Financial engineers at the throttle

Posted by Bill Stephens
on Monday, February 10, 2020

Union Pacific spent $5.8 billion last year to repurchase its own stock. Bill Stephens photo.
Railroads employ locomotive engineers, civil engineers, and financial engineers. The first two make the railroad work. And the third? Well, to varying degrees they’ve got their hands on the throttle at the four U.S. Class I railroads that are embracing Precision Scheduled Railroading.

Consider that CSX Transportation, Kansas City Southern, Norfolk Southern, and Union Pacific each spent more buying back shares last year than they spent to maintain and expand their networks. In some cases a lot more: CSX spent twice as much on buybacks ($3.3 billion) as it did on capital expenses ($1.6 billion).

Why is this so? And what does it say about the railroad industry?

Precision Scheduled Railroading in its early phases reduces your operating expenses and your capital intensity, which dramatically increases your free cash flow – the money left over after all the bills have been paid. As PSR railroads move tonnage on fewer but longer trains, they are awash in extra locomotives, cars, and track capacity. So rather than invest for growth, the publicly traded U.S. Class I railroads are rewarding their shareholders. And they are doing so at an unprecedented rate. 

In 2016, before the four U.S. Class I systems adopted PSR, they spent 64% of their net income on share buybacks. Since 2017 – the year CEO E. Hunter Harrison landed at CSX – the publicly traded U.S. railroads have spent roughly 105% of their net income on share buybacks, a figure largely propelled by the aggressive repurchase programs at CSX and UP. 

Clearly this is unsustainable. And it stands in stark contrast to the practices of Canadian National and Canadian Pacific, which since 2017 have spent just over 40% of their net income on share buybacks.

But UP CEO Lance Fritz last year defended the practice in an interview with CNBC. Fritz, whose railroad spent $5.8 billion on share buybacks last year, says of UP’s cash pile: “The first thing we do with it is pay wages. We buy stuff. We make sure we’ve got the right capital structure in place. We make sure we are investing in the railroad. That’s the vast majority of the use of our cash.” 

Railroads are far from alone in buying back their own shares. Big companies set a record for buyback spending in 2018. And last year was on pace to be No. 2. The reason companies gobble up their own shares is simple: Reduce the share count and earnings per share will rise even if income is flat. In other words, buybacks help companies juice their earnings, which in turn boosts stock prices, which in turn helps increase the bonuses paid to executives. 

And to be fair, the bigger share buyback programs are not the only reason railroads are cutting back on capital spending. For one thing, not as much money is required for implementation of positive train control now that all the necessary equipment is in place. For another, traffic volume was down last year and isn’t expected to grow much this year, so there’s even less need to spend on things that expand your capacity.

Don’t get the wrong idea here. Railroads are holding steady on their budgets to maintain and renew their track, which has never been in better shape, and they’re generally increasing spending on things like automated track and car inspection that can make their systems safer. 

With the exception of KCS, where the U.S. PSR railroads are scaling back is growth-related projects. There are a couple reasons for this. First, there’s the capacity dividend from PSR. CSX CEO Jim Foote says his railroad could handle 20% to 30% more traffic on the existing physical plant. With thousands of locomotives stored, and operational changes making the railroads more fluid, why would you run to Wabtec for new power at $3 million a pop or lay down new track when volume is declining? Second, prospects for meaningful growth in U.S. rail traffic seem virtually nil this year as the industrial economy slumps, coal continues to fall, and intermodal pricing is out of whack when there’s plenty of truck capacity.

Yet it’s hard to believe that railroads could not use some of the cash found at the end of their PSR rainbows to do things that would further improve service. What about fixing perennial choke points? Or how about lengthening arrival and departure tracks to help terminals more efficiently handle today’s monstrously long trains? Delays would be reduced, service reliability would improve, all those expensive assets would move faster, and in theory railroads could get more traffic because they would become more dependable.

Railroads have released scant details about their capital budgets, so it’s unclear to what extent work like this might be in the cards this year at CSX, NS, and UP. But it seems likely those things will have to wait until the so-called pivot to growth that comes after railroads first implement Precision Scheduled Railroading. For now at the big three U.S. PSR systems it’s bare bones capital budgets as money flows to shareholders.

You can reach Bill Stephens at bybillstephens@gmail.com and follow him on Twitter @bybillstephens 


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