Another cultish cost-saving formula gets off-track

NEW YORK, March 29 (Reuters Breakingviews) - Beware the company, or industry, with a one-track mind. General Electric (GE.N) had one for years, consumed by Six Sigma, whose gospel the U.S. conglomerate helped spread to boardrooms far and wide. At Kraft Heinz (KHC.O), the cost-saving dogma was zero-based budgeting, which caught on with other packaged-goods makers and beyond. For North American freight train operators, the obsession is precision scheduled railroading, or PSR. Like other cultish management fads, it worked for a while and has now gone too far.

The lionized efficiency model recently started to lose some steam among the biggest railways, but it is getting renewed attention thanks to a pushy investor at Union Pacific (UNP.N). Soroban Capital Partners is urging the $120 billion company to replace Chief Executive Lance Fritz with its former chief operating officer, Jim Vena, a protégé of the late Hunter Harrison, who pioneered PSR and implemented it as boss of four different operators, starting three decades ago with Illinois Central. Fritz said last month that he would step down this year, just as Soroban Managing Partner Eric Mandelblatt went public with a campaign against him.

As with most brand-name strategies championed by consultants and CEOs, PSR boils down to boosting productivity, in this case by shrinking workforces, running trains faster and optimizing schedules. Despite its multiple interpretations and approaches, success is widely gauged by a railway’s operating ratio, a simple measure of how much it spends to make a buck. Back in 2004, Union Pacific’s was nearly 90%, meaning for every $1 of revenue generated, it shelled out around 90 cents to operating costs. A decade later, the year before Fritz took over, that dropped to around 65 cents. Union Pacific’s peers improved similarly, indicative of the antiquated ways the industry had been deploying resources.

GETTING RATIOED

Union Pacific made all that progress without even officially embracing PSR. It didn’t do so until 2019, just before it hired Vena to be COO. Calling it a “Unified Plan,” Fritz responded to frustrated customers and shareholders by targeting a 55% operating ratio, to be achieved partly by minimizing the time railcars sat idle and deploying crews more effectively. He never quite got there, although Soroban credits Vena with the dip to 56%, a trend that reversed after he left the company in 2021 and the pandemic upended labor markets and supply chains.

Fast forward, and flaws in the system have started to appear. Under Fritz, Union Pacific’s headcount tumbled 37% by 2021, a decline destined to frustrate and demoralize many of the remaining 30,000 employees, especially in a business where generational legacies and emotional attachments play a role. Safety issues are also a growing concern. Rail operators recently detailed how larger crews helped save trains from serious crashes as they urged Nebraska senators to consider legislation that would require freight trains to have at least two crew members.

Union Pacific also found itself unable to bring back enough furloughed workers in areas where they were most needed. Strict attendance rules led to tense industry-wide negotiations with labor unions, prompting intervention by Congress and U.S. President Joe Biden to prevent a national work stoppage that threatened significant economic damage. Over the weekend, the company, as part of a labor agreement, backed off its push to cut crews down to one person.

Many of these issues extend beyond Union Pacific. A Norfolk Southern (NSC.N) derailment in Ohio, which included toxic chemicals, invited fresh scrutiny of railroad safety standards. Although accidents and incidents logged by regulators at the Surface Transportation Board fell by nearly 15% from 2017 to 2021, the rate of decline at a half dozen of the largest operators, including Union Pacific and Norfolk Southern, was only about 12%. Similarly disproportionate, the number of fatalities increased about 17% industry-wide over the same five-year span but jumped 27% at the big six.

When he was hauled up to Capitol Hill earlier in March, Norfolk Southern CEO Alan Shaw used the opportunity to emphasize his $47 billion company’s recent decision to distance itself from PSR’s core tenet. “In a significant departure from the railroad industry's recent past, we deliberately moved away from a singular focus on operating ratio,” he told lawmakers. “Instead, we are taking a more balanced approach to service, productivity, and growth.”

In practical terms, Shaw said that means beefing up the workforce. And instead of temporarily suspending employees during slowdowns, the company intends to use the time to provide them with extra training.

LOCO MOTIVES

Unhealthy allegiance to efficiency often unravels too late, in many cases after growth is overly neglected, there’s little expense left to optimize, and regulators take notice of the consequences. Under Jack Welch, GE elevated Six Sigma from a useful quality control mechanism to a more comprehensive doctrine. Infatuation with it after he left the company proved distracting and led to misallocated capital and underinvestment in new technology. Once a $600 billion juggernaut of corporate America, GE (GE.N) is breaking itself up. Its two pieces are worth a combined $138 billion.

The sweet taste of zero-based budgeting also went sour at the maker of Jell-O and Oscar Mayer hot dogs. Its private equity backer, 3G Capital, led the charge on forcing managers to justify expenses anew each year. Investors lapped it up and persuaded other companies to do the same. In time, however, the sluggish top line attracted as much attention as the costs being hacked away. Since Kraft and Heinz completed their merger in mid-2015, the stock has lost more than half its value, far underperforming the broader market.

In September 2020, Chief Executive Miguel Patricio tried to steer Kraft Heinz in a new direction. In unveiling its new strategy to investors, company executives invoked “costs” two dozen times compared to nearly 250 mentions of “grow” or “growth,” according to a transcript of the event. Since then, its return to shareholders, including reinvested dividends, has been 34%, versus 22% in the S&P 500 Index (.SPX), according to Refinitiv.

These are cautionary tales for PSR, whose staying power – or swifter evolution – could be determined by the outcome of Union Pacific’s CEO search. Promising signs beyond Norfolk Southern suggest the grip of Hunter Harrison’s precepts is loosening.

Union Pacific added more than 3,000 people to its workforce in 2022, reversing at least seven consecutive years of shrinkage, to expand by 11%. What’s more, just over a year ago, Vena pulled out of the running to be Canadian National Railway’s boss despite being supported by a group of investors led by Chris Hohn’s aggressive TCI Fund Management. The company, an early adopter of PSR under Harrison, said it was not in the operating ratio business. “If we wanted to drive [operating ratio] lower over time, we could,” the board wrote in a letter to shareholders in late 2021. “But what TCI and others fail to grasp is that the question isn’t: How low can we go? The question is: How low should we go?”

If Vena takes the wheel at Union Pacific, it stands to reason that he’ll channel Harrison’s legacy. After years of railway operators outperforming the broader market, however, Union Pacific’s shares have tumbled by more than a quarter over the past 12 months, twice the decline of the S&P 500 Index. Vena might be able to squeeze the operating ratio a few more percentage points, but the evidence suggests that devotion to PSR should be coming to the end of the line.

Follow @jgfarb on Twitter

(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)

CONTEXT NEWS

Union Pacific Chief Executive Lance Fritz said on Feb. 26 that he would step down later in 2023, after hedge fund Soroban Capital Partners called for him to be replaced.

Soroban urged the U.S. railway operator to consider former Chief Operating Officer Jim Vena as a replacement.

Union Pacific said it had hired an outside consultant in March 2022 to help identify the company’s next CEO and formed a task force of board directors to assist in November.

Fritz has been CEO since February 2015.

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