Blanchard Company - Kleifgen talk, 7/12/01

For Shortlines, It's Time to Catch Up

J. Peter Kleifgen, President, CEO, StatesRail
Cooperstown Conference, West Point, NY|
July 14, 2001

It's a privilege to be asked to make this presentation.

This panel deals with the financial condition of the Railroad Industry. Nothing affects one's financial condition like growing earnings and profits. Our industry is desperately in need of new growth opportunities. I'm hoping that the next growth area for railroads and therefore short lines, will be the merchandise carload business where some railroads are now offering new business models aimed at highway traffic. Tomorrow in his opening remarks on the Future of Public/Private Partnerships in the Rail Mode, Ray Chambers will comment on the National problem of highway congestion and gridlock, which may well require a new program that includes rail as a full partner. These two themes, a new business model for railroads and government funding for private enterprise sound strangely familiar. The last time the railroads and government partnered up together was May 10th, 1868 at Promatory, Utah. And the public image of railroads has gone down hill ever since. Things change and maybe it will be different this time around.

Our business is certainly changing and our biggest challenge in the short line segment of the industry is not to keep up, BUT TO CATCH UP. We have heard a lot of speculation over the last several months about class one railroads converting merchandise traffic to shuttle trains or getting out of the loose car business. Railroads have done this very successfully in the grain and coal business. Certainly railroads have been debating the profitability and survivability of the carload business not just for years, but for decades. But, what is driving the current debate?

Many in the short line business believe that class ones are attempting to drive short lines out of business. I don't believe that to be the case. I believe this is market driven. Its customer driven. Its rail customers trying to hold on the rail service and finding it very difficult because of the poor reliability of rail service compared to truck. Customers are saying to railroads if you don't change the way you execute the merchandise carload business, you will lose it.

The old way of doing business for railroads has been to focus almost exclusively on price. The fundamentals of all commercial transactions are based on a combination of price and service. Price + Service = Value. This formula is the basis for choosing winners and losers in commercial transactions. For decades the trucking industry has out-classed railroads with superior service. So railroads had to reduce prices as a way to win the customer value contest. To do this railroads have had to reduce costs. And as rail service reliability declined, price and therefore cost cutting became more and more important. As time went on and the big cost savings were identified and implemented, rail mergers came to the forefront, again as a way to reduce costs. During the 90's railroads spent almost 100 billion dollars on capital improvements, mostly on rail infrastructure and locomotives: an investment in speed and efficiency and cost reduction. And our industry developed a new concept called shuttle trains, again to reduce costs.

Like many of our solutions of the past, moving more traffic to shuttle trains only deals with the first part of the formula price, and price has been the railroad industry 's answer to the customer value formula for decades now. Move longer, heavier trains longer distances so we can reduce costs and reduce price to attempt to maintain enough value so our customers will continue to ship rail. Rail market-share is still going down. Our history has been that we cannot compete based on service and that's why we are hearing about shuttelizing merchandise traffic.

Yes, it is a concern to all of us in the short line business for Two Reasons.

First: some of our customers will have to bypass many of our railroads to get this service, as has happened in much of the grain business (although admittedly, in comparison to grain customers, it will be more difficult for a merchandise carload customer today to make that adjustment);

Secondly, focus on the price side of the Customer Value Formula Has Not Worked. Railroads are still losing market share to truck. Without focus on service, without both innovation and collaboration between railroads and with customers we are all slowly getting out of the merchandise carload business.

Well, there is some good news out there.

Class one railroads are working on the service side of the customer value equation by attacking interchange and terminal delays. Railroads and rail customers know that interchange delays and terminal delays are one of the biggest roadblocks to improving service reliability.

In the West, (and maybe in the East although I most familiar with BNSF and Union Pacific) Class ones are focusing resources, making investments and taking risks in order to achieve schedule reliability. They have designed new innovative service offerings along specific high-density rail corridors. They have bypassed terminals where possible, narrowed performance windows, scheduled departure times, and more.

Examples include

UP's Express Lane Service
BNSF's Ice Cold Express
AMTRAK Express Track
UP 5-7-9 Day service
BNSF's I-5 Corridor Service

This is pretty strong evidence that Class Is believe they have made meaningful improvements in reliability. There is collaboration among transportation providers. In California, UP, California Northern Railroad, CSX and The Hub Group teamed up to offer something called The Wine Connection, offering up express lane service with CSX to Napa Valley wine producers for wine deliveries to the east (that may not be good news for some of you New York wine producers).

There is more. Class ones are redesigning networks, integrating operating departments with service design functions, with equipment management and with sales and marketing, all to achieve the goal of improving service reliability. I used to be in the restaurant business a few years ago; Tony Roma's was one of our restaurant chains. In that business, there are three keys to success: location, location, and location. In the railroad business the three keys to our success in growing merchandise traffic is now reliability, reliability, reliability. Customers are demanding it, NS is preaching it UP, BNSF and CSX are putting it into practice and CN seems to have largely achieved it.

There is another effort going on inside big railroads, again driven by customers telling railroads we're losing the carload business. Class ones have spent millions of dollars on their internal operating systems over the last several years. We know that. These are very sophisticated and complex systems designed to provide operating management with real time on line information about the status of every aspect of the rail network. And they do it anywhere, at any time on demand.

But now, they have superimposed the rail customer over the operating system. Class ones are making operating system information available to customers as a means of improving service. And its much more than just car tracing.

Look at the web sites. They have created for customers a user-friendly web-based electronic interface connected to the big railroad operating systems. They provide powerful new tools for customers to design their own performance measures, customize their own reports, management waybill payment, manage demurrage, order and release equipment, estimate trip times by route, track cars against trip plans, design trip plans jointly with the class one and tie the trip plans performance to performance measures and to customer report cards. BNSF is even practicing open market pricing on some merchandise traffic with its logs program, so that customers see transactions and prices with other customers.

Objective? To change the merchandise carload business----because the customer said change it or lose it. So we are now seeing a new business model based on service created by the big railroads who are attempting to offer reliable, scheduled and in some cases guaranteed results to merchandise customers.

For the railroaders in the room, this is not new information.

I had the good fortune to serve on BNSF's first customer advisory board. Rob Krebs opened our first meeting by saying, "the truth will set you free. But first it will make you miserable". Here's the miserable part.in my view the truth is that the short line industry is way behind the curve. As I said earlier, our challenge is not to keep up but to catch up.

Short lines are behind the curve because we are not positioned to be part of the new service offerings class ones are now executing for merchandise carload customers, many of whom are our customers.

What do we do? We can do three things.

First. Get integrated

Most short line operators can do their part to achieve reliable efficient interchanges with class ones. Short lines typically don't have large terminals and classification yards to interrupt operational flow. Running short lines that provide service on demand is much simpler than operating a fully integrated class one network. For us, completing the ever allusive interline service agreement with class ones, agreements with teeth, is the first step. The more reliable class one service becomes, the more essential these agreements become. Our San Joaquin Valley Railroad has just such an agreement with UP. It is focused on UP's express lane service. Growing that business with up is a top priority at the San Joaquin and it is being monitored closely by our executive team in Dallas. We are watching it because I believe UP and other class ones will be successful with these new business models and I want StatesRail railroads to be part of that success. This agreement will initially cost us money but I believe the investment will be well worth it. We must get more integrated with our class one partners because their success will drive new business. The San Joaquin - Express Lane business and the wine connection are good examples of how innovation and collaboration should work between class ones and short lines to drive market share.

But we should go much farther. Rob Krebs, Paul Tellier and Reilly McCarren may have given us a new collaboration model that should be pursued. Sure it was in the merger environment of the time where deals were being made. But it has merit standing alone today. In an agreement announced in the first quarter of last year, BNSF and CN granted 10,000 miles of haulage rights to Wisconsin Central. It was conditioned upon the completion of the BNSF-CN merger, which of course was not closed. BNSF and CN granted these rights in seven states in the Midwest and in Ontario. Reilly McCarron pointed to the agreement as a way to overcome "the challenge of interchanging short-haul traffic with another railroad that has resulted in highway carr5iers securing a disproportionate share of regional freight moves". Rob Krebs said; "we will insure that Wisconsin Central merchandise traffic moves as seamlessly as possible between our two systems, eliminating the need for interchange between two carriers". The agreement was clearly aimed at over-the-road merchandise traffic.

However, reliable efficient interchanges are only part of the collaboration that must take place between short lines and class ones before short lines can be an effective part of the new merchandise business model.

Second: we must get connected, electronically, to exchange data so we can be part of the service provided to customers on their desktops, over the web. E-commerce is an area where our industry has made vast improvements in a short period of time. It is also the area where we must accelerate the rate of improvements if we are to accomplish our market share goal. We can no longer ask our customers to access web site upon web site for service information or to evaluate two or three sets of data to measure our service performance. Short lines and class ones must not only link up, we must freely exchange data, integrate web sites and become user friendly to our customers if we are to effectively compete with truck service.

Getting connected is not a technological problem. In fact is can be done now, simply and inexpensively. It is a question of will. Do class ones really want short lines wandering around inside their operating systems? No. Nor did class ones want short lines operating on their mainlines ten years ago. But we found out that with training, careful planing, improved technology, and limited access, we could operate safely and efficiently on class one mainlines and it now works very well for us both. Limited exchange and integration of data will also work. Short lines make up between 15 and 20 % of class one carloads. That's a big number, bigger than everything except coal and intermodal. And in 2000 and again in 2001 carloads interchanged with short lines grew faster than all segments of the merchandise commodity group. The stakes are high for both of us. We must integrate rail service offerings to customers if we are to be successful at growing the merchandise carload business.

Third

Short lines should redefine rail assets.start thinking of our businesses not as railroads but as part of a larger collection and distribution system. At StatesRail we have had some success with this. In Alabama and Florida the Alabama & Gulf Coast Railway is developing transloading services in conjunction with BNSF for a major chemical customer. Without BNSF we would not have had this opportunity. It's a very good fit. We do the legwork; they do the heavy pulling. This lead to one other opportunity to be more of a distributor than a railroad and to a third transload opportunity on another of our railroads.

In Arizona, our San Pedro & Southwestern Railroad has a very strong relationship with GrupoMexico the large Mexican integrated copper mining and manufacturing company. We have used that relationship to develop transload business for San Pedro and for the UP across the Mexican border. Phase two of that relationship could well result in the first opening of a new Mexican -US rail border crossing in recent years. We believe that this service could set a new standard for data exchange with the existing compatibility between the StatesRail and FerroMex operating systems.

My own judgement is that big railroads will be successful in growing market share versus truck in the immediate future, and that merchandise traffic will be the new growth area for railroads. I want our company to be prepared to participate in that growth. And I want our short line industry to participate.

Harvard Business Review published an article recently entitled "Collaborate or Die". That's a theme we in the railroad industry should adopt. Class ones and short lines (who are responsible for the third fastest growing component of rail traffic) must integrate service at all levels to maximize our opportunity for success.

Thank you.

Copyright J. Peter Kleifgen. Used with permission.

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