As CEO of Canadian Pacific Railway, E. Hunter Harrison’s efforts of the last few months to acquire Norfolk Southern Railway have raised a very relevant aspect of the U.S. railroad industry. While other segments of the transportation industry have consolidated to gain network efficiencies, the railroads continue to operate with the structural constraints of a bygone era.
Since the deregulation of the trucking and passenger airline industries over three decades ago, both have experienced major consolidation. The less-than-truckload industry, valued at only $35 billion, has seen more carriers either acquired or shut down than are currently operating.
Even the U.S. domestic parcel industry, with annual revenue of $75 billion, has been reduced from three to two with the exit of DHL in 2009. Likewise, the much larger, $175 billion global parcel market will be reduced from four to three carriers in a few months with FedEx’s acquisition of TNT Express.
Moreover, the passenger airline industry, with a market of $80 billion, had over 20 large national network airlines just a few years ago. However, with the blessing of the federal government, the U.S. skies are now dominated by just four airlines (United, Delta, American, and Southwest), each having their own fortress hubs that limit competition in major markets.
In contrast, the U.S. railroad industry, with a market of only $70 billion, still operates with the inefficiencies of not having a single railroad that can seamlessly move shipments across the country. The last major railroad consolidation occurred in 1999 when Conrail was sold off in pieces to CSX Transportation and NS.
The current structure of two railroads in each half of the country requires shuttling of rail cars and intermodal containers between the two eastern and two western railroads in time-consuming and environmentally unfriendly ways at interchange points like Chicago and Memphis.
On the surface, the regulators may perceive that having five railroads promotes competition. However, Kansas City Southern Railway mainly operates between Mexico and the U.S and of the other four, with Union Pacific Railroad and BNSF Railway operating in the western states and CSX and NS in the eastern states, there are only two railroads in each market from a competitive viewpoint.
So a merger of an eastern rail with a western rail that results in two railroads with nationwide coverage will still retain the current competitive landscape. Furthermore, two national railroads will eliminate shuttling of railcars and intermodal containers between the rail yards of each regional railroad. It will speed up transit time and reduce traffic congestion and air pollution in the interchange markets.
In addition, having just two competitors can still ensure competition. In the parcel industry, there are only two private carriers, yet FedEx and UPS compete aggressively even after DHL pulled out of the U.S. domestic market in 2009.
Having more carriers also does not ensure that there is more competition, which would usually suggest lower operating margins for the carriers. The LTL industry has 20 carriers and while many large LTL carriers generate mid-single digit operating margin, Old Dominion Freight Line generates high double-digit margins while providing great value to its customers as illustrated by its continued ability to grow shipment counts at a faster rate than its competitors.
Moreover, even with just two competitors, the operating margins of FedEx and UPS’s parcel segment are lower than that of ODFL, illustrating that fewer or more carriers does not ensure less or more competition.
Mr. Harrison is right about the need for consolidation in the railroad industry. However, he has chosen the wrong railroad to pursue such a mission. CP’s merger with NS would primarily benefit executives and shareholders while the more important stakeholders like employees, customers, suppliers, and communities, will be hurt.
NS is a very profitable railroad whose operating margin increased from 13 percent in 2000 to 31 percent in 2014, while doubling revenue over these 14 years. Given such a high operating margin, if the railroad mergers are permitted, it will not be for the railroads to increase their operating margins, but for the benefits derived for shippers, communities and their employees.
A merger of CP and NS will not pass such a test as there is little freight transfer between these two railroads and minimal service improvements for the shipping community.
In contrast, the merger of eastern and western railroads will result in faster transit times and reduced cost, which will put pressure on the competing trucking industry to improve service to support its higher rates. The resulting conversion of truckload shipments to intermodal shipments will be welcomed by motorists who will see fewer trucks on the road and reduced wear and tear on national highways.
With such advantages for all stakeholders, Mr. Harrison will find a more receptive audience for his ambition to operate a larger railroad and leave his mark on the railroad industry, joining the ranks of industry legends like Fred Smith and J.B. Hunt. However, Mr. Warren Buffett, who already owns BNSF, could spoil that by acquiring CSX or NS to create the first national railroad.
For CP investors looking to capitalize from the efforts of Mr. Harrison, they should invest in one of the U.S. railroads and then convince the board to appoint Mr. Harrison as its CEO so he can create a full national railroad in the U.S. and show the merits of such a merger. Thank you, Mr. Harrison, for drawing attention to the merger opportunity in the U.S. railroad industry.
Satish Jindel is President of SJ Consulting Group, Inc. which has a staff of 25 people located in Pennsylvania and India.