Until Hunter Harrison, there was a lack of focus on how efficiently rail assets could be employed. Customers demanded service and the railroads invested. More equipment was better. The result was a consistent inability of the roads to cover their cost of capital. Herb Kelleher founded Southwest Airlines as a low cost no-frills regional. It first took off in 1971 and changed the nature of air transportation for millions of Americans. Both Hunter and Herb focused on transforming operations. Hunter’s message? Here’s what really matters: “Precision Scheduled Railroading”. Sales and customer service focus on driving top line growth while operations and investment measures focus on asset turnover and margin improvement (e.g. lowering the ‘operating ratio’ for railroads). In both the Air and Rail industry the challenge is to design, invest in, and manage network capacity so that it best meets customer demands while managing pricing, maximizing profitability, and meeting society’s goals. As Matt Rose, the retiring Executive Chairman of the BNSF recently stated, “It’s a three legged stool”. Customers, Capital, People (and politics).

What’s the key metric? Return on invested capital (ROIC) is the one metric that captures both operating margins as well as the capital required to generate it. It tells us how much a firm earns for each dollar invested. When ROIC is greater than your weighted average cost of capital you are creating “investment” value. Identifying the components of ROIC and acting on those components is what creates value. But ROIC is a Wall Street investment analyst measure and discussions are generally confined to finance departments. The genius of both Hunter and Herb is that they understood the components of ROIC. They inspired, motivated, and challenged their people to focus on constantly improving performance. Net operating profit after tax (‘NOPAT’) as a percent of Invested Capital is used to generate ROIC. The main components of invested capital include equipment, spare parts inventory, operational facilities, and the ‘working’ capital needed to run operations. But the formula doesn’t identify how to influence the value drivers. The ‘DuPont’ analysis disaggregates ROIC into its key parts: return on sales (NOPAT/Sales) and asset turnover, or capital productivity (Sales/invested capital). Both return on sales and capital productivity measures can be further broken down. It’s these components that managers must act upon. Understanding this allows operations to identify the causes of differences in performance over time and among competitors. Activities can then be designed to increase both return on sales and capital productivity, thus maximizing value. Strategies that improve capital asset productivity are the focus of precision scheduling railroading. Eliminating excess equipment from the system and increasing the productivity of remaining equipment. For Southwest Airlines it’s a commitment to their people and to operating a single type of plane (the Boeing 737). The other component of capital productivity is sales. So, finding ways to expand offerings that drive revenue growth using existing equipment is key.

The BNSF’s focus is on long term investment results. Charlie Munger, Buffet’s right-hand man, says “We don’t have to make the last dollar”. And, as Southwest’s Herb Kelleher once said, “We have a strategic plan. It’s called doing things.” With a focus on the mechanics of Air and Rail equipment finance, industry conditions, competition, customers, investment returns required to deliver capacity, and the people and politics of service delivery, we’ve designed a platform for sustainable Aviation and Rail investment. If you are interested, call us. Call RESIDCO.

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