Untitled Document

RAILROADS AND E-COMMERCE:
A TOOL TO DRIVE SHAREHOLDER VALUE

The North American Railroad Internet Summit, General Electic Transportation Systems,

GE Leadership Institute -- Crotonville, NY, September 22, 1999

The advantages of Electronic Commerce have been described as a tool to "lower the cost and complexity while increasing the speed and certainty" of doing business. These days one thing is certain in a rapidly changing world, one operating as much under Moore's law as Adam Smith's: if you are not focusing on the opportunities and advantages opened up by e-commerce applications, your customer, supplier and competitor is. You had better do it for defensive purposes alone, although it is an excellent potential offensive weapon. For now, I will look at electronic commerce, including but going beyond the internet, and on the rails as a system (the way customers see them) and for now ignore intramural squabbles. Many of my rail contacts laughed at this topic I was asked to discuss by Steve; indeed, the marriage of the stock markets' oldest and newest industries seems odd. Very little has been communicated to the Street about any of this, outside of big customer or dispatch centers, new websites, and better data availability. So, is there nothing going on? A look under the hood shows that not to be the case, however.

First, the problem defined: Railroads are under pressure to increase shareholder value. Who isn't, you may wonder? I am sure that here at GE the pressure to perform is also intense. Unlike GE and its terrific recent and long term track record, the rails have a lot to prove here, however, and one could argue that time is running out. After deregulation in 1980 the rails had a fresh start. They seemed to be making the most of it. Good stock performance followed the cost cutting, non-core asset divestiture, and market share recovery that was the story of the decade of 1985-94, a period I coined the "Railroad Renaissance". However, the rail share performance has been abysmal since then. Rail stocks trade at about a 50% discount to the market, based on consensus next years' earnings estimates. This is an all-time, post-Staggers low, thereby signaling the markets' lack of confidence in the rails and seemingly not acknowledging any progress since deregulation. While we know that not to be the case (merely look at the operating ratio improvements since 1980, or 1990), it is beyond worrisome. Why did this happen? Here's a list: Mergers, the unfortunately related congestion crises, lack of consistent earnings growth, doubts about the investment theme or "story", the threat of reregulation all have "contributed". In the 1980s, cost cutting, asset sales, increasing cash flow were the "story". In the 1990s, it appeared that regaining market share by utilizing their lower cost structures and increasing service reliability (the "Renaissance" thesis) could supplant the cost case; so far, anyway, mergers haven't helped this theme along. As management attention has shifted to the growth thesis, the already heft annual capital expenditures have exploded - by spending over $7 billion in each of the last two years the rails have been spending about a quarter of their revenue base. Wall Street has been patient, but with the poor returns of late the din of questions about the capital intensity has risen....if not to a crescendo then at least to a noticeable roar. Continued poor performance will lead to a forced reallocation of capital. Capital naturally flows to the areas offering the highest return. In the 1960s and '70s this simple but inviolable rule led to the awful conglomerates that the railroad holding companies became. As recently as the beginning of this decade one carrier, CSX, bought back 40% of its stock in a single Dutch auction. And this year, the railroad that has most publicly argued the growth case, BN, announced a quarter billion dollar reduction in its capital budget (in favor of a share repurchase). As BN is no longer in its merger phase, what is one to make of that?

RAILROADS AS (PERCEIVED) TECHNOLOGICAL DINOSAURS

Clearly rails have to jump start their growth plans, and turn around the perception that they are the (road) gang that couldn't shoot straight. Nothing is more important than providing consistent, reliable service, for both defensive (ending the rereg threat) and offensive reasons. I know that they are incented, and I have seen signs that it can be done. Indeed, as recently as 1994 intermodal growth was an astounding 14% and rails were clearly recapturing market share from the highway. To regain that "renaissance" momentum, the rails have to take advantage of every tool available, and surprisingly to many outsiders, technology has been and can be a big weapon for this industry. As I researched this speech, I was struck by the fact that IT people in the industry positively bristled when the "dinosaur" label was thrown around. After all, they (correctly) point out, rails have actually been at the technology forefront since the development of signaling to mainframes to today. First, a list of recent efforts:

EDI - over 85% of waybills are now processed electronically (mostly mainframe-mainframe)
AEI - has been rolled out as a start to true tracing capability
Net-REDI - customer car ordering
ISM- interline service management, a bilateral effort at solving the most enduring rail service issue
Grain car exchange/COTs&SWAPs, etc.- a covered hopper "futures" program
PTC - positive train control via satellite, etc, an FRA "hot button" issue pushed for safety that, along with dynamic braking, could eventually lead to higher speeds and better asset utilization
Others: There is an active supplier industry out there seeking to help rails in e-commerce issues, in areas of dispatch, tracing, data collection, decision making, etc.

Most of these useful efforts fall into the category of "increasing the ease of doing business" with railroads, which is nothing to lightly dismiss, given the long history of troubled customer relations that have plagued the industry. Not doing them well leads to big problems - look at some of the EDI errors in the Eastern split of Conrail (the "ping pong" effect), for example. So, they are clearly valiant efforts, but is it enough? Most don't attack the central problem (providing consistent service), however, and those that do, like ISM, have been around most of this decade, and therefore only add to the rails' perceived inability to "get it".

THE COMPETITION

Wall Street views the competition in a rail era of "grow or die" as coming from the (subsidized) highway, and I already stated this talk is about the rail system. Most of the buzz in transportation e-commerce involves either non-competitive segments like LTL/package delivery, like UPS (indeed, a major customer). Some direct competitor efforts could actually help rails. After all, information comes without bias, and logistical efforts to seek supply chain value can play into rail economic advantages.

For the most part, the rail competitors are too small to really have a threatening competitive technological edge. It's just that they have a consistent service edge. Two issues that I can think of offer a different story however: one is the tracking capability offered through GSMs, etc, whereby any shipper with a laptop can know EXACTLY where their load is on carriers like Werner. That is real, and it beats AEI. The other is potentially even more scary, however: Truckload companies, their profitability and their shares are directly tied to utilization, density, etc. If one of the auction-like load matching services currently out there, like NFE (National Freight Exchange) actually achieves scale and can lower TL dead mileage, then that could have a big effect on margins, pricing, etc. Something to think about, for rails, and some of their current customers, like the IMCs.

CUSTOMERS

Which leads to what I think is an even bigger question: How is e-commerce changing not the direct competitive environment for rails today but the very way that customers do business in the future, with all the ramifications for carriers? What if entire traditional patterns of the supply chain (with all their legacy systems and infrastructure) are permanently altered? What does the Ford-Microsoft direct customer vehicle ordering agreement mean? (Is the mixing center, itself a breakthrough contract for the rail industry, ahead of the curve here? Or...) Similar if less hyped deals are changing patterns in steel, chemicals, general merchandise, and, of course, most of all in retail goods (and we should expect to learn a lot more about the Net impact on that industry now that Commerce will collect and publish internet sales data). Will the ease, reliability and speed of information flow mean that JIT becomes a reality (or, that the word "just" supersedes the latter two)? Will lots become ever smaller? Speeds faster? Can rails play in the new game?

RAILS, E-COMMERCE AND GROWTH

Yes, they can. The rail economic advantage in the variables of cost, distance, bulk, weight, etc. will not go away in a electronic world. First and foremost the service issue must be addressed. But here is where electrons can help. Yield management can lead to better asset utilization by smoothing out the cycle in the week, month, quarter, season and year. To do so a form of auctioning can be imposed on the current traffic ordering pattern, but it requires fast and relaible data flow and quick (and local) decision making skills. Rails can not only ease the customers' frustrations but help manage the process to mutual advantage. Soon, the rails will be capable of offering a complete package of advertising, ordering, tracing/search, receiving, billing and collecting through electronic means. But there's more: Better information flow should also free up physical bottlenecks and move more freight on existing assets, faster.

Profitability through efficiency: Which leads to the second part of the equation. While big cost cutting as a railroad investment thesis is a thing of the past, increased utilization will not only lead to better service but to better margins, less dwell, reduced clerical support, etc. Rails can also use the net for better supplier control, as others, notably the auto industry, have done. But best of all, in a capital intensive industry, harder working assets means better ROIC. In essence, electrons can "replace" railcars and cents for dollars.

THE WAKE UP CALL

Actually, I think that phrase is redundant, for this industry has received a myriad of wakeup calls and is responding. They are here, after all. But listening, indeed understanding, is not the issue, In a bottom line world, execution is. After all, rails have been working on ISM since the early 199os, if not before. Much rail business is interline. Can the rails achieve e-commerce success as a system? Can they work unilaterally? (One marketing chief told me that was like trying to "herd cats") Or can they only move bilaterally? (And what does all this mean for transcons?) It is essential that the entire rail system convert its historical business practices to the (changing, dynamic) real world, and fast, not just crow about the success, however real, of small pieces (like EDI).

Railroads have every desire and incentive to push for growth and increased shareholder value. The IT folks that I talked to to prepare for this seemed to feel they had corporate support and were eager to show that they were far from the Jurassic era. But can the talk be translated into action? Only time will tell, and there's not much of it. And we will see it in the numbers.

Copyright Anthony B. Hatch. Used with permission.

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