Supremacy in the West

CSX is struggling, driverless trucks are on the horizon, and the railroad world seems in disarray. Let’s talk about something that works: railroading in the West. Let’s talk about BNSF Railway and Union Pacific.

We have here two magnificent companies, each well run and hugely profitable. Their differences are what interest me. Why, for instance, has BNSF’s business over time been growing and Union Pacific’s shrinking? And why, despite this, does Union Pacific consistently report more operating income than BNSF—shouldn’t it be the other way around?

Part of the explanation may lie in something neither railroad controls, route structure. Explains Chip Paquelet of Skylands Capital: “If I were able to invest in both railroads today, I’d buy Union Pacific. Managements change every seven to ten years. Therefore, so can management practices. The one thing that cannot change is who has the best route structure, and it’s Union Pacific.”

Their ownership affects how the railroads are run, too. Publicly held Union Pacific falls captive to the short-term focus of Wall Street. The analysts want to know what will happen the next quarter. If you have a long-term vision for your company, tell it to your kids because we’re not interested, is the thinking. This isn’t Union Pacific’s fault. BNSF since 2010 has been a wholly owned subsidiary of Berkshire Hathaway, whose chief executive Warren Buffett is famously committed to the long term ands largely ignores Wall Street. Every year the railroad writes Berkshire Hathaway a check—the amounts vary between $2.5 and $4 billion—and Executive Chairman Matt Rose sends Buffett a quarterly letter keeping him abreast of what’s going on. Otherwise, Rose and Chief Executive Carl Ice are pretty much left to run the railroad as they see fit.

Constantly under Wall Street’s gaze, UP’s focus is the profitability of its business—the term used is “reinvestibility.” In other words, UP asks if the rate it gets on new and even existing business is sufficient to pay for and replace the equipment and other assets used in handling it. If not, UP isn’t interested. Union Pacific, in other words, isn’t out to be the biggest railroad. It just wants to be the richest. This has been the guiding principle at the company for at least a dozen years. But it grates on customers. Says one western unit train shipper (who is switching to BNSF): “Their marketing effort seems to be totally based on trying to get customers to pay more.”

BNSF also wants to be the richest railroad, obviously. But it seeks to get there by baking a bigger pie. I cannot prove this, but I believe that Rose, Ice & Company read Union Pacific pretty clearly. BNSF’s strategy is that if it can bring on new business and increase market share and over time increase the profitability of that business, BNSF will grab it, even if the rate of return is less than what UP demands. (BNSF is also not above poaching Union Pacific’s portfolio, although of course Rose publicly denies doing so.)

I’ll offer an example, coal. Coal for power plants is under pressure from two directions, air-quality regulations and cheap natural gas. Railroads can’t do anything about regs. But they do serve power plants, mostly in Texas, that can switch between coal and gas as fuel. Union Pacific’s stance has been: Here’s our rate, take it or leave it. BNSF is willing to do what Rose calls “gas deals.” Instead of losing a plant to natural gas, BNSF modifies its contracts so that the rate goes up and down in line with the price of natural gas. This way the railroad keeps the business (and maybe picks up a Union Pacific customer or two) and still makes money.

So those are the two approaches being employed in the West. UP emphasizes profitability in the here and now, BNSF does as well, but looks longer term. A business school professor would say both are perfectly legitimate ways of running a railroad. What I wonder is whether one is better than the other. Or to be blunt: Has Union Pacific backed itself into a corner?

The numbers are interesting. Since 2000, UP’s carload business (that’s everything but intermodal, coal, and autos) fell 2.7 percent. But BNSF’s carload traffic rose 23.7 percent. That’s an astounding deviation, largely driven by the pricing policies I just discussed. Coal: Both railroads peaked in 2008. In the following eight years, UP’s coal loadings fell 50 percent, BNSF’s just 29 percent. Intermodal: BNSF held a small lead in 2000, a much larger one in 2016. BNSF first passed Union Pacific in total loads in 2004, and last year carried 16 percent more traffic.

Never bet against Union Pacific, because year after year it still brings home more operating income than its rival. This reflects both its emphasis on high rates and the traffic base it enjoys, meaning you earn more per car of chemicals (UP) than per container carried (BNSF). Still, I wonder if there’s a tipping point. In other words, both railroads have their high fixed costs. The more business that goes over the rails, the less each car has to carry of those costs. BNSF spreads its fixed costs over more and more traffic, UP over less and less. You’d think these trends cannot continue without BNSF’s gaining a decided cost advantage over its rival and therefore the ability to under-price the other railroad, with huge consequences.

Today, if you believe in a growing business, it’s advantage BNSF Railway. But UP still comes home with that bigger pot of gold. How long can this odd imbalance last?