3. Railroads 101
Railroads: Strong entry barriers with duopoly market structure
The North American rail industry is made up of seven Class I rail operators and several regional and local railroads. Class 1 railroads are defined as having annual revenues of at least $ 250 m (based on 1991-dollar terms) and carry 90% of market share. Class 1 operate are a duopoly within their respective regions.
Starting a new railroad is today unviable for a new player. There used to be over 40 class I railroads. Then after the 1980s Stagger Act, the 40 railroads merged into seven with four railroads taking the largest share. BNSF (owned by Berkshire Hathaway) is the largest freight railroad by volume and revenues. Along with UNP, they have a duopoly on transcontinental freight rail lines in the west. CSX Corp. (CSX) and Norfolk Southern (NSC) compete in the east of the Mississippi River where they have a shorter and much complex network. Canadian Pacific (CP) and Canadian National (CNI) are based out of Canada with fright lanes extending till the US.
UNP’s Hidden asset: Interestingly, UNP’s unique franchise provides it with the best access to Mexico. It is the only railroad to serve all six major rail gateways between the U.S. and Mexico. It also holds a 26% minority ownership interest in Ferromex (FXE), a rail network covering ~70% of Mexico. UNP can interchange traffic at the border, working with both Ferromex and KSU. It derives ~10% of revenues from Mexico.
Competitive advantage vs trucks
Rails have a significant barrier to entry with irreplaceable networks-built 100+ years ago. A high fixed cost provides significant operating leverage to improving volumes. Rails primarily compete with Trucking for market share. They have lost a substantial amount of share to truck over the last few decades for traffic that economically should move via rail – but shifted to truck given historically unreliable and inconsistent rail service. Rails are much more fuel-efficient with Class 1 railroads able to move a ton of freight between 450-500 miles using a single gallon of diesel.
“With a very high degree of certainty, in my view, BNSF will be carrying more carloads 10 years from now, 20 years from now; that there will be no substitute for the service that they provide; that there will be two important railroads in the west and two important railroads in the east; and that they will have an asset that has incredible replacement value, nobody could turn out something like it, and that they’ll get paid fairly for what they do. It’s not very complicated.”
– Warren Buffet at 2013 AGM
What do the rails carry?
Right from transportation of autos to your local dealership, to agricultural products and industrial commodities, US railroads are the lifeline of the US economy. Categorisation of freights can vary between companies. UNP categorises freight into under bulk, manifest, and premium. An easy way to compare is to classify them into – coal, intermodal and merchandise.
Can merchandise and intermodal offset the decline in coal?
Coal is high-margin and has been at a structural decline. As a % of carload volumes, it is greatest for BSNF and CSX at 18% and 14%, respectively. Canadian railroads have the lowest exposure to coal.
Intermodal (IM) is when your stuff moves by more than one transportation type and could be anything. This has been a key growth driver for rails helping them partially offset the decline in coal but remain low margin as compared to coal since IM competes fiercely with other modes of transport such as trucks. It is considered that rails with longer length of haul and higher density of industrial networks get an edge over trucks. This is the reason Canadian rails (CP/CNI) were able to grow their volumes supported by fast-growing traffic from the ports of Vancouver and Rupert. So, has been the story for western rails (UNP/BNSF) with an increase in traffic from the western ports. However, east (CSX/NSC) lost their competitive edge to trucks due to shorter haul.
Merchandise includes remaining stuff not classified under the above two and includes stuff such as steel, lumber, chemicals, soda, ethanol etc. Margins for this segment are better than IM. Both Canadian rails and UNP in the US have the highest percentage of merchandise. UNP has a disproportionate number of chemical plants located on its lines giving it a higher share. This segment also has the potential to regain market share from trucks as the service and reliability of rails improve with the implementation of PSR.
Understanding the unit metrics for the industry
If you feel like the rail industry has its own language, you are right — and it’s not always easy to navigate.
Carload means the amount of cargo that fits in a rail car.
Revenue per carload (RPU) which looks simple and intuitive (used by many) has a flaw. It does not provide meaningful insights on the profitability as cost structures are driven by tonnage and mileage. Shorter haul traffic (like CSX/NSC) generate lower unit revenue but have the highest yields on a ton-mile basis.
RTM is the ton per mile covered only by revenue-generating freight cars. This is a helpful proxy for volumes as it eliminates length of haul differences among carloads but which still carries some problems of an underlying mix.
Therefore, revenue/RTM is a better unit revenue measure on a ton-mile basis. With the efficiencies that come with a longer length of haul, UNP and BNSF charge a lower rate per mile to move freight while the Eastern rails charge a higher rate per mile. However, a comparison is not that easy as it also depends on the mix and other factors.
GTM is the ton per mile covered by the fright cars including empty ones.
RTM/GTM ratio – an indicator of network efficiency. Usually, coal has the highest followed by merchandise and intermodal.
O.R. The operating ratio is a major measure of profitability in the railroad industry. This is the company’s operating expenses as a percentage of revenue. Or in other words, the inverse of operating profit margin.
Yard: A waiting room for rail cars (without the free coffee and dog-eared magazines). A yard is where rail cars chill until they’re connected to a train and shipped out.
Hump yard: Hump yards are where rail cars are pushed up a hill (hump), uncoupled, and then rolled downhill into remotely controlled sorting tracks. In a hump yard, an inbound train rolls up a man-made hill (known as the hump). At the top of the hump, the train is broken up one car at a time and each car rolls down the opposite side of the hump into the “bowl” where it is classified into the appropriate outbound train.
This compares to a flat switching yard, where trains are broken up into blocks of similar carloads (rather than one at a time), which are classified into outbound trains without the use of a hump.
In general, hump yards require a significant amount of carload activity to justify their operating costs. Also, flat switching yards can be more efficiently run than hump yards, leading to reduced dwell times.
The following video shows the operation of the world’s biggest hump yard which belongs to UNP and explains how it slows down the speed to process freight for various destinations.