The Merger Paradigm

[gabe]

My limited knowledge of the rail industry has caused me to hold back on this, as I know there are people who know a lot more about railroading than I that favor mergers. However, as excellent as Trains' recent merger article was, I don't think it put forth the countervailing view.

Here is my two cents:

(1) Manageability: I believe that railroads larger than those that exist today will harm the public and not produce projected long-term stock dividends thought to derive from such mergers. Is it any coincidence that one of the best run (and profitable) railroads in today's industry is CN, one of the smaller class ones. For all of the size, superior routes, and elimination of redundant systems, the large and cumbersome Union Pacific has been taking a beating.

Consolidating the rail system creates two manageability problems. First, larger systems create more complex management problems. Second, the consequences of a poor management system will be more deleterious in a larger system. Both negative consequences have been demonstrated by UP--do we really want to see UP’s problems X2?

(2) Trains are different than other industries. The rail industry is not the only industry to undergo major consolidation in the last 15 years. Some of the aegis of American Industrial consolidation has been Alan Greenspan. In his early days, Greenspan wrote a thesis concerning anti-trust legislation and why it is unnecessary because the market will provide for the necessary correction. In many regards Greenspan's theory has proven successful.

For instance, banking is consolidating at a rate equal to the rail industry. Yet, in many areas—particularly trust banking and areas that are highly customer-service oriented--the small-town, small banks are giving the big boys a shellacking. This is because the big boys are too large, cumbersome to offer the individualized customer service such accounts require. Thus, as predicted by Greenspan, the market is solving the problems associated with banking consolidation.

Rail is different because (1) line dominance prohibits upstarts from moving in like small banks can, (2) banking customers are not "captive" like rail customers, and (3) railroads are too cost intensive for upstarts.

(3) Consolidation = Government control. In order to compensate for some of the competitive disadvantages caused by further consolidation, more government regulation of the industry will likely result. Does the industry really want to trade beauracatic regulation for market regulation?

(4) What happens when a consolidated mega-system is in the dumper? In the past when a rail line ran into hard times, poor management, or both, there was little risk of government ownership of the entire rail industry. But what if UP and CSX team up and their management continues their same stellar performance? If 45% of the rail industry goes bankrupt, can the government step in without running the entire industry? Stated differently, is it worth sustaining a 25% chance of government ownership for a 3% greater profit?

* * *

Michael Blaszack's (sorry for the spelling of the last name, I don’t have the article on hand) excellent article notes that the industry is currently making money and reaping the benefits of the last round of mergers. If the industry is currently in a state where it can make money, why run the risks associated with another round of mergers?

Gabe

[MP173]

I may have mentioned this on the merger/pricing thread....but one of my customers is a large shipper by rail.

Comment from the shipper when asked about further merger was something to the effect that UP is a mess and could NOT handle more lines.

The problem, as I see it with merging with another rail company is that you are buying that company. Because you are purchasing it...you are paying a premium for it (look at the Conrail situation). One could say that CSX still has not recovered by the premium they paid, plus the cost of upgrading their Chicago line.

Along with buying the company, you are also paying a premium for that railroad's problems. What forms can those problems take? Let's see, what has happened in history to define problems in rail mergers?
1. System incompatibility (NYC +PRR, UP and everyone after MP/WP)
2. Buying either unprofitable lines or marginal lines (every merger). When you purchase an entire company, you generally have your eye on certain lines, but must buy the entire package. You buy the company, not the assets, except in the case of Conrail, when assets were split.
3. Older motive power. Who's fleet is better...NS or CSX?
4. Deferred maintenance.

Could go on if I had more insite to the industry, but these come to mind.

Gabe, like you I admire what CN is doing. Not only tactically, but also strategically. Look at the last few mergers they did....Great Lakes, BC Rail, Wisconsin Central, and Illinois Central.

They filled in the blank spots on the map, at reasonable prices.

ed

[Anonymous]

I believe NS/BNSF could pull it off. Not so sure about UP/CSX. Your banking analogy is good, Gabe, but aren't the regionals working like the local banks?

[Anonymous]

dubya, remember that currently UP and BNSF can exchange with either NS or CSX, and so on. If one of the two major Western lines merges with one of the two major Eastern lines, each of the lines will lose half of its interchange partners for cross country traffic. Remember, there are places that UP serves without competition from BNSF, places BNSF serves without competition from UP, and on the other coast there are places served by NS that are not served by CSX, and vis versa. If I'm a manager for any of these railroads, I don't want to potentially lose half my customers on the opposite coast, so I'd be very tepid about going after a coast to coast merger.

Also, you can't compare the banking analogy with the regional railroads, since most of the latter are themselves captive to their spin off originator, whereas regional banks can operate independently. That's why Gabe's observation is so astute, e.g. you can't apply the Greenspan market paradigm to the railroad industry.

[gabe]

Dubya,

Futuremodal stated it as well as I could have as to why regional railroads are not the equivalent of small banks; their captivity seems to make true competition impossible.

Furthermore, the biggest problem--that I see--with the merger paradigm is your contention that “there are two railroads out there that could pull it off.” The problem is, when twp pull it off, the others must endeavor to pull it off—despite the fact that they are not ready--or suffer at the hands of the newly formed many-headed hydra.

Ed,

I completely agree with your contentions. Also, I would have responded to your excellent merger pricing thread, but it was so well done and I know so little about the subject, I didn't want to pollute it.

Gabe

[BaltACD]

Due to the capital intensive nature of railroading, todays Class I's have become pawns of Wall Street's 'foamers'. Wall Street, in general, views railroads as a dying industry with little value to 21st Century investors and they thereby portray their beliefs that Wall Street analyists know more about operating railroads profitably than the managements that actually do.

The capacity issues that today railroads have are based upon Wall Street's perception that a 100 car train only needs 100 car lenghts of track......great thinking if you don't want or need to move it to satisfy customers. The capacity issues have been generated by Wall Street's view of 'If it doesn't have cars on it, it is excess capacity and needs to be pruned from the system.

Wall Steet has positioned railroads to exist very well in Recession/Depression level economies. However, with freight traffic showing increased car loadings for the past 18 months and generating ton miles greater than the peaks that were generated during WW II today's railroads are far from the shriviling and dying entities that Wall Street percieves them to be.

Mergers that may occur in the future will not have the savings that were projected from previous mergers. Virtually any combination of Class I's that anyone is talking about will be end to end mergers, under which there can be very little elimination of duplicate lines. The only real savings will be in TOP LEVEL managment, as only one will be required and in the so call back room areas, which are mostly computerized already and are not ripe with vast manpower elimination.

The operating and run through agreements that are currently in effect amongst the Class I's have the existing companies operating in a coordinated manner already for the vast majority of interline traffic.

Any mergers that may take place will probably be Wall Street driven not railroad driven as todays comanies are still trying to come to grips with who they are today.

[CSSHEGEWISCH]

Wisconsin Central's absorption by CN is a fairly straightforward case of a merger driven by the undervaluation of WC's stock. Wisconsin Central was known to be a well-run operation in the United States but its overall valuation was probably depressed by the existence of overseas operations (UK, Australia, New Zealand) even though they were also well-run. The stockholders were not happy with the relatively low price of WC's stock and were pushing for a merger to improve their return.

Corrections or additions requested.

[MP173]

I agree Hegewisch...if i remember correctly the WC stock fell from the high 30's down into the teens.

No doubt CN had its eye on it and when it got affordable snapped it up. A great purchase.

[Anonymous]

When NS/BNSF merge, and from that fine piece in TRAINS this merger would seem the most likely, who gets the corner office?

[Anonymous]

QUOTE: Originally posted by BaltACD

Due to the capital intensive nature of railroading, todays Class I's have become pawns of Wall Street's 'foamers'. Wall Street, in general, views railroads as a dying industry with little value to 21st Century investors and they thereby portray their beliefs that Wall Street analyists know more about operating railroads profitably than the managements that actually do.

The capacity issues that today railroads have are based upon Wall Street's perception that a 100 car train only needs 100 car lenghts of track......great thinking if you don't want or need to move it to satisfy customers. The capacity issues have been generated by Wall Street's view of 'If it doesn't have cars on it, it is excess capacity and needs to be pruned from the system.

Well what do you expect from folks that think that there is no life west of the Hudson?