Wall Street May be Backing Away From OR Obsession

A Wall Street analyst said this week that some institutional investors have begun to move away from their obsession with ever lower railroad operating ratios.

Most North American Class 1 railroads have in recent years striven to drive their quarterly operating ratios into the 50s.

The operating ratio is a measure of what percentage of operating revenue is spent on operating expenses and is widely viewed as a measure of efficiency and profitability.

The quest for a lower operating ratio has driven management into taking aggressive cost-cutting measures, including selling real estate, closing and consolidating facilities, and operating longer trains manned with fewer crew members as a way of reducing labor costs.

An analysis published on the website of Trains magazine said the shift in thinking would represent a major change for how Wall Street investors view publicly-traded railroads.

One implication of what some have termed “the cult of the operating ratio” is that railroads have sacrificed traffic gains in order to focus on the most profitable commodities that they haul.

Allison Landry of Credit Suisse said the new outlook on Wall Street is a desire for railroads to focus more on attracting higher traffic volume.

The Trains analysis noted that analysts in the recent years have seen unconcerned that railroad freight volume peaked in 2006.

Instead, their objective was to see earnings growth driven by rate increases, cost-cutting, and share buybacks.

The popularity of precision scheduled railroading, which had aggressive cost cutting as a byproduct in how it has been implemented at most railroads, played into that line of thinking.

Now, the Trains analysis said, investors seem to be concluding that PSR was a one-trick pony.

“While there is still plenty of room (particularly for the U.S. rails) for margin expansion, at some point, expense cuts will . . . bottom out; whereby the O.R. will approach a number for which it will not go below,” Landry wrote in an outlook note to clients earlier this year.

“The bottom line is that long term rail valuation will be dictated by growth; the margins at which the growth comes; and how much it costs to maintain the asset base.”

The Canadian Class 1 systems, Canadian National and Canadian Pacific, have already moved in the past couple of years toward giving a higher priority to traffic growth.

CSX, Norfolk Southern and Union Pacific may not be far behind as railroads seek to reverse a steady loss of market share to trucking companies that has been ongoing for decades.

In January CSX CEO James Foote hinted at a change in thinking when he said, “If we wanted a 50 operating ratio, we’d have a 50 operating ratio. We would do it . . . quickly. I’m not sure what would be left of the company in the process.”

Railroad management is not going to give up its laser focus on keeping down costs because otherwise it might lose some competitive edge. Railroads are, by nature, a high fixed costs business.

Nor are railroads going to stop turning away low margin business.

However, the fixation on ever lower operating ratios has meant sacrificing some profitable volume growth.

The average operating ratio last year for North American Class 1 railroads was 60.4 percent, an improvement of 10.4 percentage points since 2012.

Todd Tranausky, vice president of rail and intermodal at FTR Transportation Intelligence, a freight forecasting firm, told Trains that even if operating ratios were to skyrocket into the 70s there would still be plenty of profitable business for railroads to seek to capture.

Some railroad executives, among them Union Pacific CEO Lance Fritz, have argued that the cost cutting of recent years has created a situation in which business that once didn’t look attractive now looks good because UP has a lower cost structure.

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