Introduction to precision railroading, Part 2: Parsing the developments in recent earnings

(Source: freightwaves.com 10/29/2018)

October 29, 2018 Brian Bowers, contributor

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This article by FreightWaves advisor and intermodal consultant Brian Bowers is the second of three reviewing the controversial subject of precision railroading, an operational system and a management philosophy that in the railroad business today is leading to one question: which side are you on? You can find the first installment of the series here.

It has been an interesting week. I have been encouraged by the number of people that have reached out with opinions and ideas concerning precision railroading following the publication of my first of three entries on the topic. It is a subject that is redefining the rail landscape so it is a discussion that needs to occur.

This week we are going to explore current performance within each of the five foundations of the strategy.

1.     Improve customer service

Improving service quality and consistency is key to achieving precision railroading. It makes sense that executing a simplified point to point network will produce the desired transit experience. The only problem is that it hasn’t happened. Railroads tout improved train speeds, reduced terminal dwell time, improved locomotive utilization and reduction in cars on line. These metrics all reflect positively on internal operating efficiency but are not tied to the missing metric: on-time performance. You can’t achieve what you don’t measure and communicate. Railroads calculate on-time service performance but for some reason do not share it with investors nor hold operating personnel responsible to achieve it. Establishing on-time performance as a primary metric would transform service and provide real value to customers. CSX did publish train origination and arrival data in the third quarter financial report. Train originations improved to 85% and arrivals an anemic 64%. Both numbers improved significantly year-over-year but fall short of precision performance. They also reflect that cost tradeoffs appeared to occur during transit that delayed destination arrival.
I am optimistic that enhanced execution of precision railroading can transform service quality but it will require changes in operational accountability and incentives.

A shortcoming of the current strategy is its confinement to individual railroads. That strategy may function in the transcontinental Canadian rail configuration but it is not ideal in the United States. Expanding the aperture to include interline rail partners, drayage carriers, terminal operators and equipment suppliers will maximize efficiency for all parties including the beneficial owner. This is an encouraging component of the new Norfolk Southern “Clean Sheeting” operational initiative so hopefully it will be adapted across the industry.

2.     Strict cost control across the organization

Financial results have been a clear win for application of precision railroading. Operating ratios at the Canadian National (NYSE: CNI), Canadian Pacific (NYSE: CP) and CSX (NYSE: CP) have fallen into the high fifties while creating billions in incremental market cap. Improved asset utilization, significant reduction in force and strict cost controls have all contributed to this improvement.  The strategy has been the catalyst for massive changes that were achieved in a very short timeframe. It has also created aggressive expectations for lower operating ratios that could push railroads to make short term decisions that may be detrimental to long term performance. The benefit to investors is obvious but must be weighed against the loss of talent and cultural disruption that has occurred.  Thousands of employees have been laid off from the three railroads, straining relations with unions and white collar employees. It is a difficult task to find the ideal boundary between justified expense reduction and strategic investments. Advocates claim that poor execution and cost management required decisive action. Opponents fear that manpower, locomotive and facility cuts were excessive and have adversely impacted employee workload and network safety. I believe that the truth resides somewhere between both positions and will become clearer in the months to come.

A key area for savings in precision railroading is equipment cost. Rightsizing the locomotive fleet eliminates ownership or leasing expense while also improving productivity by removing older and less reliable units. Operating expense benefits from better fuel economy and lower maintenance expense. Railroads pay a fee for every day that a rail car resides on their system. The strategy’s focus on asset velocity is designed to lower this expense by reducing the days required to pick up and deliver a customer shipment. Scrutiny of the inventory of empty cars held on the network is also critical. This activity addresses a longstanding industry practice of carrying excess locomotive and rail car capacity. When executed well, precision railroading creates incremental capacity at lower cost. If the cutback in assets goes too far or if unforecasted demand spikes occur, corrective action is expensive.  Getting this right is challenging because it is a new practice for the industry.

Listening to the Canadian National and Norfolk Southern (NYSE: NSC) third quarter calls left me believing that they are managing to a more balanced process. The Canadian National operating ratio deteriorated 2.3 points to 59.5 due to significant maintenance of way and costs related to adding new train crews and technology. I was encouraged by the position taken by Canadian National CEO J.J. Ruest, to defend the balancing of current financial results and strategic investment in their infrastructure. Commentary from Norfolk Southern leadership indicated they understand the need for change.  A key point of difference, however, is their commitment to take time to secure input from internal and external sources while they move forward. A new strategy called “Clean Sheeting” will be a blend of precision railroading and other strategies. Implementation has begun, and a detailed review was promised for delivery at the company investor day in February. The sub 60 operating ratio desired by investors did not occur in the quarter, but solid progress was achieved across many areas of their railroad. I applaud the leadership displayed by Jim Squires and his team to move forward in a thoughtful manner.

3.     Monitor the use of each asset to optimize utilization of railcars and locomotive power.

The use of asset trip plans that is associated with precision railroading is not new to the strategy. The change is enforcement of the plans within rail operations. Past plans were typically overridden as operations worked to move planned assets and unplanned coal and agriculture trains across their networks. Overcoming the inertia of old line rail operations that has been achieved through precision railroading is no small task. It took the iron will of Hunter Harrison to demand immediate change. Accelerated rationalization of network flows and core operating processes is having a significant impact on the efficiency and capacity of the engaged railroads. Expanding the effort to include on time delivery would position railroads to capitalize on the window of opportunity to convert highway traffic to intermodal. It would also address current terminal congestion by enabling customers to tighten scheduling of pickup and delivery carriers.

 4.     Operating safely is a priority.

It is difficult to identify any meaningful impact that precision railroading has on standard industry safety policy. Reducing the number of work events is a positive attribute but the reduction in manpower, if poorly managed, could negatively impact employee morale and engagement.

5.     Value, develop and empower employees at all levels.

Maintaining a productive company culture during periods of change is a challenge for any leader. Harrison’s leadership style and passion for change created conflicts with union and non-union employees. Keith Creel, his successor at Canadian Pacific, has spent considerable time working to address and reverse conflicts at the railroad.  Rebuilding and maintaining trust must be a focus for precision railroading to achieve sustainable success.      

Exploring the concept or precision railroading is a fascinating endeavor.  It is interesting to hear the spectrum of definitions that have been applied to the strategy. Investors tend to be fixated on the operating ratios tied to its application. My guidance to Wall Street is to view lower operating ratios as an outcome not a goal. The most exciting value of precision railroading is the rapid pace of operational change that it has achieved. A healthy debate is beginning to emerge that I hope will retain the passion that Harrison contributed to the process with a more inclusive and strategic balance. Either way it will continue to be an interesting journey.

Next week the third article in the series will focus on the future of precision railroading.  Let me know your thoughts at bbowers@freightwaves.com.