A capital way to run a railroad - capital investment programs for rail companies - Interview

Railway Age, April, 1999 by Luther S. Miller

There are many reasons for Norfolk Southern's extraordinary success. One is carefully-crafted capital investment programs.

Mile for mile, the Norfolk Southern Railway consistently ranks at or near the top of any list of the world's safest, richest transportation systems--and as it adds 7,200 miles of Conrail to its existing 14,400-mile network, NS intends to keep it that way. A massive but no-frills capital investment program is part of the strategy.

The Conrail transaction has propelled Norfolk Southern into the billion dollar club of capital spenders. NS will invest $1.07 billion in capital improvements this year, including about $300 million on the Conrail lines that it has controlled for several months but won't begin operating until June 1. Of the total capital program, $651 million will go for roadway, signaling, and related projects; $387 million will be invested in equipment, including 138 locomotives-all d.c. traction; though NS is about to inherit its first a.c.-power, 18 units, from Conrail.

The big chunk of the capital program related to the Conrail acquisition, on top of a sizable similar expenditure last year, reflects NS's determination to "get things right-from the start," as NS Chairman, President, and CEO David Goode has put it.

Goode recently told a meeting of financial analysts in New York when it was suggested that during a relatively slow economy NS might have to put some costly power in storage. "We've tried to be good Norfolk Southern people and address the cost side, but we have tried to be careful not to put ourselves behind the eight ball with Conrail in any way, shape, or form. I hope we have exactly the right number of locomotives, but if we err, we'll probably err on the side of having a little more power than we might otherwise have."

"Good Norfolk Southern people" don't put together the kind of streak-of-fat, streak-of-lean budgets that Wall Street finds so distasteful; but where the need is clear, and the payback abundantly assured, the money is abundantly available.

The role of a strong capital investment program in NS's past successes and its future hopes was underscored by Goode in a submission to the Surface Transportation Board as NS and CSX Corp. sought authority to purchase and partition Conrail.

"Norfolk Southern is widely recognized as one of the most successful and well run transportation companies in the world," said Goode. "As reasons for our success, I would single out Norfolk Southern's commitment to six objectives: to excel in safety, efficiency, economic development, as competitors, as innovators, and to continuously replenish our plant and equipment through investment. The facts show our success at meeting each of these objectives."

Wall Street, the shareholders' watchdog, keeps a wary eye on corporate spending and recently has not looked kindly on the capital programs of some railroads. "They're spending like drunken sailors," one analyst grumps. But while Norfolk Southern may be a big spender, it's a "prudent" spender, at least in the eyes of Morgan Stanley's James J. Valentine. "Disciplined" and "responsible" were also words that Valentine recently used to charactetize NS spending.

What is NS's overriding philosophy with respect to capital investment? Railway Age put the question to Henry C. Wolfe, the railroad's vice chairman and chief financial officer.

"We believe that capital spending is something to be looked at not as cyclical but as continuous," said Wolfe. "We try to smooth our spending, and as a consequence we are well positioned going into the Conrail transaction because our physical plant is in excellent condition.

"We look very carefully at the internal rate of return that each investment yields. When we do our overall analysis for the board--and there are some capital investments such as rail, ties, ballast, etc., that you can't develop a rate of return analysis on, you're making that investment just to stay in business; even with respect to those, if we assume them to have an internal rate of return of zero, though we know that's not true, we're looking to get an overall return on our capital budget that is in excess of our cost of capital." That's in the 11-12% range.

How does NS judge the effectiveness of its capital programs?

"One of the things we do is a post-audit review, particularly on the large projects, where we go back two years, three years, five years after the project, depending on the size, and compare what's actually happening to what was projected. For example, we may have expanded an intermodal terminal, and we check to see if the projected incremental traffic flowing through that terminal did, in fact, develop. All capital projects don't produce as originally forecast, but overall our results have been quite good."

What have been recent trends in capital investment on NS and what lies ahead?

"Our capital budgets were rising steadily prior to the Conrail transaction because our traffic was growing and facilities to accommodate future growth needed to be put into place. Expenditures reached $789 million in 1996. Then in 1997 they jumped to $929 million, some of that reflecting connections being put into place with Conrail, and also work on computer systems to facilitate the Conrail integration. In 1998 the final numbers were $1.06 million. We told the financial community that in the first three years after the acquisition we expected capital expenditures to be in the range of $1.1 billion to $1.2 billion. That is still our plan."