Adequate Capital

Adequate Capital

The financial rail bed for the railroad industry shifted just a bit last week.

The Surface Transportation Board's decision setting the latest cost-of-capital calculation for U.S. Class I railroads seemed an anticlimactic conclusion to a tortuous process that has seen verbal missiles fired between railroads and their shippers.

The sharp words and congressional and STB hearings have contrasted with debates on paper over such issues as to whether market risk premiums should be measured to the hundredths or rounded down to the first decimal point.

In the end, the STB concluded the average cost of capital for the industry after taxes in 2006 - yes, 2006 - was 9.94 percent. That was down sharply from the 12.2 percent cost of capital the year before, but more importantly it was up from the 7.5 percent the STB said would have been the cost of capital under the new Capital Asset Pricing Model the board adopted in January.

So depending on how you look at it, the railroads' cost of capital went up under the new formula, but it actually went down. What that means is the STB has created a near-perfect regulatory ruling. It's perfect because just about all sides can throw bricks at it without bothering with the substance of the decision, the arcane calculations that are behind this battle.

But those calculations are where the real battles for pricing power between railroads and shippers are being fought, and the returns in transportation markets suggest the financial landscape has changed a great deal since cost of capital parameters were outlined amid rail industry deregulation. More than ever, the private financial world is the real deciding force on what sort of returns railroads should expect on invested capital, and there the railroads are looking shinier by the quarter.

Just a day after the STB issued its decision, CSX came out with a report on the first quarter that saw the railroad's net profit grow 46 percent over last year to $351 million. That is, during a period when truckers were parking tractor-trailers, three airlines were on their way to shutting down and a handful of major retailers were preparing bankruptcy papers, CSX added $291 million in revenue, $141 million in operating profit and $111 million to its bottom line. 

All that, and CSX says it expects pricing to increase by at least 6 percent this year.

Those results are a stark example of what is between the lines in the STB cost of capital decision, and of the implications of the decision.

With the railroads' cost of capital now formally set lower than it had been, shippers now can argue that it costs less for railroads to earn back invested capital. Rail revenue could be - and we must catch our breath and apologize here for using that nastiest of rail industry words - adequate.

That CSX can earn a nearly 13 percent profit margin in an economic downturn and that the STB found railroads have seen their ability to attract capital grow suggests that the industry's performance in the 28 years since deregulation has been very, very adequate indeed.