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The holding company movement is a rather recent phenomenon which was initiated in 1960, when the Interstate Commerce Commission first ruled that it lacked jurisdiction over the holding company. Between 1960 and the early 1970's, the majority of class I railroads moved into holding companies. The holding company became generic to the railroad industry, I maintain, because it provided a vehicle for achieving diversification without Interstate Commerce Commission approval. The basic motivation that drove the majority of the railroad industry into diversification had its origin in the regulated nature of the industry and the low rate of return on railroad assets. The railroad responded to this low rate of return by forming a holding company to allow them to pursue other lines of business. This is known as defensive diversification in the literature, or a defensive conglomerate, where the firm moves from their basic industry into other, unrelated industries, because of either real or imagined declining opportunities for a relatively poor current position in their primary industry.
Once the railroad is included in the holding_company, it competes with the other subsidiaries for capital. I appreciated Mr. Bressler's comment this morning, as he noted that the Burlington Northern Railroad is currently doing a good job-and I quote him-"of competing with other divisions for capital". He put the emphasis on the fact that the Burlington Northern was currently successful in competing for capital. I would put the emphasis on the fact that he acknowledged that Burlington Northern Railroad does in fact compete with the other divisions for capital. And I would like you to keep that in mind in my later remarks. It is very important to the theory that I will develop.
Joel Dean, in an investigation of conglomerate corporations, stated:
A conglomerate-and this is a corporation with a lot of different divisions in different industries-is an efficient mechanism, both for milking an obsolescent operation and flowing its cash earnings to investment in more promising divisions and for liquidating an obsolescent operation.
The Interstate Commerce Commission, in a preliminary report in 1969 and in a later report in 1977, noted that, as has already been suggested this morning, there was concern over the possible transfer of funds from the railroad to other subsidiaries or to the parent holding company. Such transfers have escaped the regulatory overview of the Interstate Commerce Commission and possibly harmed the railroad. The Interstate Commerce Commission further suggests that the two most likely avenues suggested for this disinvestment are undermaintenance of track and excessive dividends paid to the parent holding company.
Given all of this background, since I am an economist, I thought it would be interesting to develop a model to try to explain the behavior of the firm. Economics is nothing more than a series of models explaining the behavior of firms and consumers, not always terribly successful in predicting, but it generally does a pretty good job at analyzing. We are not so good at predicting, because there are so many variables that enter into the predictions.
With respect to the holding company model, I think we can break a holding company down into a fairly straight-forward analysis-namely, once a holding company is formed, all of the divisions
in the holding company can be looked at as sort of a portfolio, much as an individual might have a portfolio of stocks and bonds, and the holding company then can direct funds to those parts of their portfolio that have the highest profit potential.
I would like to emphasize that prior to the formation of the holding company, the stockholders of the railroad had the primary interest in maintaining the railroad, the financial health of the railroad. Once the holding company is formed, the stockholders of the holding company now have as their primary interest the financial health of the holding company, and the railroad becomes a secondary interest. The holding company management has to recognize this situation.
What I propose in my model is, given this portfolio approach, the holding company would review all of its divisions by comparing profit potential in all of the divisions and they would measure the rate of return, either in equity or assets, for each division and then direct funds to those divisions that are most profitable. They would freeze funds, or in fact, divert funds, from those divisions that are least profitable.
Given this model, the railroads appear to be in a rather unenviable position because of their relatively low rate of return, both in terms of equity and assets in the last several decades.
I do have a couple of qualifications to this fairly straightforward model that looks at profit differential, or as I will call it, profit gap between the railroad and the other divisions. One qualification involves risk. When we look at rate of return figures, we typically do not include risk in the figures. I would argue that when you have relatively low rates of return, if they are stable and if you can depend on the low rates of return, they may be more profitable on a risk-adjusted basis to an industry compared with high rates of return that are very volatile. If the railroad industry, although unprofitable, is not risky, the holding company may prefer to maintain that railroad in spite of a profit gap between the railroad and the alternative investment.
Very quickly, two other qualifications. There is a significant cost of liquidating or divesting the railroad, particularly with a tremendous amount of fixed, specialized capital in the railroad, and so the company may maintain the railroad even though it is not generating nearly as much profit as the alternatives; and third, there may be a complementary relationship between the natural resource divisions and the railroad-namely, the railroad can ship the products of the natural resource divisions over the railroad.
Thus, I would suggest there is some profit gap that the holding company would tolerate between the railroad and its alternative investments, and as this gap gets larger and larger, the incentive to undermaintain the railroad and to divest the railroad gets greater and greater. I have studied a number of railroads that have gone into holding companies and have discovered what I consider to be a causal relationship—namely, those railroads that are relatively unprofitable going into holding companies tend to deteriorate after they go into the holding company. Those railroads that are very profitable or are above average in profitability tend to maintain their efficiency and financial operating characteristics in spite of the holding, or maybe because of the holding company.
This finding provides some guidelines for the type of policy we should recommend.
First, a few specific characteristics about the Burlington Northern. I would agree with testimony this morning that Burlington Northern has been improving recently in terms of profits. It has consistently been above the overall average for U.S. railroads, but below the average for the western roads. Its operating ratio, which is a measure of efficiency, is not very good at all-in fact, it is worse than the rest of the western railroads, but it has been improving slightly. To the Burlington Northern's credit, they do have a fairly good maintenance policy for maintaining track.
I would not classify the Burlington Northern as a weak railroad at this point, and therefore, I do not see in the short term any concern over the Burlington Northern and this holding company. But in the next 5 or 10 years, it is very possible that the optimism for the railroad industry that is currently felt by a number of people could turn out to be incorrect; the railroad earnings could fall. If the holding company pursues its diversification of financial resources, as it argues it is going to do, this would produce a tremendous profit gap which would provide the incentive for the holding company to divest itself of the railroad eventually, or at least lead to deterioration of the railroad.
I would recommend that the Interstate Commerce Commission more closely monitor these holding companies with respect to the transactions with railroad divisions and they more closely analyze what is happening to the specific railroad divisions. In the case of the Burlington Northern, I think the potential exists in the next 5 to 10 years, given the right scenario, for the Burlington Northern Railroad to be harmed by the holding company. If, in fact, the railroad turns out to be improving in profitability all those years, then I would have little concern for the Burlington Northern Railroad. Senator BAUCUS. Thank you, Dr. Sattler. [The following was received for the record:]
Statement by Edward L. Sattler
The Burlington Northern
Railroad recently formed a holding
company, Burlington Northern Inc.
railroad exchange their shares of the old company for the new holding company shares. The railroad then becomes a subsidiary within the context of the holding company. In the Burlington Northern's case, the railroad will be one of eight independent operating companies with each company operating as a separate profit center.
As stated in the Burlington Northern's Annual Report for 1980, the holding company will allow for "greater objectivity in future decision making".' This straightforward statement appears to imply
that funds should be allocated to the subsidiaries based on the rate of return each subsidiary is generating. The annual report further states that while the corporate return on equity has improved to 9.7% in 1980, because the cost of capital is from 12% to 15%, the return on 2 equity for all divisions is inadequate. The return includes the Historically railroad rates of return
railroad and all subsidiaries.
in equity have been below the 9.7% level.
The Annual Report for 1980 also notes that the holding company structure will allow for the company to issue securities for non3 transportation acquisitions. This combination of relatively low rate of return for the railroad, a profit center organizational structure where the railroad must compete with other divisions for funds, and the increased capability to acquire non-transportation investments has raised some legitimate concern about the long term impacts of the holding company on the railroad.
It should be noted that Richard M. Bressler, President and Chief Executive Officer of Burlington Northern Inc., has expressed optimism about the profit potential of the railroad. He has also indicated
that acquisitions in the future would most likely be in addition to
expand investments in the resource activities so that a better balance
is achieved between the transportation and resource activities.5
At this time it is not clear that these two short term goals consistent.
Without questioning Mr. Bressler's sincerity, this would not be the first time the chief executive officer of a newly formed holding company has pledged an upgrading of a railroad and not followed through over the long term.
In order to view the Burlington Northern holding company in perspective it is appropriate to examine the holding company movement in the railroad industry over the past twenty years. A brief history of the holding company movement will be followed by a review of the motivation for forming holding companies and some of the reasons for concern. Next, a theory of the holding company phenomenon in the railroad industry will be advanced followed by a. analysis of railroad holding companies and a conclusion for the general phenomenon. Burlington Northern will then be analyzed within the context of the overall holding company movement.