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Railroad barons are reconsidering the playbook that made them rich

The railroaders are now seeing that they’ve gone too far

Choo choo! (Jim Allen/FreightWaves)

Usually when I sit down to read prestigious publications targeted at insidery urbanites, I do not get the opportunity to learn about railroad management. But the last few months have given us lengthy features about just that in publications like New York Magazine, The New York Times and Slate.

The operational model in question in these pieces is precision scheduled railroading, or PSR. The journalists who wrote about PSR were not complimentary of them. 

Federal regulators aren’t happy about PSR either. While PSR has allowed railroads to boost profits and manage costs amid declining demand for rail services, critics say it’s left railroads with fewer staff and equipment needed to properly operate

It seems that the railroaders are starting to also see the issues around endless streamlining. Class I freight railroads are reconsidering some factors around PSR, which has left them with furious customers, employees on the verge of striking and probes from the Surface Transportation Board on unusually bad service. In one quarter of 2021, a year of unusually high U.S. imports, rail’s intermodal sector, which moves containerized goods, claimed just 11% of all freight movement — its lowest in almost 12 years. 

“I truly believe they’ve learned their lessons,” said Bloomberg Intelligence’s Lee Klaskow, who leads logistics and transportation research. “I think they will operate not as lean as they once did because they missed a huge opportunity. Because there’s so many different commodities that collapsed during the pandemic, they could have been winning a lot of intermodal share — especially given the tight trucking market that we saw a year ago. But they couldn’t, because they didn’t have the service.”

It is time, as Fadi Chamoun of BMO Capital Markets put it, for “PSR 2.0.” 

That means reconsidering — or even undoing — previous moves around efficiency. More railroads say they want to increase volume and improve service. Omaha, Nebraska-based Union Pacific and Atlanta-based Norfolk Southern are reopening yards they used to sort railcars, as The Wall Street Journal reported in September. Jacksonville, Florida-based CSX is reintroducing locomotives it had previously stored away, the Journal reported in its September piece. 

And all are hiring staff — after shedding 28% of the headcount in the past decade, according to federal data. The train and engine workforce across rail increased 8% from January to October, according to John Gray, senior vice president of policy and economics at the Association of American Railroads. 

“Railroads are working hard to make sure they have the assets they need in place in 2023 to meet their customers’ needs safely, reliably, and cost effectively,” Gray wrote in an emailed statement to FreightWaves.

Railroads began cutting employment in the late 2010s, and then sharply cut more in the early days of the coronavirus pandemic. They’ve tried to add headcount back since. (FreightWaves SONAR)

Some doubt that railroaders will actually embrace volume growth over profitability. Railroaders don’t blame PSR for their service and staffing issues, saying the pandemic and resulting labor shortage were more to blame. CSX CEO Jim Foote said at a July conference, for example, that PSR could not be blamed for the company’s service issues, but the management tactic presumes that railroaders slash headcount. And complaints from customers about service issues predate the pandemic

Even as rail turns against some of the key operating principles of PSR, like reopening hump yards and reintroducing locomotives, executives still say PSR governs their operations. During Norfolk Southern’s investor day meeting on Tuesday, for example, CEO Alan Shaw said he wanted to pursue both service and PSR — which may appear to be conflicting. 

Why is everyone obsessed with PSR?

Railroad barons worship at the so-called “cult of the operating ratio.” Operating ratio measures expenses as a percent of revenue. A low OR is king; in rail, that means below 60%.

Railroaders weren’t able to capture an OR anywhere near 60% until a gentleman named Hunter Harrison came onto the C-suite scene in the late 1980s. At that point, ORs were more likely in the 70s or even 80s. 

Through his leadership of Canadian National and Canadian Pacific, Wall Street began to see that railroads could actually be profitable. And other publicly traded rail companies would soon be pressured to adopt the operating principles that Harrison favored — sometimes by takeover of hedge funds and activist investor boards. 

Now, rail is one of the most profitable industries around. It wasn’t always this way. In the mid-2000s, before PSR became commonplace in the U.S., the five largest U.S. railroads reported profit margins around 15%. In 2021, these companies reported an adjusted operating margin of 41%. 

According to STB Chair Martin Oberman, the biggest freight railroads spent $191 billion on dividends and stock buybacks between 2011 and 2021.

As an executive, veering too far from the “cult of the OR” can get you and your colleagues booted from the C-suite, as FreightWaves’ head of intermodal solutions, Mike Baudendistel, told me. 

“If you have some buffer in there, some extra pieces of equipment and a 10% cushion of employees so we can give people a better work-life balance, then you’re going to have an operating ratio that’s worse than your peer group,” Baudendistel said, “which then means the activist shareholders will buy up the shares in your company and force out the management team and put someone else in there. If a railroad management team wants to keep their jobs, they need to have an operating ratio that is at least as good as their peer group.”

Long trains reign supreme

Like much of transportation, economies of scale reign supreme in PSR. That means trains reaching 2 or 3 miles in length. My colleagues in FreightWaves’ research arm explained in 2020 why that’s beneficial:

Longer trains means fewer locomotives and fewer employees. Longer trains also imply changes to train schedules and service. Operating fewer locomotives and cars more efficiently requires railroads to consolidate freight and build longer trains more deliberately. Cars will no longer wait at customer facilities to be loaded when it is convenient for the customer but will arrive and depart on fixed schedules that customers must adhere to.

PSR is all about shedding assets, closing down classification yards and cutting headcount. Rail companies also canceled certain service offerings in the process, which frustrated customers.

Railroads went too far and infuriated their customers and employees

A fascinating contrast between railroaders’ massive windfall is that it wasn’t achieved by satisfying customers or expanding one’s volume. In fact, in the last quarter of 2021, Union Pacific saw profits up 24% despite a 4% decrease in volume. 

Railroad volumes have declined through the past 15 years. (FreightWaves SONAR)

Supply chain issues that slammed manufacturing were a drag on rail volumes last year, as were crew shortages. When you slash assets and headcounts too much, you can’t provide customers the same level of service they might have expected. Nothing quite captures this like the ballad of Washington state’s rotten potatoes. 

Over the last 15 to 20 years, Eric Voigt of the Washington Potato Commission said the farmers in his association have stopped moving potatoes by train. They’re all moved by truck now. Rail is much cheaper than truck, but it wasn’t dependable, Voigt said. 

Around 1 in 10 carloads of potatoes had some quality issue as a result of rail transportation, Voigt said. One example might include a carload of potatoes forgotten on rail siding, rotting for weeks. 

Defend the potatoes! (AP Photo/Roberto Pfeil)

Farmers in the Washington Potato Commission have stopped shipping by rail because of the lack of dependability. (AP Photo/Roberto Pfeil)

The potato farmers of Washington state now use rail to move frozen potatoes; around 20% of frozen potatoes go on rail, according to Voigt. 

They are hardly the only customers frustrated by declining rail service. In April, the STB held a two-day hearing on rail service with representatives from unions and industries like grain and coal. As my FreightWaves colleague Joanna Marsh reported from the hearing, the grain industry said transit times between the Midwest and West Coast had doubled. Late arrivals resulted in flour mills and ethanol plants curtailing production. This meant $100 million in revenue losses for the grain industry, according to the National Grain and Feed Association. 

Now, railroaders seem keen on delighting farmers and industrial magnates once more. During its investor day on Tuesday, for example, Norfolk Southern leadership emphasized its interest in working closely with manufacturers like U.S. Steel, as well as e-commerce providers. Shaw emphasized “resilience” over, say, employee furloughs that could save cash in the short term but result in critical understaffing months later. 

Still, PSR isn’t going away. “We mention PSR frequently — but this is a different kind of PSR,” Shaw said Tuesday. “Reducing operating ratio is not our singular focus. We strive for more. Our pursuit of margin improvement will be balanced with other important financial measures, such as earnings per share, return on invested capital, and revenue.”

In an emailed statement to FreightWaves, a CSX spokesperson said continued service improvement, including hiring more than 2,000 new craft employees in 2022, will be key in facilitating volume growth.

“While there is substantial economic uncertainty today, we know that many of our customers want to give us more business,” the CSX spokesperson wrote. “We know we have to earn this opportunity through strong service execution that proves our ability to move our customers’ freight with reliability and consistency.”

High-quality service is necessary for the railroads’ perusal of intermodal volume, which has become a key growth area for the rail industry in recent decades. However, retailers that typically ship via truck need tip-top service that goes beyond what rail has recently provided. 

We are still waiting for ‘The Great Pivot’ on the railroads

Some have their doubts that railroaders can pick volume growth over profitability. The RailTrends 2021 conference saw leaders calling for a “pivot to growth.” As Adriene Bailey, a partner at consulting firm Oliver Wyman, said in her presentation titled “The Great Pivot,” “It is not going to happen unless we make fairly major changes in the way we approach things.”

But following RailTrends 2022, which occurred last month, some attendees noted that “The Great Pivot” didn’t happen. Quoting Oberman: “Rails said at RT21 that they were pivoting to growth and all I got was this lousy T-shirt!” 

Gray of the AAR wrote that broad factors outside of rail service levels may hinder volume growth next year, including a downgraded macroeconomic outlook for 2023 and supply chain crunches that will continue to limit manufacturing and warehousing. 

Turning away from short-termism is probably wise for the railroad barons. Chamoun of BMO Capital Markets said PSR doesn’t have to mean worse service, but he said furloughing too much staff ultimately meant railroads couldn’t grow their businesses when the economy reopened with a roar in 2020. 

“Because of that labor issue, they missed out on a lot of revenue,” Chamoun said. “From a financial perspective, it was a poor decision to not incur those additional costs.”

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Rachel Premack

Rachel Premack is the editorial director at FreightWaves. She writes the newsletter MODES. Her reporting on the logistics industry has been featured in the New York Times, the Wall Street Journal, Bloomberg, Vox, and additional digital and print media. She's also spoken about her work on PBS Newshour, ABC News, NBC News, NPR, and other major outlets. If you’d like to get in touch with Rachel, please email her at [email protected] or [email protected].