Ex Parte No. 664 Railroad Cost of Capital Charles W. King Snavely - - PowerPoint PPT Presentation

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Ex Parte No. 664 Railroad Cost of Capital Charles W. King Snavely - - PowerPoint PPT Presentation

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Snavely King Majoros OConnor & Lee, Inc. Ex Parte No. 664 Railroad Cost of Capital Charles W. King Snavely King Majoros OConnor & Lee, Inc. 1111 14 th Street NW, Washington DC 20005 February 15 th , 2007 The 15.18% Return on

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Snavely King Majoros O’Connor & Lee, Inc.

Ex Parte No. 664 Railroad Cost of Capital

Charles W. King Snavely King Majoros O’Connor & Lee, Inc. 1111 14th Street NW, Washington DC 20005 February 15th, 2007

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2 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com

The 15.18% Return on Equity Found by the Board is Unrealistically and Unreasonably High

15.18% 12.40% 13.00% 12.84% 0% 2% 4% 6% 8% 10% 12% 14% 16%

STB 1926 to 2003 Average 1971 to 2003 Average S&P 500 stocks Railroads Experienced Returns

Return on Equity

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3 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com

The 15.18% Return on Equity Found by the Board is Unrealistically and Unreasonably High

11.74% 11.74% 13.90% 11.81% 11% 15.18% 0% 2% 4% 6% 8% 10% 12% 14% 16% Katheleen McShane James VanderWeide William Avera Wayne M. Leja Utility Average STB Market Returns Railroads

Return on Equity (STB compared to Utility Witnesses)

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4 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com

Beta and Safety

Beta Safety

BNSF 0.95 2.00 CSX 1.00 3.00 NS 1.05 3.00 UP 0.90 1.00

Average, 4 Railroads 0.98 2.25 All Stocks 1.00 3.00

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5 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com

The 12.2% Composite Cost of Capital Exceeds Estimates of the Railroads’ Capital Costs Developed by Independent Investment Analysts

6.10% 8.30%

11.94%

6.20% 8.00%

11.84%

6.30% 8.80%

12.20%

6.30% 9.20%

12.87%

6.20% 8.58%

12% 0% 2% 4% 6% 8% 10% 12% 14%

BNSF UP CSX NS All Railroads

Cost of Capital

Citibank Legg Mason STB

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6 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com

Discounted Cash Flow (DCF) Components

Total 15.18% Total 15.18% Growth 13.66%

Dividend Yield 1.52%

0% 2% 4% 6% 8% 10% 12% 14% 16%

DCF Components

Dividend Yield Growth

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7 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com

Reasons for high railroad earnings growth forecasts

Motor carrier problems More “headroom” for price increases Growth in long-haul Intermodal Improved train scheduling Weak regulatory constraints

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8 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com

Federal Energy Regulatory Commission (FERC) Two-step Earnings Growth Formulation

Term Rate Weighting Composite Short-Term 13.66% 0.6667 9.11% Long-term 4.50% 0.3333 1.50% Total 10.61%

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9 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com

Contribution of Traffic with Revenue to Variable Cost Ratio (R/VC) Above 180%

Source: Snavely King Estimates All other Traffic Traffic Above 180% All other Traffic Traffic Above 180%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Revenue Operating Profit Contribution of Traffic with R/VC above 180%

Traffic Above 180% All other Traffic

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10 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com

Circularity Issues

Circularity Issues

Weak regulatory constraints lead to:

High earnings forecasts High market valuation

Both lead to high cost of capital estimates

Solution for Circularity

Use FERC 2-step procedure Use book value, not market value

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11 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com

Recommendations and Results

Continue to use the DCF formulation to determine the

cost of capital for the railroads

Adopt the two step procedure used by FERC for

identifying the growth factor in the DCF formula

Use the book value of debt and equity in determining

the capital structures of the railroads

Results for 2005:

Equity Return

12.13%

Total return

8.99%

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12 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com

Snavely King Majoros O'Connor & Lee, Inc.

Charles W. King. is President of the economic and management

consulting firm of Snavely King Majoros O'Connor & Lee, Inc.

Snavely King was founded by the late Carl M. Snavely, Jr. and Charles

King in 1970 to conduct research on a consulting basis into the rates, revenues, costs and economic performance of regulated firms and industries.

The firm has a professional staff of 12 economists, accountants,

engineers and cost analysts. Most of its work involves the development, preparation and presentation of expert witness testimony before federal and state regulatory agencies.

  • Mr. King has testified as an expert witness on economic and other issues

in more than 300 proceedings in the US and Canada.

In addition to this appearance before the STB, Mr. King has testified as an

expert witness on cost of capital in 14 regulatory proceedings in nine states, since January 2000.