Wheeling and dealing (continued)

While analysts evaluate railroads' Earnings before Interest, Taxes Depreciation and Amortization (EBITDA), they understand that railroads are unlike other industries, except utilities and airlines. On railroads, capital expenditures are key; they must be made on a routine basis, as fluctuations can impact a company's long-term viability. In the end, Carlson said, the real measure of any business is free cash flow—how much is left after paying for debt service, capital expenditures and dividends to shareholders. Over time, cash flow has become a more significant measure of their performance. Going forward, the cash return on investment is going to be the critical factor in measuring performance.

"The financial markets value positive cash flow," said Patrick Ottensmeyer, managing director of Transportation Finance and Administration Co., LLC, and former vice president of finance and treasurer at Burlington Northern Santa Fe. But railroading is a capital-intensive business, and the enormous capital programs that large railroads require make it difficult to generate free cash flow.

In order to increase their market value (share price), railroads must increase rates, increase volume or decrease expenses—or some combination of these factors, Ottensmeyer said. In order to generate the types of returns that analysts find attractive, railroads would have to increase rates by 5% per year over a five-year period. That hasn't happened over the past five years, nor is it likely to happen over the next five years. Failing that, railroads would have to increase traffic volume by 14%. Volume growth simply has not been as robust in the rail industry as in others. The remaining option is to decrease expenses. Railroads have mined this area, significantly decreasing expenses over the past two decades, he said. "We're at a point at which every additional cent of reduction is a lot harder to come by."

While railroads try to improve their lot by a combination of these factors, expense reduction has consistently represented a significant part of the plan. "Necessary though expense reductions may be, it can be difficult to explain how they impact the overall health of the corporation to the frontline supervisor who is going to make it happen—or not happen—in the field," Amtrak's Mike Franke said.
The supply side of the industry has had its share of challenges, as well.

Cameron Lonsdale, vice president - technical at Standard Steel, pointed out that railroads' cost-cutting and cyclical buying patterns have left the supply industry operating in a "bankruptcy economy" over the past several years. The "feast or famine" building cycles in the car business has forced a number of suppliers to exit the business and some that remained into bankruptcy. At one point in the 1970s, there were nine wheel manufacturers operating 18 plants in North America, Lonsdale said. "Today, there are two operating five plants." North American axle manufacturers tell a similar story. In 1980, there were five; today there are two.

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