Can the benefits of consolidation be achieved through partnerships?
Monday’s railroad news was major and a surprise to most – Warren Buffett and Berkshire Hathaway announced they won’t be pursuing an acquisition of Eastern Class I railroad CSX. That has major implications for the North American surface transportation outlook, such as a partial reversal of what I said here.
Why it was a surprise
Assuming that Western Class I railroad Union Pacific’s acquisition of Eastern Class I Norfolk Southern is approved, it would put the remaining two US Class I railroads at a competitive disadvantage for much of the freight that originates and terminates on opposite sides of the Mississippi River. That may be particularly true for rail intermodal traffic, which is relatively service-sensitive than most rail traffic and may no longer need to be interchanged in a combined railroad. Instead of a “rubber wheel” interchange at an inland hub, all that would be needed to move the train on the other side of the continent in many cases is a simple crew change. Given the competitive advantage of BNSF’s competitor, that would, in theory, hurt the value of BNSF, and, the thinking goes, an acquisition of CSX would be necessary to protect its investment.
The other reason it was a surprise is that Berkshire, which fully owns BNSF, has plenty of available cash on hand. At the end of the second quarter, Berkshire had a cash position of $344 billion. That’s enough to make CSX’s valuation (market cap and enterprise value of $65 billion and $85 billion, respectively) seem small.
Why Buffett said no
Perhaps Buffett felt like he had enough exposure to the railroads already and just wanted to deploy that capital elsewhere in better available entry points. The massive cash position is an assertion that the stock market is overvalued, in general. Lately, Buffett has demonstrated a preference for investing in other sectors and beaten-up stocks. In mid-August, Berkshire disclosed it had bought a position in UnitedHealth Group, a name that is down 48% in the past 12 months, trading at multiples well below its own history and the broader market. The Berkshire investment style is to wait for the right valuation, and apparently, it believes that pressure is overdone.
Also, maybe the same benefits can be achieved with a partnership with CSX without the regulatory risk. On Friday, BNSF and CSX jointly announced that they were going to redouble their efforts to improve their collaboration on transcontinental trade flows. Even without a deal, BNSF has the access to make any capital improvements that make sense. The railroads called out certain lanes in that press release that they believe can be better served. Those include domestic intermodal between Southern California and Charlotte / Jacksonville. Other lanes include Phoenix to Atlanta, which SONAR currently shows as having virtually no containerized intermodal traffic. And Newark / Norfolk to Kansas City – SONAR shows each inbound Kansas City lane as having about 50 international containers per day. The regulatory risk is significant; the UP/NS deal is subject to a $2.5 billion break-up fee if a deal doesn’t get done and certain conditions are met.
SONAR shows that there are currently around 100 domestic intermodal containers per day moving in the LA to Charlotte (white) and LA to Jacksonville (yellow) lanes. BNSF and CSX believe they can grow that volume through collaboration without needing to combine. (Chart: SONAR)
Where does the rail industry go from here?
“If there is one, there will be two,” has been a common phrase. But if a second proposed deal is now, then maybe there won’t be any. In the weeks since the acquisition was announced, a growing consensus appeared to be that the deal would, in fact, get approved. The rationale is that Union Pacific’s belief that it would be approved is based on regular discussions with the Surface Transportation Board, as management said on its analyst call.
Berkshire’s lack of interest in buying CSX likely reduces the probability that the UP/NS deal will get approved. It’s impossible to accurately handicap how the Surface Transportation Board will interpret untested rules, but maybe it went from a two-thirds chance of approval to a one-half or one-third chance. The STB needs to find that the deal is both in the public interest and also enhances competition for approval. If there is only one railroad that can move freight from coast to coast without interchange, it seems to me that would detract from competition.
There is also the question of whether CPKC or Canadian National would acquire or merge with CSX. CPKC sounds uninterested. Because the western portions of their networks are primarily in Canada, and Canadian National’s US network is north-south, a potential CN or CPKC merger with CSX would not have the same degree of network benefits as a potential combination between BNSF and CSX.
How will Ancora respond?
The activist investment fund wants to see CSX CEO Jim Hinrichs replaced, and I don’t think the latest news will cause them to like him any better. The investment fund sent an open letter to him last week, demanding that he solicit offers from the Canadian railroads to play against a potential offer from BNSF. I imagine they still want the discussions with the Canadian railroads to take place, even if they don’t go anywhere, while also replacing management with a group that is more focused on cost-cutting and operating ratio improvement.
What this means for rail versus truckload
Outbound from LA, both international intermodal volume (yellow) and containerized domestic intermodal volume (red) have handily outperformed the volume of long-haul (>800 miles) truckload tenders (white), relative to this time last year. (Chart: SONAR)
Deals or not, evidence suggests that intermodal is again a growth area. It is clear from SONAR data that it’s taken share from truckload this year, particularly for loads outbound from LA. Certainly, intermodal has benefited from a lower degree of time sensitivity because of the pull-forward of imports, but there is more to it than that. Service has been solid, and investments in terminals and containers have improved service levels. Railroads have collaborated more closely on some routings, and domestic intermodal companies are focused on opening intermodal up to new lanes and new premium service tiers. Even without transcontinental US railroads, those trends will likely persist, which should, over time, take long-haul loads off the highway. What I see potential transcontinental mergers ultimately doing, in addition to eliminating interchanges, is coordinating investment across a single capital envelope. If a western railroad relies on an eastern one for a transcontinental move, or vice versa, it can reduce the incentive to invest in its own network when there is no guarantee that the other railroad will do the same.
