The Railroad Week in Review:
Week ending March 25, 2000

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The thread continues on scheduled service. An institutional investor friend and regular contributor notes, "One reason scheduled service for a nearly nationwide railroad becomes impossible is that the task is too huge. The trucking industry works precisely because its schedules are small enough to respond to the needs of local demands in simple fashion.

"I still maintain that the real-estate, track, rolling stock, operations, and logistics businesses are distinct businesses with individual competitive and scale economies. Containing these in single corporations results in gross misapplication of capital and misexpenditure through inappropriate internal subsidization."

Sounds like a plug for the "Virtual Railroad" thread we've been running of late. Let the shortlines do the marketing and sales, supply the equipment, gather up the loads and send to them each other. That leaves the trunk roads to do what they do best: move trains from yard to yard. All they have to do is run crews and locomotives between the same points every day at the same time. Limit the carloads per train to some number and when the slots are filled the train is sold out. No more holding for tonnage. What a radical concept.

A slightly different take comes from an article penned last year by a railroad executive with a fair amount of experience dealing with the non-unit train carload business. He writes, "Carload [traffic] is under extreme pressure. The industry continues to produce a service product that becomes increasingly undesirable in the market place. It's not that service gets worse, it's that the marketplace over time, loses more and more of its acceptance for low quality, unreliable products."

A shortline operator in the northeast sees it all first hand and is not amused. His e-mail begins, "Anyway, from my perch it's apparent to me that no one in the upper levels of railway management has vision extending beyond the next quarterly stock report. These are guys who may be career railroaders, but they move around following the big bucks and have no loyalty to their companies, their employees, or their shippers. All they seem to be interested in is the big stock options and the golden parachute."

From NYC a long-time railroad investor adds, "I couldn't agree more with your comments on the lack of vision from rail executives! The primary reason service hasn't improved is because there is little rail competition to drive better service and innovative ideas. The rail industry is satisfied with its captive traffic and scared to death of rail-to-rail competition."

Finally, the chap who provided the opening quote sends an observation from a truckload perspective. "As you state so well, the rails have to think differently to capture truck traffic. The first step is to recognize you have a problem. The second is to break out of the mold set by the industry. This is extremely difficult to do because we are all so preoccupied with market share and who got the latest big deal and the fear of failure by management and the reaction that Wall Street will have. But unless you venture out, you will forever be left to the level of mediocrity."

OK, it takes money to make service better. But there's more money on the table than the incremental cost of better service. Nobody has contradicted my contention that there's a market for a $6,000 boxcar in scheduled transcontinental food service. Economists are predicting 4-5% growth this year and both CSX and UP have already said they intend to grow merchandise business by GNP or better. The answer clearly is to run more trains smarter to tap the market for premium service at premium rates. It'll do wonders for productivity and profitability.

Which needs doing. Rail stock prices last week languished once again. The DJIA rose another 5% while the major rails lost 5%, except for NS - off 10%. You've read in the papers how BNSF and CN are promoting their merger plans in what seems to be a hostile environment with Wall Street clearly unconvinced. Says Tony Hatch, "Investors believe that rail mergers correlate to long periods of stock market underperformance." To which Jim Valentine adds, "You can't create value for your shareholders unless you create value for your customer."

What the student of the industry must ask at this point is simply, that if this small sample of mail indicates that there are folks out there who get it, why are so many shippers still unable to get the rails to perform for them? It may be a function of what you say and to whom. Shortlines, at least, give the shipper a chance to talk with the owner. Somebody like Gary Marino. For once the popular press has got it right. CBS MarketWatch for 3/23 (www.marketwatch.com) carried a nice upbeat story on RailAmerica and its new economy growth plans in an old economy environment. "After all, the technology's entering its third century, there's no place left to build, and traffic and revenue growth's been averaging something like 3 percent for the last 50 years. Well, some people have found there's still value in the industry that helped spread the industrial revolution, if you know where to look."

One place to look is the balance sheet. Reading a lengthy (20 pages) investment opinion on Amazon I was suddenly struck by the remarkable similarity of the debt structures between RAIL and AMZN. RAIL's LTD is 70% of total capitalization (equity+LTD); Amazon's is 90% for the quarter ending 9/30/99, the most recent quarter for which we have RAIL info.

Forgetting for the moment AMZN sales at 356 mm are seven times RAIL's, the margins and ratios are telling. RAIL made money; AMZN did not. The railroad's LTD is $155 mm, the bookseller's is $1.5 billion, ten times more. The cash flow ratio (how well the company manages inventories, receivables and payables) is twice as good at Marino's shop.

The kicker is the Debt/equity ratio. For RAIL the LTD is 2.45 times equity; for AMZN it's 9.41. Yes, class, NINE times equity. Yet investors are standing in line to pay $73 a ticket for Amazon, pushing prices up 20% over the past 12 months, albeit with considerable volatility. RailAmerica closed Friday at $7 and change, off 20% for 12 months with little volatility. Also, RailAmerica trades at six times earnings vs. a non-extant PE at AMZN because there are no earnings.

But, hey, this is the new economy. And with it go new rules, and chief among them is that market adaptability counts for more than making better buggy whips. Like Amazon's Bezos, Marino is not content to build a one-product franchise and let it go at that. In recent months Amazon has invested $168 mm in line extensions worth five times that in sales. In calendar 1999 RAIL added properties in the US, Canada, and Australia with combined revenues half again what RAIL had on Jan 1, 1999. And while in the past some of us have not been comfortable with the debt ratios Marino is undertaking, it may be he is working under a model more representative of the new economy. It works for Jeff Bezos.

If you look at the line clusters he has assembled (see system map at www.railamerica.com) in just the US and Canada with the RTEX acquisition you can see candidates for the Virtual Railroad mentioned above. And Marino's expansion mode is not over yet.

--Roy Blanchard

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