The Unsexy, Boring, yet Highly Effective Business Model of the Rail Industry
Okay, so it’s not Starbucks, Apple, or Uber—it’s railroads. Boring, been-around-forever… railroads. But in a world where new gets the most attention, sometimes it’s worthwhile to celebrate the tried and true. Trains may not seem to be the most cutting-edge technology to rally behind, but they work—both as machines and as a successful business model. And they’re not just still around, they’re actually thriving.
Today, Canadian railways move 75 million people and more than 70% of all intercity surface goods in Canada each year. With 49,422 kilometers of track, Canada’s railway network is the fifth largest in the world, handling the fourth largest volume of goods. By comparison, the United States’ $60 billion railway network is the largest in the world consisting of 140,000 rail miles and accounting for approximately 40% of U.S. freight moves by ton-miles (the length freight travels). The North American rail industry is alive and well.
However, the railroad business hasn't always been wealth creating. For a long time, it was wealth destroying. Securing access rights, laying track, and developing the necessary infrastructure for railways has never come cheaply or easily, particularly for those in the early days that structured their companies opportunistically around government subsidies that quickly disappeared. The history of the private rail industry is strewn with failed companies with flawed business models that either went bankrupt or otherwise succumbed to market pressure. But over the last thirty years we’ve witnessed a renaissance in rail profitability thanks in part to three important factors: consolidation, deregulation, and better management.
Less competition is usually better for business than more competition. Decreased competitive intensity within the industry usually leads to better pricing power and better profitability. By the 70's and 80's there were plenty of railroads in North America, but hardly any of them had scale and few of them actually made money. Since that time we have seen significant consolidation within the industry. In the U.S. there are currently seven Class I railroads (those with operating revenues of around $433.2 million), 21 regional railroads, and 510 local railroads. While in Canada, there is essentially a duopoly between Canadian Pacific Railway (CP) and Canadian National Railway (CN).
The regulatory environment for railroads was once very onerous, restricted by a complex system for setting shipping rates. Reforms over the past four decades have allowed for a greater range in railroad pricing without close regulatory restraint, and the reforms now require that access must be given to each other's rails in the case where a single railroad had "bottleneck" control of the rail traffic. Following these reforms, studies conducted by the U.S. Department of Transportation's Freight Management and Operations showed that: railroad industry costs and prices were halved over a ten-year period; the railroads reversed their historic loss of traffic to the trucking industry; and railroad industry profits began to recover, after decades of low profits and widespread railroad insolvencies. 1
Management teams have also improved significantly over time. For example, the idea of precision railroading pioneered by CP’s CEO, Hunter Harrison, has been a definite game changer. Precision railroading is based on five values that serve as CP’s vision: improving customer service, controlling costs, optimizing asset utilization, operating safely, and valuing and developing employees. We see this ideology gaining traction throughout the North American rail industry and when it’s combined with the management fundamentals we look for (growing revenues, managing costs, allocating capital prudently, and managing risks within the business), it bodes well for the future.
Boring…but it works.
It seems unlikely that the rail industry will be replaced anytime soon by some revolutionary advancement in transport. At this point in time there is nothing scalable that can compete as efficiently and effectively at moving heavy things great distances across land as trains. Rails provide an essential service and truly are the life blood of the economy for longer haul transport; transporting goods from point A to point B in the most cost effective way.
One of the most important characteristics we look for in a business model is pricing power, and the rails have pricing power. As a business model that grows with the economy, rail companies have been able to incrementally increase pricing over the past two decades for the services they provide. As long as we have an economy in North America, railroads are comfortably positioned to remain a significant economic driver that should benefit over time. Railroads also have a sustainable competitive advantage: they have a massive barrier to entry given the difficulty for any new entrant to get right of ways to lay new rail track, and their business is so capital intensive that there is a significant barrier to profit.
Of course, the rail industry faces risks like any business. Canadian railroads have a large exposure to commodities—if Canada produces less stuff, railroads are negatively impacted. Also, while the regulatory environment has improved considerably over time, which has been a tailwind for the industry, there is that stroke of a pen risk that would come if regulations once again become more oppressive. Furthermore, rails have gradually taken market share away from trucking due to higher fuel costs which could also reverse.
Overall, though, we think the rail industry has evolved into a pretty steady-eddy, boring business that is run by good management and has created a fair amount of wealth for shareholders over time. It’s not flashy, but it works, and that’s exactly the type of business model we look for.
1 Association of American Railroads, Washington, D.C. (2011). "The Impact of the Staggers Rail Act of 1980."