Kansas City Southern (NYSE: KCS) is going down the precision railroading track.
In announcing its fourth quarter 2018 earnings, KCS President and CEO Patrick Ottensmeyer said the company in 2018 “did not meet our own expectations for financial or operations performance.” He added that KCS “did not meet the expectations of our customers or shareowners, particularly in the areas of customer service and growth.”
The solution: adopt the principles of precision railroading. “KCS has entered 2019 with a renewed and heightened focus on operational excellence,” Ottensmeyer said. “Throughout the year, we will implement principles of the Precision Scheduled Railroading (PSR) methodology that are most applicable to our network. We expect this focus on operational excellence and PSR principles to help drive improvement in asset utilization, cost and capital efficiency and customer satisfaction.”
The move by KCS shows how compelling the PSR story has become. At a conference just three months ago, Ottensmeyer sounded skeptical that precision railroading would be a policy that KCS would adopt. “One of the things that concerns me and concerns the (Surface Transportation) Board is the focus that seems to be gaining momentum on cutting costs and cutting things that in the short-run might produce some benefits in term of improvement in operating ratio,” Ottensmeyer said at a Washington, D.C. conference of shippers and railroads. Such an emphasis, he said, is “not necessarily customer-focused.”
But now, the focus is on a railroad’s operating ratio (OR). The lower the OR, the better the performance. A company improves when its OR goes down. KCS has gone all in. CSX (NYSE: CSX) announced that its fourth quarter OR was 60.3 percent but it was its 58.7 percent OR in the third quarter that jolted the railroad industry enough that both Union Pacific (NYSE: UNP) and Norfolk Southern (NYSE: NSC) said they were adopting PSR principles in response. With the two Canadian railroads already operating on a PSR basis, it leaves BNSF – owned by Berkshire Hathaway – as the only Class 1 railroad not adopting PSR.
KCS’ OR for the quarter was 63.1% on a non-adjusted basis and 64.3% on an adjusted basis. That is an improvement over the 64% OR from the fourth quarter of 2017. In his earnings statement, Ottensmeyer said KCS will target an OR of 60 to 61% by 2021.
A quick definition of precision railroading is difficult to agree on. But its basic principles include fewer hub-and-spoke operations, more rigid scheduled trains, tighter adherence to those schedules, quick turnaround of equipment (including a tougher stance on demurrage for equipment held by a recipient) and fewer workers.
The transportation team at Deutsche Bank led by Amit Mehrotra said in a note to investors that an improvement in OR to the level talked about by Ottensmeyer would mean an additional $8 per share in “earnings power” in 2021. KCS’ full-year 2018 earnings per share were $6.13.
But Mehrotra was cautious. He noted KCS didn’t hit its most recent OR target, “so investors are not likely to discount these targets until there is tangible evidence of progress, but nonetheless this is clearly a step in the right direction for KCS shares.”
Out of the gate, markets liked what they saw. At approximately 10:30 a.m., Kansas City Southern shares were up 6.48% to $110.89. Other rail stocks were higher though it isn’t clear why improvements in one railroad would boost the fortunes of others. (KCS is overwhelmingly dependent upon cross-border trade, so it does not have as clear a competitor as CSX and Norfolk Southern might view each other in the eastern part of North America.) CSX was up 3.12% to $67.12, Norfolk Southern rose 2.28% to $168.85 and Union Pacific was up just under 2 percent to $100.49. All outpaced the broader S&P 500, which at that time was up about 0.67%.