The Railroad Week in Review:
Week ending August 19, 2000

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Companies must ask themselves where their corporate cultures end. If their cultures end before the community begins, they will have no market. Cluetrain Clues 36, 37.

KCS Railroad (NYSE: KSU) was on the move this week as Gary Yablon kicked it up a notch to Strong Buy. The week started at $6.75 and ended at $8.50, a bump of 26%. CBS Market watch quotes Yablon as saying the company was a "top pick" among the railroad sector. Full year estimates are in the $0.60 range and $0.90 for 2001. At $8.50 a share the FY2000 PE is a reasonable 14.4; for FY 2001 the PE is less than ten.

Moreover, the estimates indicate a potential 50% earnings increase. A stock trading at ten times earnings with a 50% growth prospect has a zero-point-two-oh PEG ratio and, as you will recall, class, a PEG of one represents full value. What's going on?

The real story at KSU is the Mexican operation, TFM. Over the past couple of years we've reported on the steadily improving performance of TFM, however until the distraction of the Janus relationship was out of the way, it was tough to look at KSU as a pure rail play. We can look at the record and see KSU equity income from TFM progressing from deep in the red in 1997 to a plus $2.5 mm in 1999 and potentially as much as ten times that in 2000.

S&P gives TFM a value of $5 a share; I figure $6.50 on equity income alone; others using an asset-based approach even more than that. As for the US rail operations, the marketing relationships with Norfolk Southern and CN-IC can only help. We know KCS took a dim view of the BNSF-CN merger, however the KCS potential NAFTA trade growth via TFM looms large. The advantage KSC has vs the two big western roads is its small size, which means it can be more fleet of foot in service and value. Surely CN - and now NS (see below) - will have an impact. We will be taking a position at this price.

We also have seen significant improvements at NS since the quarterly meeting. Over the past few days we've been about speaking with shippers, shortlines, local governments, and others about performance in the field. To be sure, revenues and carloadings have been stuck at about the same level since the start of 3Q99, however there are signs the worst of the merger follies are over and NS can become itself once again.

Here in Philadelphia, I'm seeing the same trains running in roughly the same time slots every day. The 10Q for the quarter says NS is paying well over half the operating expenses of the SAA, indicating NS is capturing the dominant share of the SAA carload business. NS earned 63 cents a share in 1999 and looks to do a buck a share this year, a whopping 58% increase. The current FY PE is 18, a tad high for rails, however the growth rate gives it a PEG of 0.31, clearly a Buy indicator.

Given the operating picture we see and the near term prospects for NS returning to its usual self, interest in NS appears to be growing. JOC reports Sanford C. Bernstein & Co., a New York-based investment advisor and securities firm, says it has increased its Norfolk Southern stake to 10.1% from 8.9%. This is a big bet since there are 383 mm shares and the NS market cap is $6.9 bn at Friday's close a teeny shy of $18. The firm said it acquired the shares of the Norfolk, Va.-based railroad holding company as an investment and not to influence control of the company.

Genesee & Wyoming stock is up more than 40% YTD, far better than any other rail. Part of the story is in the Trailing Twelve Months (TTM) numbers previously reported: sales up 22%, operating income up 36%, and net income up 38%. The rate of change in quarter-to-quarter results has been slowing, however. Sales have drifted down from a plus 25% 2Q99 over 1Q99 to minus 5% from 1Q00 to 2Q00. Operating and net incomes have likewise gone from high positive rates of change to slight negative rates. Thus it is proven again that as the rate of change in revenues goes so do the returns.

Forward estimates look for $3.10 a share this year. Through 6/30 GNWR had earned $1.55, so we're half way there. Obviously the quarterly rates of change have got to turn around and assuming they do GNWR will rack up a 10% earnings increase this year. With a PE of 5.8 and a growth rate of 10, the PEG is 0.58, and we have yet another Buy indicator.

BNSF's website now provides estimated transit times between select O-D pairs. See www.bnsf.com/bnsf.sph/svGoalTP. The parameters are time and place of shipment origin or interchange point to BNSF and destination for placement at a BNSF customer or interchange to another road for beyond. The result is transit time in days and hours for each day of week release or interchange.

For example, El Paso to Galesburg is seven days 12 hours (7:12) if released Mon or Sat, 6:12 on any other day. Spokane to Birmingham is 8:15 starting any day but Friday when it's a day quicker. It would be instructive to hear from any shippers or shortlines using this tool as to its reliability and usefulness in planning their respective operations. I would expect the reviews to be positive.

Last week we wrote, "If you have an example of the Railroad Industry Agreement (RIA) working to put more business on the rails it would be a great help if you would drop me a quick line." The response was underwhelming, unfortunately.

Maybe I should rephrase the question. For shortlines, "Have you ever approached a class 1 with a prospective RIA opportunity? What was the outcome? Have you ever thought about approaching a class 1 with and IRA application but not followed through? Why?" For class 1s: How many times in the last year or so have you been approached by any shortline with an IRA application? How many were successful? How many were found lacking and why? The lines are open for your responses.

Regarding short, fast trains, a reader writes, "Given current capacity problems and concerns I'm not sure short, fast trains (which means more trains) could be run with little incremental cost." He has a point. Big trains mean economy of scale, and as long as power and crews can be scheduled to make the turns it works.

However, a second reader notes, "It is more important to keep the traffic moving to increase the velocity. Small, frequent trains address this situation as well as several others. Locomotive and equipment costs outweigh the crew costs associated with train operation. By running smaller trains more frequently the locomotive utilization goes up and the car hire cost is reduced. The customer may even get better service."

The railroad that can maintain acceptable velocity and asset utilization with big trains and still meet schedules will be the winner. The rails that do not will continue to lose share to the trucks and will either be acquired or be abandoned.

The need to move to web-based pricing without delay is quite real. A shortline manager writes, "I am frustrated beyond belief that rate requests take 30 days or longer. Yet my customers know truckers can quote a rate over the phone, same day. Usually within minutes. They are stunned that railroads take days or weeks to respond."

Happily, this is a short-term problem. Any pricing managers who insist on dealing only in person and over the phone are pricing themselves of a job. Capacity-based laptop pricing will shortly overtake individual rates and even contract rates. After all, why lock oneself into a long-term price that may be higher than a spot price that may be of greater value on any given day?

--Roy Blanchard

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