Beware the operating ratio trap

(Source: Railway Age 02/11/2019)

Written by Frank N. Wilner, Capitol Hill Contributing Editor

Watching Washington, February 2019: Sizzle sells product. No wonder the sizzle of ever-lower operating ratios is leading to remarkably higher railroad share prices. But as operating ratios—operating expenses as a percentage of operating revenue—flirt with a sub-60%, the meaning for the longer term is unclear.

A broader range of metrics is essential to assessing trade-offs, such as between operating and capital expenses; productivity, skilled labor and technology; static margins and growth; and impacts on safety.

In fact, an obsession with lowering the operating ratio can feed a perverse result. While deferring maintenance and shedding locomotives, employees and track-miles reduces operating expenses and improves operating ratio, such actions can discourage new business, irritate existing customers and labor partners, adversely impact safety, and attract unwelcome meddling by lawmakers and regulators.

Consider (using fewer zeros) a railroad with revenue of $1,000 and operating expenses of $500, producing an operating ratio of 50% and an operating profit of $500. By increasing operating expenses by $400 to attract new business that boosts revenue to $1,500, the railroad increases operating profit from $500 to $600 even though the operating ratio has climbed to 60%.

A higher operating ratio can deliver better service and improved profits. For example, a focus on lower expenses rather than value-added impedes the imperative of replacing vanishing coal in the traffic mix. Intermodal is perhaps the best and most available replacement, but attracting it likely will increase operating ratio rather than lower it.

An instance of undue emphasis on reducing operating ratio is the straightening of track curvature to save fuel expense—but declining to invest in additional track or motive power to grow business and revenue because it would increase operating expense and operating ratio.

A significant refutation of Hunter Harrison’s addiction to lowering the operating ratio came from Jim Vena, hired in January from CN to implement Union Pacific’s (UP) version of Precision Scheduled Railroading (PSR), “UP2020.” In 2014, Vena said that following Harrison’s departure from CN, the railroad reinstalled the second tracks on double-track lines to remedy capacity problems resulting from Harrison’s obsession with beating down operating ratio.

Following that line of reasoning, consider BNSF, the lone Class I railroad not hitched to Wall Street’s quarter-to-quarter operating-ratio myopia. BNSF pursues the long-term building-the-business strategy of its investment conglomerate parent, Berkshire-Hathaway. Not coincidentally, BNSF CEO Matt Rose—Railway Age’s 2010 Railroader of the Year—said in a December 2018 discussion of PSR with Editor-in-Chief William C. Vantuono, that “less is not better.” The implication is a criticism of trading long-term growth for short-term financial reward.

In the long-term, the raison d’etre for PSR should be to improve service quality, not take a hatchet to operating expenses to trim operating ratio. Already, this short-term hatchet approach and its adverse impact on service quality is attracting interest at the Surface Transportation Board (STB).

Not long ago, captive shippers, who are considered by railroads as a legion of peasants with pitchforks, descended on Capitol Hill with schemes to reregulate railroads. A growing perception among them now is that railroads are using PSR to disinvest so as to create artificial scarcity to facilitate rate increases.

Captive shipper solutions pitched to Congress and the STB are not the stuff railroad executives or investors care to swallow.

Now-retired railroad economist Robert E. Gallamore, co-author with John R. Meyer of American Railroads, suggests, as an alternative to a singular focus on lowering operating ratio, going in another direction: “Improve infrastructure and operating plans to attract more intermodal traffic; hire and train employees to be truly dedicated to customer service; invest in, and train, employees to use advanced systems for forecasting demand; develop pricing methods and systems to match demand and supply; offer new and more valuable services; and make the workplace safer.”

Perhaps PSR should be rebranded: Proper Service Reliability.

Frank N. Wilner is author of six books, including Amtrak: Past, Present, Future; Understanding the Railway Labor Act; and Railroad Mergers: History, Analysis, Insight, all published by Simmons-Boardman Books. Wilner earned undergraduate and graduate degrees in economics and labor relations from Virginia Tech. He has been assistant vice president, policy, for the Association of American Railroads; a White House appointed chief of staff at the Surface Transportation Board; and director of public relations for the United Transportation Union. He is a past president of the Association of Transportation Law Professionals. Wilner drafted the railroad section of the Heritage Foundation’s Mandate for Leadership (Volumes I and II), which were policy blueprints for the two Reagan Administrations; and was a guest columnist for the Cato Institute’s Regulation magazine.