What made railroads profitable?

[MP173]

Michael:

Thanks for the input on this. Is there a source for MILW financial data on line? If not, I could probably find something in the local university library in a Moody's.

Your discussion of working capital is interesting. Comparing manufacturing companies to others is a little misleading or difficult, as you stated. You mentioned that BNSF had a negetive working capital of $1.1 billion. Looking at two other companies shows the following:

McDonalds 2004 working capital was negetive $663 million
Proctor and Gamble's was negetive $5.03 billion. YES....-5.03 BILLION. Really.

That surprized the heck out of me. McDonalds didnt.

A little more data, if you will:

This is day's receivables, which measures how many days of revenue is in accounts receiveables.

BNSF (2004) 6 days
McDonalds 14 days
Proctor Gamble 29 days

Most people consider McDonalds to be a "cash" business, and would wonder why the high number of days. In reality, a large portion of McDonalds business is franchise, in a way they are much closer to a real estate operation.

Proctor and Gamble's 29 days is fairly typical for a manufacturer.

What is extremely surprizing is that BNSF's was only 6 days. How did that happen? I dont know, but either they are set up for almost immediate billing and payment (electronically) or they factor their A/R's.

A negetive working capital number in itself is not necessarily a red flag, it must be compared with other balance sheet numbers. The fact that BNSF has almost no Accounts Receivable tied up allows them to finance their working capital needs thru cash flow.

Yes, they borrow money and they refinanced loans. They are going thru a massive capital investment program. It will be interesting to see, in a decade if that investment will pay off.

Fascinating discussion.

ed

[MichaelSol]

QUOTE: Originally posted by gabe
Sorry, ... But, I would be suprised if anyone on here could verify the numbers to which you assign weight.

Financial ratios are pretty well understood, and are taken directly off of published Consolidated Financial Statements.

Most of them involve simple division of two numbers.

Sometimes simple addition involving two or more numbers is involved beforehand.

You may be right.

Best regards, Michael Sol

[gabe]

QUOTE: Originally posted by MichaelSol

QUOTE: Originally posted by gabe

Railroads are profitable? Who knew? Since when have they been able to earn the cost of capital?

I recently was discussing this topic in relation to the Milwaukee Road in 1977, and used "Financial Ratios" as a means of comparison of Milwaukee's position at that time, as a company entering bankruptcy, with current railroad financial ratios.

An interesting ratio is net assets to total liabilities. This would be general measure of "wealth" of a company.

In 1977, Milwaukee Road's ratio was 131%. In 2004, BNSF was 48%. Total Assets/Total liabilities, MILW 231%, BNSF 148%.

The basis for Trustee Stanley Hillman's remark, reacting to a report he received in 1978 to which he seemed surprised, "the Milwaukee Road is a relatively wealthy company" becomes clear. In relative terms, Milwaukee Road in the year of its bankruptcy was a substantially wealthier company than BNSF today.

Two financial ratios, Current Ratio and Quick Ratio are often called Liquidity ratios, or even solvency ratios. They measure the ability of a company to meet current liabilities out of current assets. A ratio greater than 1.0 is pretty comfortable. A ratio less than one is evidence of insufficient working capital. The higher the ratio, the better.

Year 1977, Current Ratio MILW 1.5, BNSF (2004), 0.6.

The Quick Ratio measures liquidity. Cash on hand and accounts receivable are measured against current liabilities. The industry average today is 0.5. Lower than that is bad.

Quick Ratio, MILW (1977) 0.5, BNSF (2004), 0.2.

For total debt to net worth, the lower the ratio, the better.

Total debt/net worth, MILW 0.9, BNSF, 2.1.

There are a variety of financial models which measure the overall financial situation of a publicly held company based upon multivariate analysis of important financial ratios. These models were designed for manufacturing companies, but have been found over the past 30 years to have powerful predictive value for all sorts of publicly held companies, where detailed financial information is available, as opposed to privately held companies where such information is not routinely available.

One of the most widely recognized models is called the "Altman Z" model, after its author, Edward Altman. [E. Altman, "Financial Ratios, Discrimination Analysis and the Prediction of Corporate Bankruptcy," Journal of Finance, 23, September, 1968].

During the 37 years of its use, it has achieved a remarkable 94% accuracy in predicting corporate bankruptcies. [E. Altman,"Predicting Financial Distress of Companies: Revisiting the Z-score and ZETA® Models," (working paper at
http://pages.stern.nyu.edu/~ealtman/Zscores.pdf ) 2000.

Interestingly, Altman found that in 1999, 20 percent of U.S. industrial firms referenced in Compustat data tapes had Z-scores below 1.81. Using this indicator, the unusually high incidence of US corporate bankruptcies in 2001-02 was predictable.

The scoring system recognizes the following risk levels, based on empirical application of the model.

Z-SCORE ABOVE 3.0 -The company is safe based on these financial figures only.
Z-SCORE BETWEEN 2.7 and 2.99 - On Alert. This zone is an area where
one should exercise caution.
Z-SCORE BETWEEN 1.8 and 2.7 - Good chances of the company going
bankrupt within 2 years of operations from the date of financial figures given.
Z-SCORE BELOW 1.80- Probability of Financial embarassment is very high.

Altman Z scores:
MILW Road, 1976:1.16, 1977: 1.36.
BNSF, 2003: 1.09, 2004: 1.14.

The Railroads themselves are looking nervously at those models. UP's president, James R. Young, is quoted in the June 6, 2005 issue of Traffic World (a trade magazine), page 10.... "We were told by a consultant recently that if we were a manufacturing company we'd be out of business." I have no doubt they were referring to Altman Z scores.

Another indicator, taking a somewhat different analytical approach, is termed the "Logit" analysis. [Ohlson, J.A., "Financial Ratios and the Probabilistic Prediction of Bankruptcy," Journal of Accounting Research, Spring 1980].

The attractiveness of the Logit model is that it generates a percentage probability of bankruptcy, using a somewhat different array of financial comparisons and financial indicators for a particular company. It is considered a more "robust" model than the "Altman Z" test. [Lo, Andrew W. "Logit Versus Discriminant Analysis: A Specification Test and Application to Corporate Bankruptcies," Journal of Econometrics 31 (March 1986): 151 - 179].

"Logit" results -- probability of bankruptcy:
MILW 1976: 54%, 1977: 48%.
BNSF 2003: 60%, 2004: 59%.

Now, take these with a grain of salt. Obviously these models did in fact have predictive power for the Milwaukee receivership. However, they were designed for manufacturing industries. While they have been widely tested and used for non-manufacturing companies, and found reliable, the railroad industry is just enough different that reliance on the models without testing them thoroughly could well be misleading. And, other than what you see here, I am not aware of the models being used with this industry previously.

Moving on, my calculations show that the BNSF had a negative $1.5 billion in net working capital in 2003 and negative $1.1 billion in net working capital in 2004. If you find that shocking, it certainly was to me.

The number of days working capital at BNSF is a negative 37 days. I haven't seen negative working capital like that before, but it is an improvement over 2003 when it was a negative 58 days. Liquidity was maintained by issuing $250 million in 4.88% notes [p. 20] and $300 million of 5.9% notes. [p.21, BNSF Annual Report, 2004], a total of $550 million in short term borrowing for just 2004 alone.

Note 64 to the BNSF 2004 Consolidated Financial Statements shows that a $700 million short term loan which was originally due in June, 2004, was extended to June 2006. The Company was unable to pay this when it fell due.

This note, combined with the additional $550 million in short term borrowing in 2004, totals $1.25 billion in short term financing necessary to pay things like dividends and keep cash in the till. Working capital is in essence borrowed, not internally generated.

The negative net working capital of $1.5 billion at BNSF is interesting. Milwaukee Road almost always had a positive working capital. *** Kratochwill would get a little nervous when working capital got down to around a positive $10 million or so. The ICC used to routinely comment when a Class I railroad began having working capital "problems" as it means the money must be borrowed, usually short term, at rates above the rate of return of the company.

Union Pacific felt obliged to note that it also had negative working capital in 2004: "At December 31, 2004 and 2003, we had a working capital deficit of $226 million and $367 million, respectively. A working capital deficit is not uncommon in our industry and does not indicate a lack of liquidity. We maintain adequate resources to meet our daily cash requirements, and we have sufficient financial capacity to satisfy our current liabilities."

Well, that was an interesting statement as a deficit in net working capital is a definition of lack of liquidity. Also noteworthy was that UP's deficit was so significantly smaller than BNSF's.

However, comparing the Current Ratio, MILW (1977) 1.5, BNSF (2004), 0.6, to UP's 2004, .91, and it's Quick Ratio of 0.6, compared to Milwaukee's 0.5 and BNSF's 0.2, UP's liquidity is above the industry average and appears excellent in contrast to BNSF's.

The point of this analysis was not to show that today's railroads are just about to go under. To the contrary, the exercise originated as an analytical tool to assess Milwaukee Road's weaknesses in 1977. The results just happened to be quite surprising, and didn't really help with understanding Milwaukee Road's situation but rather made that whole debacle somewhat more perplexing, since Milwaukee was, by today's railroad financial standards, overall a significantly healthier company than today's Western railroads. Yes, that's weird. Did not expect to find that.

Noteworthy too is the fact that Milwaukee Road's condition was assessed at a time when the economic climate was indeed poor, whereas the comparisons with BNSF measures BNSF during a period of remarkable economic health for the country as a whole, and its financial ratios, in particular, should reflect a roaring good health.

The fact is, they do not, and instead show a poorer overall financial condition than a railroad that has since disappeared from our map.

Best regards, Michael Sol

2 + the square root of 269 - the cube root of 399 multiplied by Avagadro's number with a cotangent of 12 divided by common sense = they still went out of business.

Sorry, I am not saying your assertions are invalid. But, I would be suprised if anyone on here could verify the numbers to which you assign weight. Absent such an ability, I am going to go with the historical fact that--as much as I love the Milwaukee Road--it still went out of business and a good deal of its physical plant is ripped up all to Haities.

Gabe

[squeeze]

What hurt the railroad was trucking, they can go most anywhere, but trains need tracks. Amtrack helped out by taking over the passenger service, but they are in big trouble because they are forever in debt.

[bobwilcox]

QUOTE: Originally posted by nanaimo73

Poor management waiting to merge with C&NW starting in 1954 and letting the railroad rot away beneath them.

I use to compete with the Milw in the midwest. You hit the nail on the head. The MILW board in the 70's should get a Darwin Award.

[oltmannd]

Back in the late '40s, the RRs listed 3 major issues facing them - all the result of gov't regulation or policy:

1. Passenger losses - "public good" not profitablilty was guiding principle for ICC
2. High labor costs - full crew laws in many states
3. Regulated rates and routes - "common carrier" status, not profitabiltiy governed the ICC.

The amazing thing is that the industry survived the 50s and 60s at all.

Each of these three issues has been dealt with.

1. Amtrak and commuter agencies have removed nearly all costs from the RRs. In fact, BNSF actually finds contract commuter business profitable these days.

2. Full crew laws are gone and train crew size has been greatly reduced.

3. Staggers act lets RRs drop unprofitable routes and set their own rates with comparitive ease.

Even with this, the RRs have struggled to earn the cost of capital, although it appears that the industry may be getting close to that goal.

[bobwilcox]

QUOTE: Originally posted by garyaiki

After decades of bankruptcy and fallen flags, railroads are now profitable. What change turned this around; getting rid of steam, getting rid of passenger service, computer automation, consolidation? Or was it something else?

After the rise of effective competition the railroads were givin back the ability to operate in a market enviroment.

[nanaimo73]

Poor management waiting to merge with C&NW starting in 1954 and letting the railroad rot away beneath them.

[Anonymous]

Michael,

I always enjoy your posts and thank you for the one above. Truly fascinating reading.

As a Milwaukee Road survivor of the era you mention, all I can think is "What happened?"

Mitch

[Anonymous]

Thanks Michael, my head is spinning.

[MichaelSol]

QUOTE: Originally posted by gabe

Railroads are profitable? Who knew? Since when have they been able to earn the cost of capital?

I recently was discussing this topic in relation to the Milwaukee Road in 1977, and used "Financial Ratios" as a means of comparison of Milwaukee's position at that time, as a company entering bankruptcy, with current railroad financial ratios.

An interesting ratio is net assets to total liabilities. This would be general measure of "wealth" of a company.

In 1977, Milwaukee Road's ratio was 131%. In 2004, BNSF was 48%. Total Assets/Total liabilities, MILW 231%, BNSF 148%.

The basis for Trustee Stanley Hillman's remark, reacting to a report he received in 1978 to which he seemed surprised, "the Milwaukee Road is a relatively wealthy company" becomes clear. In relative terms, Milwaukee Road in the year of its bankruptcy was a substantially wealthier company than BNSF today.

Two financial ratios, Current Ratio and Quick Ratio are often called Liquidity ratios, or even solvency ratios. They measure the ability of a company to meet current liabilities out of current assets. A ratio greater than 1.0 is pretty comfortable. A ratio less than one is evidence of insufficient working capital. The higher the ratio, the better.

Year 1977, Current Ratio MILW 1.5, BNSF (2004), 0.6.

The Quick Ratio measures liquidity. Cash on hand and accounts receivable are measured against current liabilities. The industry average today is 0.5. Lower than that is bad.

Quick Ratio, MILW (1977) 0.5, BNSF (2004), 0.2.

For total debt to net worth, the lower the ratio, the better.

Total debt/net worth, MILW 0.9, BNSF, 2.1.

There are a variety of financial models which measure the overall financial situation of a publicly held company based upon multivariate analysis of important financial ratios. These models were designed for manufacturing companies, but have been found over the past 30 years to have powerful predictive value for all sorts of publicly held companies, where detailed financial information is available, as opposed to privately held companies where such information is not routinely available.

One of the most widely recognized models is called the "Altman Z" model, after its author, Edward Altman. [E. Altman, "Financial Ratios, Discrimination Analysis and the Prediction of Corporate Bankruptcy," Journal of Finance, 23, September, 1968].

During the 37 years of its use, it has achieved a remarkable 94% accuracy in predicting corporate bankruptcies. [E. Altman,"Predicting Financial Distress of Companies: Revisiting the Z-score and ZETA® Models," (working paper at
http://pages.stern.nyu.edu/~ealtman/Zscores.pdf ) 2000.

Interestingly, Altman found that in 1999, 20 percent of U.S. industrial firms referenced in Compustat data tapes had Z-scores below 1.81. Using this indicator, the unusually high incidence of US corporate bankruptcies in 2001-02 was predictable.

The scoring system recognizes the following risk levels, based on empirical application of the model.

Z-SCORE ABOVE 3.0 -The company is safe based on these financial figures only.
Z-SCORE BETWEEN 2.7 and 2.99 - On Alert. This zone is an area where
one should exercise caution.
Z-SCORE BETWEEN 1.8 and 2.7 - Good chances of the company going
bankrupt within 2 years of operations from the date of financial figures given.
Z-SCORE BELOW 1.80- Probability of Financial embarassment is very high.

Altman Z scores:
MILW Road, 1976:1.16, 1977: 1.36.
BNSF, 2003: 1.09, 2004: 1.14.

The Railroads themselves are looking nervously at those models. UP's president, James R. Young, is quoted in the June 6, 2005 issue of Traffic World (a trade magazine), page 10.... "We were told by a consultant recently that if we were a manufacturing company we'd be out of business." I have no doubt they were referring to Altman Z scores.

Another indicator, taking a somewhat different analytical approach, is termed the "Logit" analysis. [Ohlson, J.A., "Financial Ratios and the Probabilistic Prediction of Bankruptcy," Journal of Accounting Research, Spring 1980].

The attractiveness of the Logit model is that it generates a percentage probability of bankruptcy, using a somewhat different array of financial comparisons and financial indicators for a particular company. It is considered a more "robust" model than the "Altman Z" test. [Lo, Andrew W. "Logit Versus Discriminant Analysis: A Specification Test and Application to Corporate Bankruptcies," Journal of Econometrics 31 (March 1986): 151 - 179].

"Logit" results -- probability of bankruptcy:
MILW 1976: 54%, 1977: 48%.
BNSF 2003: 60%, 2004: 59%.

Now, take these with a grain of salt. Obviously these models did in fact have predictive power for the Milwaukee receivership. However, they were designed for manufacturing industries. While they have been widely tested and used for non-manufacturing companies, and found reliable, the railroad industry is just enough different that reliance on the models without testing them thoroughly could well be misleading. And, other than what you see here, I am not aware of the models being used with this industry previously.

Moving on, my calculations show that the BNSF had a negative $1.5 billion in net working capital in 2003 and negative $1.1 billion in net working capital in 2004. If you find that shocking, it certainly was to me.

The number of days working capital at BNSF is a negative 37 days. I haven't seen negative working capital like that before, but it is an improvement over 2003 when it was a negative 58 days. Liquidity was maintained by issuing $250 million in 4.88% notes [p. 20] and $300 million of 5.9% notes. [p.21, BNSF Annual Report, 2004], a total of $550 million in short term borrowing for just 2004 alone.

Note 64 to the BNSF 2004 Consolidated Financial Statements shows that a $700 million short term loan which was originally due in June, 2004, was extended to June 2006. The Company was unable to pay this when it fell due.

This note, combined with the additional $550 million in short term borrowing in 2004, totals $1.25 billion in short term financing necessary to pay things like dividends and keep cash in the till. Working capital is in essence borrowed, not internally generated.

The negative net working capital of $1.5 billion at BNSF is interesting. Milwaukee Road almost always had a positive working capital. *** Kratochwill would get a little nervous when working capital got down to around a positive $10 million or so. The ICC used to routinely comment when a Class I railroad began having working capital "problems" as it means the money must be borrowed, usually short term, at rates above the rate of return of the company.

Union Pacific felt obliged to note that it also had negative working capital in 2004: "At December 31, 2004 and 2003, we had a working capital deficit of $226 million and $367 million, respectively. A working capital deficit is not uncommon in our industry and does not indicate a lack of liquidity. We maintain adequate resources to meet our daily cash requirements, and we have sufficient financial capacity to satisfy our current liabilities."

Well, that was an interesting statement as a deficit in net working capital is a definition of lack of liquidity. Also noteworthy was that UP's deficit was so significantly smaller than BNSF's.

However, comparing the Current Ratio, MILW (1977) 1.5, BNSF (2004), 0.6, to UP's 2004, .91, and it's Quick Ratio of 0.6, compared to Milwaukee's 0.5 and BNSF's 0.2, UP's liquidity is above the industry average and appears excellent in contrast to BNSF's.

The point of this analysis was not to show that today's railroads are just about to go under. To the contrary, the exercise originated as an analytical tool to assess Milwaukee Road's weaknesses in 1977. The results just happened to be quite surprising, and didn't really help with understanding Milwaukee Road's situation but rather made that whole debacle somewhat more perplexing, since Milwaukee was, by today's railroad financial standards, overall a significantly healthier company than today's Western railroads. Yes, that's weird. Did not expect to find that.

Noteworthy too is the fact that Milwaukee Road's condition was assessed at a time when the economic climate was indeed poor, whereas the comparisons with BNSF measures BNSF during a period of remarkable economic health for the country as a whole, and its financial ratios, in particular, should reflect a roaring good health.

The fact is, they do not, and instead show a poorer overall financial condition than a railroad that has since disappeared from our map.

Best regards, Michael Sol

[daveklepper]

OK Mark Hemphill is the real expert and let us hope he gets around to reading the website and picking up on this thread.

Railroads were generally profitable because they were the lowest cost means of moving people and freight from one point to another. Sometimes with some Gov. help but usually only from investor capital they built their infrastructure and bought their equipment. They often engaged in unfair practices which brought regulation. They continued to be profitable, generally, until tax revenue was used by the ogvernments to assist road, water, and air competition. They became profitable again after the Staggers Act legislation which altered and eliminated regulation to allow them to operate more as businesses and less as public servants. This is an oversimplification but does explain the heart of the matter.

[gacuster]

I have read the Staggers Act of 1980 (?) which deregulated the railroads helped alot, but I am not familiar with the specifics of this legislation.

[Modelcar]

....By lowering costs. Overhead.

[nanaimo73]

CN just reported a second quarter net income of US$ 340 million.

[gabe]

Railroads are profitable? Who knew? Since when have they been able to earn the cost of capital?

Gabe

[Anonymous]

After decades of bankruptcy and fallen flags, railroads are now profitable. What change turned this around; getting rid of steam, getting rid of passenger service, computer automation, consolidation? Or was it something else?