Overview

By any measure the proposed Union Pacific – Norfolk Southern merger is a key event in railroad history.  Approved or denied, the process will redefine the industry moving forward.  It is also the first application of the new rail merger rules that were put in place by the Surface Transportation Board (STB) after the last round of rail mergers. The CP/KCS merger was the lone exception.

The new STB merger rules require Union Pacific to demonstrate that combining with Norfolk Southern Railway will be in the public interest and enhance competition.  Union Pacific’s merger application to the STB should list the initiatives that will enhance competition and generate public benefits.  As part of the merger process, and mitigation requests by impacted stakeholders to the STB could add other requirements to increase competition. 

As I write this, Union Pacific has yet to submit its merger application.  Theoretically Union Pacific could propose a group of initiatives that would increase competition, increase public benefits and demonstrate strong support for its common carrier responsibility.  Such a forward-leaning strategy would forestall potential opposition to the merger and facilitate its approval.  Alternatively, the UP could go head-to-head with opponents with the aim to limit, to a bare minimum, STB’s remedies to address stakeholder issues. 

See excellent map of combined Union Pacific/Norfolk Southern merged network in Trains Magazine:
Union Pacific and Norfolk Southern reach $85 billion merger deal

Some Definitions

• Reciprocal Switching – The regulatory provision that allows a shipper served by a single rail line to request their freight be interchange to a competing railroad at the closest interchange or be served via trackage rights.
• Paper Barriers – A contractional provision attached to the sale or lease of a branch line to a short-line railroad limiting the ability of the short-line railroad to interchange traffic with a competing railroad.
• Bottleneck Rail Rates – Pricing strategies by the railroads to lengthen line hauls and increase revenue by instituting high rates to closer interchanges with other railroads.

Midwest “Watershed” Market

The area in the Midwest with sizable 800 – 900-mile markets, potentially competitive and profitable for rail, but split into two shorter-hauls with interchange delays, uncoordinated service and unfavorable pricing.

See excellent map of Midwest Watershed Market in Trains Magazine:
Analysts say stalled growth, fading pricing power drive UP–NS merger push

Initiatives that would Smooth the Merger’s Approval

Outlined below are some initiatives that would address the concerns of many stakeholders and thereby enable approval of the UP/NS merger.

Key Competition Expanding Initiatives:
Changes that would result in shipper support would be:

• Full Reciprocal Switching.
• Elimination of Paper Barriers.
• A cap on Bottleneck Rates.

If Union Pacific wants to do something dramatic to curry shipper support it could initiate pre-merger service and marketing initiatives along existing North-South single carrier markets (I-5, I-35, I-55, I-75 and I-95 corridors) to demonstrate the strategies and commitment to fulfill the promise of truck to rail conversion in the 750 -1,000-mile markets.

Finally, Union Pacific will likely propose significant Canadian National and CPKCS trackage rights to increase competition in the Midwest “Watershed” area and to forestall a hostile bid for the NS. 

Forward Leaning Service and Reliability Initiatives:
The key issues weighing down the merger proposal among stakeholders are the freight railroads record of inconsistent service, outright service failures and seeming institutional aversion to any service improvements.  Some initiatives to reverse this perception would be:

• A companywide total focus on building a culture of consistent service.
• Expansion of shipper freight car visibility across a shipment’s entire route.
• Further expansion of Automated Train Inspection Portals to increase safety of train operations.
• Expand Norfolk Southern’s Short Line Interchange Project to Union Pacific routes.
• Accelerate on-network UP and NS capacity projects as the merger is reviewed to demonstrate confidence that the proposed merger will drive traffic growth and investor return from volume growth.
• Outline and begin design for UP/NS connectivity capacity projects while the merger is being reviewed.
• Hiring and training initiatives to guarantee sufficient staffing to implement the merger in the face of unforeseen events and to support traffic growth.

Public Benefit Initiatives:
While the Surface Transportation Board and high-profile stakeholders will focus on freight competition issues, the general media and the public will want to know the public benefits.  Action on concessions outlined below would generate substantial positive media and support for the merger.  Examples of key mitigation actions are:

• Early identification and mitigation for locations when the shift of rail traffic due to the merger may result in conflict with lineside stakeholders.
• Mitigation initiatives to deal with current lineside conflicts due to recent operational changes (trains longer than existing yard tracks and sidings).
• Settlement with Metra regarding access costs for the former Chicago & Northwestern routes in Chicago.
• Agreements with Amtrak to address the on-time performance issue in line with FRA metrics. In addition:
  • Agreement with Amtrak on its priority service expansions with the only investments for passenger service required.
  • Daily Sunset Ltd
  • Operation of Daily Sunset Ltd. without the requirement to rebuild the Wellton Branch.
  • Service Atlanta, GA to Ft. Worth via Meridian, MS.

Hard Costs and Soft Costs:
When a railroad looks at mitigation investments to gain support or offset negative consequences of the merger, costs can be separated into two categories – hard costs and soft costs.  Hard costs are something like a grade separation on a route with higher merger traffic.  A soft cost is a concession, i.e. reciprocal switching, trackage rights, etc. that might reduce the railroad’s post-merger traffic, that may never be implemented because UP’s pricing and service post-merger is top-notch.

The Benefits and Potential of the Union Pacific-Norfolk Southern Merger

Overview
The new STB competition requirements and synergies of the merger create the potential for UP to establish a new paradigm for freight rail with a focus on volume and market share growth. This would reverse volume declines due to the combination of inconsistent service, outright service failures, aggressive rate increases and the singular focus on yield maximization.

Overcoming the Legacy of Merger “Meltdowns”:
The public and regulatory focus on management competency means there will be a strong incentive to “Get it Right”.  Aiding UP in its effort is a clear history of what can go wrong and the need to focus on the details.  If achieved, resources other railroads spent on dealing with chaos can instead be used to provide consistent and reliable service.  This will mean traffic growth through highway diversions.

Network Advantages of the Combined UP/NS:
Union Pacific and Norfolk Southern RR are both strong networks which when combined will have key direct routes and alternative routes that bypass Chicago and New Orleans.  The two key new connecting routes are:

• Kansas City to Springfield. Ill., the direct route from Midwest to upper Midwest.
• Meridian Speedway via Dallas Ft. Worth – direct route from Southern California to cities in the Southeast. 

The UP/NS connection in Chicago is direct (Western Ave. Corridor) with trackage already owned by both companies (See Map 1).  The Union Pacific – Norfolk Southern Western Ave connection route is the purple line from the left (west) jog (UP) to the right (east) jog midway along the corridor.  The right jog links to the Norfolk Southern at Ashland Ave yard.  The Western Ave. Corridor has benefited from Chicago’s CREATE Program to ease congestion and speed train movements.  Planning and design for additional projects is underway.

Improved Competition:
The potential restructuring of the rail network through merger concessions, reciprocal switching, an end to bottleneck rates and paper barriers, expanded CN and CP/KCS trackage rights have the potential of increasing the value of rail service to shippers resulting in additional traffic.

Market Potential and Benefits:
There is a huge upside market potential in converting existing truck traffic to rail, especially from the West to the eastern side of the Watershed area and from the East to the western side of the Watershed area.  Traffic growth means more jobs for a key stakeholder in the merger, organized labor.  Finally, resolving the Amtrak on-time performance issue will mean more ridership, ticket revenue, lower costs and greater customer satisfaction.

Map 1. Western Ave Corridor Chicago

Economic Risks in the Proposed Union Pacific-Norfolk Southern Merger

Overview:
The railroad industry has a highly visible record of being unable to manage the merger process without a substantial service meltdown.  Typically, the managerial hubris that drives the merger initiative also leaves management blind to the importance of a focus on the details, warnings of potential trouble spots and the need to provide sufficient resources to overcome merger challenges.  Recent events at CSX, where an activist investor, Ancora, forced the ouster of a customer focused CEO replacing him with one with merger experience clearly shows that Wall Street is still focused on short-term financial results.  In summary, we have clearly seen this movie before.

Financial Market Realities and Risks:  A major risk is if Canadian National provokes a proxy fight with counter bids raising the cost of the merger leaving less funding for capacity investments to smooth the merger transition.

Network Realities:
While there is much discussion around the benefits of a transcontinental railroad, such a company will still be limited by its tracks.  Unlike “go everywhere” trucks, a transcontinental railroad with not offer dock-to-dock service for most shippers.  Substantial traffic will still be interchanged – to short lines, regional railroads and between the remaining class 1 railroads.

Because of this, the temptation for a newly merged transcontinental railroad will be to focus on transcon point-to-point traffic, where it can offer one railroad dock-to-dock service.  This focus will maximize revenue in the short term, but leave interchange traffic, the majority of traffic, unreliable and any benefits will be invisible to many shippers.  As a result, there will be a near-term spike in volume before traffic growth and mode share will resume their long-term decline.

The past is prologue.  Both NS and UP offer single line service in several 750 – 1,000 mile north-south corridors (I-5, I-35, I-55, I-75 and I-95) yet their market penetration is modest given the volume of trucks on these Interstates.  Given this performance the promises of great traffic growth in the Midwest Watershed area tend to ring hollow.

Business as Usual:
Given the pressure we saw from the activist investor Ancora in the CSX case, there is no guarantee that Wall Street won’t quickly pivot return on investment (ROI) priority. The Operating Ratio will continue to be a priority.  As a result, the newly merged railroad will focus on the most profitable of the new traffic maximizing yield rather than traffic growth.  Also, there will be limited initiatives to attract traffic in the Midwest Watershed area.

The priority for ROI will put pressure on cost containment.  So, capacity improvements will be postponed, hoping local management and operating employees can make it work. Just as with Precision Scheduled Railroad (PSR), management will wait and see what fails first and then adding capacity only when service failures risk gridlock.  Finally, there will be pressure to keep crew base numbers tight, accepting delays to trains that result from recrewing.

Negative Impacts on the Public:
The “wait and see what fails” investment strategy will limit investments to offset the mitigation of negative impacts of the merger and past railroad operational changes.

If UP succeeds in holding concessions to a minimum – limited or no expansion of reciprocal switching, with Bottleneck Rates and paper barriers still in place – this will reduce rail competition which will mean fewer diversions of traffic from trucks.  Also reducing rail competition is if there are limited or no trackage rights concessions for the CN, CPKCS, BNSF and CSX.

Finally, limited capacity investments and merger meltdown will result in Amtrak on-time performance in the single digits, reducing ridership, ticket revenue and increasing costs and reducing Amtrak’s financial performance.