It seems like for the past 60 or so years, that a lot of the major railroads, if not all, diverted a lot of their money into non-railroad investments. To me, it makes sense when the investments are somewhat railroad related,such as mining or logging, that benefits the railroad. A lot of times, it seems like it was just money invested elsewhere that could, or should have been reinvested in the prime business-railroading. At one time, one of the midwest lines owned Fruit of the Loom Underware!
Is this type of investment by corporations common even today in the industry? How does/did it effect the success of the railroads? Would they have been better off investing in their own business first?
Interesting question and one I haven’t thought much about. I’m not home so I can’t go back into the annual reports to refresh the memory.
At present investment in non-core business by Class I railroads is very small, I think (someone will, I hope, confirm or deny that).
Investment in non-core business was a strategy undertaken during the regulated era by railroads that were throwing off lots of free cash from railroad operation but could not make the case for an adequate return on investment for cash invested in the railroad itself. In other words they were actively disinvesting in the railroad and using up the physical plant. Investment sometimes had a basis in building traffic for the railroad – UP, for example, participated in coal and soda ash mining joint ventures but sunk much, much more free cash into petroleum exploration, refining, and marketing. More often than not the investment was totally unrelated to the railroad – D&RGW into mainframe leasing and roller-coaster manufacture, for instance.
Would the railroads have been better investing their free cash into their own plant? To what purpose? Until around 1995, on a collective basis railroads were significantly overtracked for the existing and projected future traffic (with exceptions like the PRB after 1970), and capacity once purchased just doesn’t sit there until needed but eventually perishes. I can’t imagine many railroad stockholders would have been in favor of such a plan. In the long-term it might have been nice to buy up things like land for future intermodal terminals in San Pedro or Kearney. But stockholders are born, live, and die in fairly short timeframes and want an investment they can use in their own retirement not some ingrate offspring’s.
I’d like to know why the free cash wasn’t tossed off as stock buybac
It’s not as common now as it may have been even ten years ago. CSX had an intermodal subsidiary and got rid of it. UP had a trucking company, Overnite Transportation, which it never seemed to coordinate with and eventually sold off.
After it had become Employee-owned, the C&NW purchased a Wisconsin-based manufacturer of snow plows (the name Butler seems to stick in my memory). I think the theory was that the seasonal nature of this company’s income would be a nice offset for the more-or-less seasonal nature of CNW’s business pre-PRB. I don’t think this company was a subsidiary for long before being sold off.
No maybe about it. Regulation has a heck of a lot to do with how one invests money. In the “right” political system, you can make a killing investing in, say, the local cell phone company, because your cousin Mr. President-for-life writes laws that prevent competitors from entering the field and sets minimum rates that translate into yummy profits.
Then there’s the other end of the spectrum. IC’s own holding company selling the railroad becuase it became a liability! Then there’s Southern owning Piedmont airlines, lock, stock and barrel, IIRR. Phillip Anschuetz, beer magnet, buying whole the D&RGW, then the railroad leased(or rented, or sold, or just plain allowed?) one of his other companies to bury cable along the right of way. CSX owned a least one company in just about every mode of transportation there was, hence CSXT(ransportation) in the 90’s. And I’m sure I’ll be corrected, but I believe it was BN that used some of it’s early profits from PRB to invest in natural gas and oil.
More than likely the reason there were no stock buybacks was that concept really wasnt developed during that era. The stock buybacks really started to take off during the 90’s…and that was in responce to the a law which was passed around 1993 or so.
The law basically limited CEO or executive compensation to $1million per year. After that amount the compensation was not tax deductible. However, the compensation could be tied to performance. What occured at that time was the escalation of stock options as a major form of executive compensation.
As stock options were issued and then executed, it added to the number of shares a corporation had. Thus, earnings were diluted as the number of shares increased.
So, a company found itself using the free cash flow (net income + depreciation and amortization - capital expenditures) for buying back shares. It accomplished a few things at once. First, dividends are income taxed twice. First as corporate income and then as a distribution to the shareholders. The Bush tax cuts in this early decade reduced the taxes on dividends, thus making that payout much more attractive, but in the 90’s dividends were taxed at regular income tax rates.
So, a $1 level of income before taxes would be taxed at say the 35% level (35 cents) and then any dividend (lets assume a payout ratio of 40% of net income would produce a dividend of 26 cents ((1 - .35)*.4)) would be taxed at the marginal income tax rate of the individual. So, the 26 cents would then be taxed (lets say 38% or 10 cents).
In the above example, the $1 of income prior to taxes would be assessed 45cents of taxes. Not very efficient.
The company could have used the free cash flow to purchase it’s shares, thus reducing the number of shares outstanding. The net income would remain the same ($1) but there would be less shares outstanding, so the net income per share would be higher.&
That’s a hard concept to grap for me: The railroads, during the regulated era, were throwing off lots of free cash, but reinvesting it in the plant that was throwing off that cash was not a good risk? At a later date, when the railroads hit hard times, partly because of the regulation, they had to canibalize the other investments to keep afloat. PennCentral is the best example of that. And when the railroads pleaded poverty in the 70’s, nobody raised hell about all those past diversions of investment money?
It’s not hard to believe at all when you think about how capital intensive railroads are. As an analogy, suppose you own a new dump truck. You have consistent steady business hauling sand to make concrete for a new Interstate Highway but you see that as soon as the new highway is built, the market for dump trucks is going to evaporate. So you buy nothing but fuel, RC Cola, and Red Man and drive the hell out of that truck for 3 years. You take all the money you make over operating costs and make payments on a mini-mart, and spend nothing on maintenance other than tires. After 3 years the truck is used up and you throw it away. You’ve successfully run your business for free cash.
Not all railroads had to go back and tap their diversifications to stay alive. The western transcons never did (Milwaukee Road I don’t know about; but I lump it into the granger category as do some others).
Plenty of people fumed about the diversions of capital into other businesses – people that didn’t like putting federal money into Conrail; shippers; passenger-train advocates. That’s one of the important reasons why railroads were deregulated, to reduce the incentive to do so.
(Ed – thanks for the detailed write-up; I’ll probably think of some questions after some time to absorb it.)
Well, that’s a good point. When were railroads throwing off “lots of free cash”? By and large, these were balance sheet financings, and typically involved a process known as “bootstrapping”. The ICC did a holding company study in the mid-1970s. Interesting results.
Would you invest money in a business with a very bleak outlook?
If one were able to survey railroad board members and senior executives of the late regulated era, up to say the late 1970s, I doubt that you would have found very many with the view that the future would produce decent returns for investments in the business. You have to keep in mind that many holding those jobs were concerned that the future might have the federal government picking up the railroads at auctions on the steps of the bankruptcy court.
To answer your specific question, hindsight might show evidence that the railroads could have been better off if a higher proportion of the very small amount of cash available for investment had been put back into the business. My guess though, is not very much.
A fundamental tenant of capitalism is that money must be allowed to flow to where it will have the potential of producing the highest return. Suppose that your company had the cash and a choice to expand the existing business and generate a 10% return or invest in another business and have a chance to get a 15% return. If the risk levels are perceived to be about the same, the owners are at least going to give serious consideration to putting the money into the new business. Now suppose the outlook for the existing business was that sometime in the next decade it would no longer be possible to make a profit due to the product becoming obselete. What do you think the owners would do then.
Unfortunately, it doesn’t help if the business manager has a vision of a positive future. If the owners don’t agree, there will be trouble. Just ask Rob Krebs.
Unless they were stupid or romantics. There were some of each. Take a look at the free cash position of Rock Island from 1945 to 1960. They went over the edge of the chasm about 1953. The strange thing is that up to that point they were blithely spending their money on projects that would have been great ideas in 1903 but were a whole half-century too late, such as the Atlantic Cut-Off in western Iowa.
Railroads generally are not as capital intensive as several other industries, in large part because of the longevity of assets and the lack of technological pressure on product output. Railroads’ capex as a percentage of income generally lags such companies as FedEx, ExxonMobil, Toyota, HP – relatively typical manufacturing companies that operate in highly competitive environments with ongoing need for access to capital markets.
Genuinely capital intensive industries look at railroads with some envy.
That was some “envy” until they saw the antiquated additions and betterments accounting while all those other industries could depreciate in their accounting.
This was a general phenomenon that had nothing to do with railroading or regulation in particular, except that railroaders adopted the strategy like many other industries across the board.
It was called a “conglomerate” strategy generally implemented through a holding company structure. Like industry experience in general, it was not wildly successful in the railroad industry, and most, not all, conglomerates were eventually unwound in favor of the idea of concentrating on “core” businesses. That’s the current “mantra”, probably soundly based, and railroads follow that one too.
The ICC found that railroads that adopted a holding company and diversification strategy generally suffered a reduction by between 1-2% of net earnings on revenue compared to railroad companies that did not adopt a diversification strategy.
Most industrial conglomerates had similar results, but it sounded like a good idea at the time and the rail industry was no more or less susceptible to a bad idea that sounded good than any other industry.
Most industries that adopted the model were unregulated to begin with, and the adoption of the business model therefore had nothing to do with regulation, but rather reflected a generalized corporate strategy of overcoming progressively lower rates of return being felt throughout the economy at the time.
From Fortune, April 5, 2004, Ratio of Assets to Revenue, 2003:
Railroads, 2.60
Motor Vehicles and Parts, 1.95
Forest and Paper Products, 1.80
Utilities, Gas and Electric, 1.50
Chemicals, 1.45
Airlines, 0.60
Pipelines, 0.55
Petroleum Refining, 0.45
(Note, the previous year, April 4, 2003, Fortune found that utilities and railroads were both approximately 2.5; mining and crude production 2.0; motor vehicles and parts 1.5; chemicals 1.2; trucking 0.5.)
Or, quoting the Federal Railroad Administration (NationalAtlas.Gov):
“By any measure of capital intensity, freight railroads are at or near the top among all major U.S. industries. From 1980 through 2003, Class I railroads spent more than $320 billion approximately 44 percent of their operating revenue - on capital expenditures and maintenance expenses related to infrastructure and equipment.”
In a previous post I asserted “Investment in non-core business was a strategy undertaken during the regulated era by railroads that were throwing off lots of free cash from railroad operation but could not make the case for an adequate return on investment for cash invested in the railroad itself.”
To back that up:
John Stover, “Life and Decline of the American Railroad,” 1970, see pages 286-291: "While diversification developments like those of the Penn Central and Illinois Central will no doubt continue in years ahead, several railroad leaders have some reservations. Some rail executives suggest it makes rather poor economic sense to continue to put money in railroad improvements when the same money placed in nonrail enterprises might return 10 to 15 per cent yearly, a yield several times the normal railroad rate of return. Jervis Langon, Jr., President of the Rock Island, clearly had such doubts when he recently said: “I wonder to what extent conglomerates … can affort to pump into their railroad subsidiaries the kind of money that is required, particularly when there are so many attractive investment opportunities outside the railroad business.”
Joseph Daughen and Peter Binzen, “The Wreck of the Penn Central,” 1971, multiple references including, p. 138, “In the face of continuing passenger losses, Saunders looked with covetous eyes towad other business investments for the railroad. Perlman … went along willingly with the philosophy that the railroad, and its assets, should be used to make money in other fields.”
p. 139, “The search for profits to offset the passenger losses never stopped.”
p. 217, "Good equipment could not change the rigid rate structure imposed on the Penn Central and on all railroads. Nowhere was the damage inflicted by this rate structure more severe than in the below-cost rates in hundreds of categories the Penn Central was forced to live