With almost all of the Class I railroads transitioning to precision scheduling railroading (PSR), an operational model that emphasizes running railcars on a fixed schedule, a question surfacing within the rail industry is how much emphasis should the railroads place on lower operating ratio.
Investors like to see how a company’s operating ratio, which measures a rail carrier’s operating expenses as a percentage of its revenue, changes over time because it can be an indicator of how well that company is generating profit.
Because PSR seeks to cut a rail carrier’s costs, it can also result in a lower operating ratio. The four railroads that have recently embraced PSR have also announced plans to lower their operating ratios. Union Pacifc (NYSE: UNP) has said it hopes to achieve an operating ratio of 60 percent or below by 2020, with a goal of eventually hitting an operating ratio of 55 percent, while Norfolk Southern (NYSE: NSC) said it its 2018 annual report that it seeks to have an operating ratio of 60 percent by 2021. Kansas City Southern (NYSE: KSU) said it seeks to have an operating ratio of 60 percent to 61 percent by 2021, while CSX (NYSE: CSX) said its operating ratio was 60.3 percent for 2018, compared with 67.4 percent for 2017 and 69.2 percent for 2016.
But rail industry observers are also wondering if the industry is placing too much emphasis on lowering operating ratio, especially in light of shippers’ doubts on whether rail service will improve significantly under PSR.
Operating ratio was a mathematically derived number that we could communicate to employees as a measurement, “but it was never an objective,” said Gil Lamphere, an early proponent of PSR, at the North East Association of Rail Shippers conference last week. Lamphere was an original proponent of PSR because of his former role as the chairman of Illinois Central Railway, a freight railroad that championed PSR decades ago. He is currently chairman of MidRail, a rail assets firm that seeks to make capital investments in the shortline sector.
One of the problems with operating ratio is that it doesn’t account for many variables, including volumes, prices, asset intensity, assets in equity, tax rates and dividend rates, among others, Lamphere said.
Some are saying that the rail industry and investors should consider looking at other metrics in addition to operating ratio to get a more informed understanding of a rail carrier’s overall performance. For instance, investors could also look at how much of its profit a rail carrier is investing back into capital expenditure projects, or they could ask what is the percent of return on a capital investment. A return rate of 14 percent to 16 percent on embedded or depreciated capital is thought to be a desirable return rate.
Operating ratio “is not bad. It’s a single measurement that should lead to good questions,” said transportation consultant Tony Hatch of ABH Consulting.
Hatch would like to see how rail carriers view the relationship between return on investment and the cost of capital. A return on investment looks at how much profit a company makes on an investment relative to the cost of that investment.
If the return on investment is greater than the cost of capital, then it can signal to investors that a company is willing to invest in order to achieve a stronger physical plant, more reliable service and more and better equipment, he said. He pointed to Canadian National (NYSE: CNI) and Canadian Pacific (NYSE: CP), both of which have employed PSR for years, as companies that have been able to generate a higher return on investment.
“I think there is a direct correlation between spending on capacity and surge capacity and the ability to both handle the world politically and to show a good return on investment,” Hatch said.
Another metric to consider is to focus on growing strategic market share in certain lanes that might have higher expenses but could take a lower margin, according to Jim Blaze, a FreightWaves Market Voices expert. Doing this shows investors that a company is pursuing top-line growth and not just seeking to lower an operating ratio, he said this week.
Despite all these possible alternatives, the underlying issue is how can a rail carrier achieve profitability, as witnessed by favorable operational metrics, without sacrificing rail service.
“There seems to be a lack of balance. How do you balance against metrics to make sure that you’re in fact fostering growth and you’re not losing market share,” Blaze said.
“Because if you continue to lose market share against trucks, you’re signaling that you’re going to go out of business. You’re not going to be relevant anymore,” he said.
