Similarities Between Railroads and Airlines Part I

“We said railroads were no damn good. There were too many of them. They had truck competition. And we were right; it was a terrible business for about 80 years. Finally they get down to four big railroads, and it was a better business. Something similar is happening in the airline business.” – Charlie Munger (Trades, Portfolio) at the 2017 Daily Journal Meeting

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In order for us to gain a better understanding of Berkshire’s (BRK.A, Financial)(BRK.B, Financial) purchase of the airlines, it is imperative to study the history of the railroads first. There’s a good number of free internet articles and reports out there about the operating history of the railroad industry, and I encourage the readers to read as much as they can.

For this discussion, suffice it to say there are three distinctive stages of the railroad industry:

1. Before the passage of the Staggers Act of 1980. For 75 years before the Staggers Act, the railroads were heavily regulated with no freedom to adjust their prices in response to market conditions.
2. Between the passage of the Staggers Act of 1980 and the early 2000s.
3. After the 2000s.

This wonderful chart tells the story:

As we can tell from the above chart, the Staggers Act of 1980 unleashed the productivity and volume growth of the railroad industry. However, at the same time, rates decreased dramatically. The net result of rising productivity, volume and declining rate was an almost 20-year decline in revenues for the railroad industry as a whole.

There are two reasons why rates had been declining for almost two decades:

• Technological developments in the railroad industry have dramatically improved efficiency, which brought down operating costs, enabling the industry to maintain profitability with lower rates.
• Competition between the railroads and the truck industry, as well as competition among the railroad industry, was intense. Most of the services provided by the industry were commodity-type services with low levels of differentiation.

Two technological advancements in the industry were particularly exciting – double-stack containers and roadrailers.

Double-stacking basically allows two intermodal containers to rest one atop the other, doubling the capacity of a flatcar.

According to Wikipedia, a roadrailer is basically a highway trailer that is specially equipped for use in railroad intermodal service. The advantage of roadrailers is their ability to be used directly behind other freight (or even passenger) equipment without trailer flatcars. The positive attributes of the RoadRailer were its exceptionally smooth ride, light weight and low capital costs to set up a rail yard. Since no flatcars were involved, no crane systems were needed to transfer the trailers between modes.

These technological developments certainly made the railroads more competitive compared to the truck industry. Freight railroads also cut costs by streamlining their workforces: rightsizing their rail track miles, equipment and facilities to more closely match demand.

The productivity gains, however, did not give the railroad industry pricing power because the industry was still relatively fragmented. As we have seen many times in other industries, consolidation usually either alleviates pricing pressure or empowers the industry participants with pricing power. Since 1980, the merger wave continued for almost 20 years.

• 1980: Chessie System and Seaboard Coast Line Industries merged to form CSX Corp. (CSX, Financial).
• 1980: Burlington Northern acquired Frisco.
• 1981:Â Union Pacific (UNP, Financial) merged with Missouri Pacific and Western Pacific.
• 1982: Southern and Norfolk & Western merged to create Norfolk Southern (NSC, Financial).
• 1988: Rio Grande merged with Southern Pacific to form Southern Pacific Lines.
• 1988: The Missouri-Kansas-Texas line became part of Union Pacific.
• 1991: Canadian Pacific (CP, Financial) acquired Delaware & Hudson.
• 1995: Burlington and Santa Fe merged.
• 1995: Union Pacific acquired Chicago & North Western. Union Pacific later merged with Southern Pacific.

As a result of the consolidation, in North America, the number of Class 1 railroads was reduced from 40 in 1980 to merely seven by the early 2000s. In the U.S, the largest four Class 1 railroads controlled 89% of the revenue and 80% of tonnage of the railroads market in 2004, compared to below 50% in 1985. Moreover, the remaining railroad companies practically operate as monopolies or duopolies in most of the markets in which they provide services. Pricing power emerged as a consequence of 20 years of industry consolidation and territory grabbing.

With rising productivity, rising demand and improving pricing power, the railroads have become a decent business. This chart shows the extraordinary margin expansion of CSX, Norfolk Southern and Union Pacific.

Along with better margins comes better fundamentals. And better fundamentals lead to better stock prices:

Is this the fate for the airline industry? We’ll explore.

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