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Consulting economist William Huneke offered his opinion several weeks ago in the Railway Age report STB “Whack a Mole.” As he pointed out, the Surface Transportation Board (STB) in the past rarely had time or staff to do more than react to the latest rate case, stakeholder petition or congressional request. He described a sense of “whack a mole” in responding to the flurry of STB regulatory reform proposals. He felt this “whale a mole” sensibility extended to the board’s tinkering with the industry cost of capital calculation, which STB uses when it must weigh in on proceedings that challenge rail rates. The calculation also helps determine the value of a particular railroad and whether to approve a proposal to abandon a rail line.
Yes, STB has periodically developed and argued about the rail freight industry’s cost of capital. It combined both debt and calculated costs of equity in its reviews. Yes, normally the debt estimate is straightforward. After all, as Huneke points out, debt is simply the weighted average interest rate of all outstanding industry debt. Pretty simple.
The argument then states, “Equity might be tougher because it is not observable and depends on investor expectations of future stock prices and dividend payouts.” Hmm …
I would argue that equity is in fact advertised in the stock market trading prices every business day. But for some reason, STB chooses to academically troll for an equity risk value that just ignores the everyday at risk trading prices (costs).
Let’s be clear on one definition: Risk value is the simple theory that, while debt might be covered during a future possible bankruptcy or reorganization, a company’s equity value might go poof. In other words, the equity value of a company might “convert to near-zero trading value on The Street.” Equity investors potentially can get wiped out.
But how often does that poof happen? Not very often.
As Huneke wrote, STB repeatedly has embarked on the use of two complicated financial models to estimate what these risk expectations might be, not what they are. Instead, the two financial models estimate what the risks — under certain future scenarios — might end up being.
First up, the multistage discounted cash flow (MSDCF) model, which estimates the value of an investment today based on predictions of how much money it will generate in the future and then adjusts or discounts that cash flow to its present dollar value to show its future worth today. It uses a made-up set of assumptions to then calculate in multiple stages a short-term, five-year growth period, a transition period over the next X number of years and a long-term growth period continuing into perpetuity.
Made up? Yes. There are no real customer/rail company outlook failure projections as evidence of the future. Are there? Even worse academically, this is kind of a fairy tale, since to some economists “forever” usually is about 50 years out. And there is no way to calculate perpetuity — not reasonably.
The second model, which is the capital asset pricing model (CAPM), adds to the intellectual airs by introducing the return on a risk-free government bond with a return that accounts for risk. In some ways, it’s a beta test.
Now let’s be fair. These are not Huneke’s models. He is merely explaining the choices made in the past by previous STB leadership.
I think we can all agree that risk is an important consideration in any investment analysis. The riskier an investment — i.e., the more volatile — the higher the return required by investors. This is often known as the risk premium. All true.
MSDCF and CAPM have different orientations. CAPM uses past data to develop its estimates. It is backward-looking. MSDCF, because it uses analysts’ forecasts, is forward-looking. But it speculates about future traffic outcomes.
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In response to shipper criticism, STB proposes to tweak the second stage of MSDCF. According to STB, the tweak will — or might — slightly reduce MSDCF’s estimate and its volatility. Huneke says that the question is whether this is the right mole to whack, or whether STB should step back and look much more broadly at the industry’s condition and prospects when reforming its cost of capital calculation.
He points out the industry’s new risk from a loss of its coal business: “Loss of coal is a major blow to industry prospects. Coal was a great business for rail. It was largely independent of the business cycle and was predictable” for a variety of reasons.
That is true. Also true is: “The remaining railroad traffic base is not so tied to rail. It is more subject to intermodal competition. That increases uncertainty and risk for the industry’s future.”
However, is the future of the U.S. Class I railroad industry thus “more uncertain,” therefore requiring investors to expect an increased risk premium and justifying an expected higher industry cost of capital?
This is where Huneke and I part ways. I don’t see that anyone on Wall Street has great fears of impending rail freight equity doom and gloom.
Let’s look at the example of coal volumes again. Coal traffic decline by some like Conrail and Norfolk Southern was foreseen in the executive suites back in about 1994 to 1996. This coal decline is not news. It’s actually history seen coming for quite some time. That’s why NS sought a mixed railroad cargo merger with Conrail. NS wanted to diversify.
How has the market reacted to railroad equities since actual coal volume declines started hitting income statements? Stock values have soared. That soaring market doesn’t support the risk premium assumption.
It is true that the railroads make large investments that, once made, are often sunk. In other words, these investments cannot be repurposed or sold to others. And yet, Stanley Crane and others four decades ago demonstrated that track assets are in large part portable from corridor to corridor. Transfers of assets reduce the so-called stranded asset risks. Why is this evidence being ignored?
The other STB high-risk argument suggests that the so-called “real options theory” demonstrates that the expected return for a sunk investment must exceed that of fixed investment by a factor typically around 2.0 or higher. I find that assertion unproved. It is a theory. Where is the data to prove it?
There is also a calculatable argument that perhaps a real options analysis might result in a cost of equity that is twice the 2018 STB estimate of 13.86% — 27.72%. The 27.72% was calculated under one formula reported by Huneke. Discount that with either STB formula (MSDCF or CAPM) and it might result in about an 18.5% cost of equity. That is in contrast to STB’s pro forma calculation of 12.22%.
Would that be absolutely appropriate as the industry watches its coal franchise dry up and transition to a riskier and more uncertain future? The market prices in the daily stock sheets say no. The free trade of U.S. and Canadian railroad equities is signaling no such 16% to 19% risk because of a failure premium.
Where is there such railroad equity and debt risk?
Where can debt risk be found? It’s found in places like Mongolia, Senegal, Mali, Ivory Coast and Nigeria. When can it be found? Whenever private equity investment is sought. Why can it be found? Because there is such a low initial railway freight market volume that a clear and evident risk premium is required. I know because I spent the better part of 17 years working on rail projects in those countries.
Based on the above logic, I conclude that there is no such risk of business collapse evident in anyone’s current long-term U.S. rail traffic projections. Traffic may be down, but there is no Penn Central-like crisis in the cards, is there? Who postulates such financial fear?
I cannot find a single railroad company financial analyst that is making such conditional warnings to its audiences. Defending 12.2% is, on a global open access to capital basis, difficult at best.
The STB, please, needs to get real. Protecting investors with extreme risk premium regulatory oversight isn’t part of the free enterprise system, is it? This is just my opinion as an “old railroad guy.” What, colleagues, is your retort?
This article first appeared on www.freightwaves.com
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