Canadian Pacific Kansas City (CP) & Canadian National Railway (CNR)

Rail freight transportation does not have the recognition that perhaps it deserves if we consider its fundamental role in global supply chains. Railways are strategic assets for the proper development of economies and, more specifically, for the North American economy, which is the focus of today’s post. Rails may not be the most popular method to move freight across the continent (the transportation industry is around $900 billion in market size, and rails make up only about 10% of that), but for some companies it is literally their only option. Transporting heavy raw materials and larger products by road or air is sometimes financially unfeasible or even prohibited by legislation. Railroads have almost no competition when it comes to grains, potash, coal or other heavy materials with low added value. They also enjoy a privileged competitive position moving less bulky goods over long distances. Customers select their transportation method of choice based on delivery frequency, punctuality, quality of service or reliability, but they will always pay special attention to cost. Over 500 miles, rail transportation typically costs 10 to 35% less than other alternatives.

There is a lot to be learnt about resilience if we read about the history of some railway companies, but the fact that technology has not changed that much in the last 200 years also works in their favor. The railway network is the lifeblood of the primary and industrial sectors of North America, and investing in a class 1 railway company means, in some way, investing in the development of two of the most important economies in the world. However, railroads were not always that good of an investment. At the beginning of the 19th century, the emergence of railroads in North America transformed people's lives and boosted the economy. Crossing the US from coast to coast went from a three-week to a three-day journey, commerce skyrocketed and market dynamics changed forever. Railroads were in the limelight and it did not take long for them to become the most predominant business. A large part of the companies that made up the first Dow Jones index were railway companies, and this period saw the appearance of the first monopolistic practices after some companies happily leveraged their pricing power, so much so that it did not take long for the government to take action on the matter. In 1887, the US Congress passed the Interstate Commerce Act, and the regulatory agency was able to intervene to ensure fair prices and limit the power of railroads. The industry's margins gradually deteriorated as its power to freely adjust prices and restructure networks disappeared, and companies were forced to provide service to unprofitable routes. The situation aggravated after the US government invested to improve highway networks and increase the number of airports, and railroads lost competitiveness compared to other means of transportation and saw their market share decline significantly. As profits decreased, so did the capital to reinvest in the business and maintenance began to be neglected. This succession of events culminated in the bankruptcy filing of Penn Central Transportation in 1970, which was the largest railroad company at the time and the sixth largest company in the country.

The railway system had deteriorated so much that in 1980 Congress deregulated the industry with the Staggers Act in an attempt to reverse the situation. This new legislation was intended to increase competition and efficiency by reducing government control over railroads. Companies regained the flexibility to set their own rates and the ability to abandon unprofitable lines and consolidate operations. Deregulation helped these companies bounce back and unleashed a wave of investments to develop and improve infrastructure like never before. The Staggers Act was a turning point and it improved the quality of service, but it also led to the consolidation of the sector. The nearly 140 class 1 railroad companies operating in the US in 1940 became 40 in 1980. Consolidation continued over the next few decades, and today there are only six class 1 railroad companies that dominate North America.

These acquisitions made sense for a number of reasons, but the most important ones were getting rid of redundant routes and improving productivity and efficiency. From the bankruptcy of Penn Central Transportation in 1970 to the early 2000s, class 1 railroads saw their operating margin increase significantly (from zero to 10-15%), but they did not turn into the companies with margins of 35-40% that we know today solely because of regulators. Railroad companies have a very high fixed-cost structure, so a greater volume of freight moving through their networks would translate into higher incremental profits due to very low marginal costs. But, if volume has barely changed in the last two decades, what has led to this striking margin expansion?