4. Everything about PSR
Prisoners Dilemma – Berkshire Hathaway owned BNSF vs. UNP
Both Warren Buffet and Charlie Munger have been repeatedly asked in Berkshire Hathaway’s AGM about their view on PSR and why BNSF remains the only Class 1 rail to be a laggard in deploying it. For example, despite having the longest-haul, BNSF has the worst O.R. of 65.3%, which is 60 bps behind NSC and 470 bps behind UNP. Comparing this in 2015, BNSF’s O.R. was infact 670 bps above NSC which shows the extent of margin expansion at NSC after implementation of PSR. Besides, BNSF’s service has struggled since late 2018. Being a privately owned entity, BNSF often misses investors scrutiny despite having the industry worst O.R.
Interestingly, Hunter Harrison has spent most of his early career with BN, which has been touted by insiders that elements of PSR are always been long present with BNSF.
Will the management change in BNSF bring it at war with UNP?
This is a question which I would love to ask Warren Buffet in the next AGM. Matt Rose (who shares great bonhomie with Warren Buffet) retired last year as Chairman of BNSF after 26 years of service. He has been a vocal opponent of PSR. Service disruptions for higher profitability will attract heightened regulatory risk, according to him. But a closer look suggests that BNSF has a heavy mix towards intermodal (51% of volumes) which requires high service to shippers. So this means that BNSF cannot ignore to disrupt service like how CSX did or what UNP can afford. Additionally, BNSF’s cost efficiency is not bad either which means that the poor O.R. is more of a problem with its mix. Could this be the reason for BNSF to not adapt PSR?
This is a prisoner’s dilemma. Can BNSF allow UNP to develop a much leaner and reliable PSR network or will it also join the game? If BNSF ignores PSR, it will continue to gain low-margin intermodal share but lose the high-margin merchandise to UNP. If BNSF embraces PSR, service disruption risk will become imminent in the western corridor with both the biggies competing for a larger share of merchandise. In both the scenarios, UNP is well placed and stands to gain, considering its early headstart.
However, thinking through this conundrum, I came across a recent tweet from Chris Bloomstran (who’s been a great learning source for me), wherein he shared the interview link of Katie Farmer, incoming president and CEO of BNSF. There are clear indications that she’s going for market share gain!
Additionally, going through Chris’s letters which are posted on Semper Augustus website (highly recommended!), I came to learn that BNSF’s growth capex provides a source of capital to Berkshire Hathaway though deferred taxes. This is a benefit that only Berkshire Hathaway could derive which gives it an edge over UNP. Also I was able to learn why BNSF’s RoIC lag others (more on this below) which was primarily owing to the jump in book value upon majority acquisition of BNSF by BRK.
To summarize, both the firms have their own strategies and there is enough room for growth in the western corridor for them to benefit.
https://www.cnbc.com/video/2020/01/27/kansas-city-southern-ceo-rail-industry-usmca-trade-squawk-box.html
Rail Renaissance – The debate on return ratios
Estimating the true returns for a railroad is a tricky concept. Investments are done from a perspective of 10-20-30 years’ time horizon. Since GAAP requires the use of historical cost as the basis of reporting, a mismatch occurs between the book value and replacement cost. Long periods of inflation significantly increase asset replacement costs for capital-intensive companies like railroads. As an example of UNP, for every dollar of assets in its book, it had to spend $1.9 over the last 12 years (BNSF was also close at 1.85x). Hence inflation is a critical driver as the assets are replaced at an inflated cost.
If this is the case, then which metric is the best indicator to determine the economics of a capital-intensive industry like railroads? While EVA metric such as CFROI will be better in my perspective, but as the regulators, shippers and rail companies give importance to RoIC, let us compare that.
Recent PSR turnarounds – such as CP and CSX have not only substantially improved their return metrics but also have the highest RoIIC (incremental investment return) over others. BNSF lags overall, partly because of the increase in paid-up capital when it was acquired by Berkshire Hathaway. Eastern players (CSX/ NSC) have historically been the worst, but CSX’s improvement showed that PSR is possible even with structurally disadvantaged rails.
Investment in the industry gathered momentum starting in the early 2000s after the railroaders gained pricing power. The industry’s capex to sales percentage jumped from 13-14% to 17-18% as they realised the gains from incremental investments supported by freight demand. This period is termed as ‘Rails Renaissance’.
There has been a long-standing debate between the STB (regulator), shippers and railroads on the usage of replacement value vs. the book value to determine the revenue adequacy. Without going into much detail (for this article), the use of replacement value will lower the return ratios dramatically and hence will be a boost for the companies from a regulatory aspect.
What is Precision Scheduled Railroading?
Ever imagined if airlines and passenger rails would wait for their seats to get filled rather than starting on time? Scary? Yes! Imagine how inefficient the system would have been. Awkwardly, this has not been the case for the freight industry. They instead wait for the carloads to arrive and be sorted, risking delays and congestion in the network. No wonder that railroads lost market share to trucks, especially for time-sensitive freights. However, this started to change with the implementation of PSR which was pioneered by the iconic Hunter Harrison.
PSR’s key tenet is that a train should leave at a scheduled time. The objective of PSR is to have the right people in the right place at the right time. An effective implementation leads to maximize asset utilisation as the speed of trains accelerates, dwell declines and safety improves. This results in significant cost reduction, better Operating Ratio (O.R. = 1- EBIT margin) and ROIC. But it is not easy as thought since it requires a change in the culture of the entire company with a dominant unionised workforce.
How effective has been the PSR in railroad companies?
CNI, considered to be a gold standard within the industry has been a pioneer and earliest adopter of PSR when it acquired Illinois Central in 1998. And the part of the deal was also to have Hunter Harrison join CNI, who was later appointed as CEO in 2003. Since then, CNI’s O.R. went from worst to best among its Class I peer group. This was followed by CP when Bill Ackman won a proxy war and installed Hunter Harrison as its CEO in early 2013. The turnaround at CP was termed as one of the greatest corporate turnarounds. CP’s network structure, geography, weather and freight mix were considered an impediment to PSR by the management and in fact, they came up with a $ 5 m study to substantiate their claims.
I’d recommend readers to go through Pershing Square’s proxy presentation on CP which serves a great source of learning the potential of PSR.
Later Hunter joined CSX in 2017. As he realised that he has limited time at his side, he spearheaded the PSR in the shortest time possible. CSX handsomely outperformed since the implementation of PSR as its O.R. went from an industry worst of ~70% to an industry best of sub-60% in two years. Being turned as the “CN of the South”, CSX’ success can be attributed to the fact that much of its current management team rose in the field together under the guidance of Hunter Harrison.
