What Ancora Gets Right and Wrong

I’ve been getting a lot of requests from people on what I think of NS’ battle with activist investor Ancora.  I’m not going to lie, my first reaction was the same as most everyone else in the industry – “No.”

But as I dug through the data and tried to consider Ancora’s claims, I discovered there’s more to it than simply Ancora trying to run out the same old playbook.  NS does have fundamental issues in its business. The only problem is that Ancora's proposed strategy is lazy and sloppy.

What’s the Purpose of Activist Investing

I think a good place to start with this would be to understand the role of an activist investor.  Coincidentally, I was listening to Lex Friedman’s interview of Bill Ackman, the activist investor who led the attack on CP that ended up putting Hunter Harrison in as CEO, when the Ancora news broke.  Highly recommend that episode if you’re into podcasts.

Corporate governance of publicly traded companies relies on a board of directors elected by the shareholders (owners) of the company to oversee the management of the company.  The board has the “fiduciary duty,” or obligation, to act in the best interests of the beneficiary (shareholders). 

To accomplish that end, the board hires a CEO to run the company, who then hires a management team.  The board of directors meets regularly with the CEO to ensure the company is being run in a way that financially benefits the shareholders.  The board works with the CEO to carve out a strategic plan for the company, but it’s up to the CEO and management team to execute that plan.

With good corporate governance, the board of directors acts as a check on the CEO, going so far as to replace the CEO if the company underperforms relative to expectations.  This (obviously) does not always occur.  Boeing and GE are two more recent examples of boards with poor oversight that resulted in negative long-term outcomes for their shareholders.

Companies will underperform.  Maybe the board appointed the wrong CEO or the strategy was misguided.  Or maybe a black swan event wipes out your business, like passenger rail, hospitality, and food service during the pandemic.  East Palestine too.  It’s up to the CEO to make the necessary corrections, the board to hold the CEO to account for their performance, and the shareholders to replace directors if either of those first two actions aren’t occurring.

Activist investors like Bill Ackman or Carl Icahn can provide a necessary check on boards that have neglected their duty.  Indeed, Bill Ackman describes himself in the same vein as legendary investors like JP Morgan who had the power and influence to stabilize markets and drive industries towards long-term progress.  If done properly, activist investors can provide a welcome counterweight to boards and management that are not operating up to their fiduciary duty.

The way Bill Ackman tells it, his proxy battle to revamp Canadian Pacific was an effort to shake up an old country club that was consistently underperforming the market.  Hunter came in, implemented PSR, and now with the acquisition of KCS, it’s successfully carved out a path to tap into any growth in new markets.  CPKC has also had the highest ROIC Year 3, as shown in the chart below.  (The decline in ’22 is a result of the added debt and equity needed to finance the KCS acquisition).

(The finance guys will probably wave this away, but ROIC Year 3 is my version of a ROIC calculation to more accurately reflect the delayed nature of any potential return on an investment.  My ROIC Yr 3 = NOPAT Year 3 / Total Invested Capital Year 1).

Is NS Underperforming?

With that understanding of activist investors, let’s review what Ancora is trying to do with NS.  We can do that by evaluating the two dimensions of an activist investor:

1. Is Norfolk Southern underperforming relative to its peers?
2. If so, what should be done?

To answer the first question, is NS underperforming?  The first chart shows the difference in revenue between NS and CSX going back to 2014.  No doubt, the revenue gap between NS and CSX has never been closed in the past 10 years.

The second chart shows that revenue difference in greater detail over the past 3 years.  Columns in the second chart that are blue are those where NS outgrew revenue relative to CSX, columns in orange are the opposite.  What you can take from this graph is the relative strength of each business unit.  No surprises here. NS has a more dominant intermodal business; CSX has a stronger chemicals and coal business.  Automotive and Metals/Minerals are pretty balanced.

(It’s important to note that part of the gap can be attributed to CSX’s trucking business and other revenue like property sales.  I’ve adjusted for this difference to look purely at carload and intermodal revenue).

Another way of looking at the strength of a business is its relative pricing power.  If a business can increase its prices without losing its customers, then it has pricing power.  Pricing power, generally, can be seen as the value of the goods and services offered by the company in the eyes of its customers. The greater the pricing power, the greater the value in the eyes of the customer. 

The chart below shows the difference between NS and CSX’s pricing growth for each business unit from 2021 to 2023.  Columns in blue show where NS outgrew CSX over the period.  Columns in orange are where CSX outgrew NS.  Again, more orange than blue shows comparative weakness in NS’ business.

There’s another way to look at this chart.  First is in terms of rail competitive commodities, or business that is primarily head-to-head between railroads.  This is coal, aggregates, and grain – all core rail commodities that aren’t competitive with truck.  The second is in terms of truck competitive business, where it’s primarily rail vs truck.  Truck competitive business would be intermodal and automotive – far easier for a shipper to shift product to truck when needed.

In general, NS outperformed CSX on truck competitive businesses whereas CSX did better on rail competitive businesses.  Yes, CSX had greater pricing gains on its intermodal business than NS (9% to 5%, respectively), but NS made $3.5 billion more overall.

What about operations?  CSX leads the industry in service metrics, right?  Looking at trip compliance metrics, the story is a little more nuanced.  The chart below shows trip plan compliance for merchandise and intermodal for both NS and CSX.

Some key takeaways from this chart, although I would state that I’m not a huge fan of this metric.  I feel like measuring to the trip plan rather than just a flat out on-time arrivals/originations allows for more opportunity for sandbagging. 

First, NS is actually pretty comparable to CSX in merchandise trip plan compliance.  Accounting for the 2023 disruption, NS really isn’t that far off.  Second, NS has never come back to its 99-100% threshold that it was hitting pre-staffing meltdown in 2021, assuming these metrics are reality and not manipulated.  CSX actually struggled far more but has notably moved to within touching distance of NS on intermodal reliability.

While NS does have some poor metrics, from a financial standpoint I’m not seeing a sloppy operation.  I posted this first chart last week which shows NS having the lowest cost/carload of any of the Class 1’s.  Additionally, NS has actually had a lower net spend (NS OPEX – CSX OPEX) than CSX for 6 of the past 10 years, 7 if you adjust for the East Palestine derailment.

What To Do About It

Let’s put this all together.  The story of NS’ business is one of a railroad built to compete with trucks, underachieving in core rail carloads, and decent financial discipline.  The question shareholders should ask is can Shaw & Co right the ship or is a change needed to improve performance?  They should also ask how much of this is under NS’ control vs how much is inherent to the NS and CSX network (i.e., determined by where the rails lie).

Ancora believes this is all on Shaw, COO Paul Duncan, and the NS Board of Directors and that by replacing all of them will only make things better.  Let’s examine their strategy.

First, Ancora wants to replace most of the board.  Somewhere they said the current directors are too far removed from the transportation industry and lack the experience to handle the current challenges.  I think that's a fair criticism and I’ve wondered for years what folks from the movie industry would bring to the board of a railroad.  Rail touches a lot of industries; surely you can and should seek out directors with experience in those industries.

Second, Ancora wants to replace Shaw and Duncan with former UPS COO Jim Barber and former CSX COO Jamie Boychuk.  I don’t know anything about Barber, but bringing in two operations execs clearly shows that Ancora is caught up in the same fundamental issue that I’ve always had with PSR:  You cannot cut your way to growth. 

I don’t care how much network capacity/resources you can unlock from a more efficient operation, carloads aren’t going to magically appear just because you start showing up on time. (And I would argue rail is never going to consistently show up on time).  If consumer demand isn’t there because of whatever market cycle a particular industry may be in, the business just won’t be there.  Rail has a demand problem (too hard to do business with so I’ll ship by truck instead), not a supply problem (not enough network capacity).

The surge in export coal volumes for CSX didn’t come because CSX was more efficient or reliable than in the past.  It came because Europe is in an energy crunch and India and China are still building coal plants.  Growth in aggregates recently came not because rail was suddenly so much easier to do business with, it came because the US Government opened up its wallet and started funding a ton of infrastructure projects.

The question with Barber is whether he’s going to be customer-focused or operations-focused.  If he’s customer-focused, he can follow the path of Joe Hinrichs and reshape a railroad based on his experience as a shipper.  Given Hinrichs’ popularity, Ancora is absolutely asleep at the wheel by not casting Barber as a rail customer coming to fix all the issues while he was on the other side of the table.  But they don’t see that because their “me too” OR-focused strategy can’t comprehend anything different.

Just like with UP CEO Jim Vena, I’ll reserve judgement on Barber and Boychuk until they’ve had the chance to perform, but like with Vena, if you’re being brought in with a clear mandate to tighten the belt then your hands are already tied by the board.

That leads into my third point and Ancora’s first: Safety, safety, safety.  I have very little patience when people say “Safety 1st” because it often means absolutely nothing.  They say it because it’s cheap.  Ancora lists the following action items supporting their “Safety is Our #1 Priority” component of their strategy,

“Instill a safety-based, accountable, disciplined workforce culture that enables employees to take ownership of their work and responsibilities."

The problem with this statement is that it’s a word salad from a bunch of knuckleheads who have never been in the field.  Especially for unions, “Accountable” screams “Unfair termination” and they’re going to fight it tooth and nail.  "Fix the hazards, don't blame the workers." Management may want employees “to take ownership of their work and responsibilities,” but treating them as a separate class from management is how all labor fights start.  Anyone with half a brain can see this strategy reeks of an old-school operating mindset that’s trying to masquerade as something else.

Contrast that approach with CSX CEO Joe Hinrichs’ “One CSX” strategy.  It’s working wonders and he’s got everyone moving in step together.  That cultural transformation is likely a key part of why CSX is being held up as the standard.  Labor unions, labor unions!, are even coming out in support of Shaw because he’s gone further than arguably any Class 1 CEO in working to address union concerns.  When did a rail labor union come out in support of anything a railroad did?

Which brings us to Jamie Boychuk.  Another point they listed the Ancora deck to support their safety objective,

“Mr. Boychuk is a proven leader who can design a rail network that will reduce car handlings creating a safer environment.”

Ancora does have a fair point in saying that increased car handling results in increased safety risk.  I don’t know enough about NS’ operation to comment intelligently on why they’re handling cars so much more often.  I do think it’s likely that Boychuk has already looked at the opportunities at NS and told Ancora this is the area to focus on.

However, it’s well known in the industry that Boychuk was a toxic personality at CSX and was let go precisely because of his negative influence on the culture.  Again, if this goes through and Boychuk gets hired as COO at NS, I’ll reserve judgement until after he’s had a chance to perform, but you don’t put a guy like him in place unless you know about the poor morale handicap that could come along with him.  Ancora’s actions say Ops #1, Safety #whatever.

That to me highlights the utter hypocrisy of what Ancora’s proposing.  It’s not about safety so don’t lie to our face.  Shaw has put safety front and center because he’s had to, and it appears to be paying dividends.  Given Boychuk’s prior safety record as highlighted below, Ancora want him only for the operational benefits he may provide.

Ancora has also stated that their strategy would include a shift in focus from intermodal to carload growth.  Running the NS for carload rather than intermodal is a bit like a 4'10" horse jockey thinking it’s a good idea to try out for the NBA.  Why would you want to ignore your greatest asset, which is the only long-term growth opportunity for rail (truck to rail conversions)?  This clearly speaks to (1) Ancora’s ignorance about the rail business and, more concerning to shareholders, (2) A focus on near-term profit maximization at the expense of long-term profit opportunity.

I could go on and on here, but I’ve got a day job.  It will be interesting to look at a more detailed deck that Ancora should be coming out with soon.  Considering their last deck had more typos than my 3rd grader’s writing, I would hope they spend more time talking to rail stakeholders and formulating a more coherent strategy.

Should NS replace its management team?  My personal opinion is that Shaw & Co should be given at least another 18 months.  Freight should be coming back in the 2nd half of the year.  Intermodal should be stronger then and already appears to be stronger this year.  This should be a market more favorable to NS.

If in 18 months time NS is still significantly underperforming, especially in its intermodal business, then I think shareholders and the board should be asking much tougher questions.  Until then, cut them loose.