. "We've been negotiating rates that reflect the current market value of rail services and the costs associated with those services."

That might not be easy. Flower's research indicates that shippers will resist railroad efforts to raise prices and that shippers that can divert some freight to other modes will do so, making aggressive pricing increases risky for the carriers. Certainly, that has historically been the case. "Since deregulation, productivity has literally tripled, volume has doubled, revenue has been flat, and price has fallen by one-third," says Matt Rose, president and CEO of BNSF.

In addition to trying to balance service and investment issues, the railroads face some political challenges. Disputes between the railroads and shippers over regulatory issues have led some shipper groups, including the NITL, to call for Congress to revisit rail regulation. Rose warns that's a path that must be tread with some care: "We have to have thoughtful resolution."