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 14 th Street NW, Washington DC 20005 February 15 th , 2007
The 15.18% Return on Equity Found by the Board is Unrealistically and Unreasonably High Return on Equity 15.18% 16% 13.00% 14% 12.84% 12.40% 12% 10% 8% 6% 4% 2% 0% STB 1926 to 2003 Average 1971 to 2003 Average S&P 500 stocks Railroads Experienced Returns 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 Return on Equity (STB compared to Utility Witnesses) 16% 15.18% 13.90% 14% 11.81% 11.74% 11.74% 12% 11% 10% 8% 6% 4% 2% 0% Katheleen James William Avera Wayne M. Leja Utility Average STB McShane VanderWeide Market Returns Railroads 3 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 4 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 Cost of Capital 14% 12.87% 12.20% 12% 11.94% 11.84% 12% 10% 9.20% 8.80% 8.58% 8.30% 8.00% 8% 6.30% 6.30% 6.20% 6.20% 6.10% 6% 4% 2% 0% BNSF UP CSX NS All Railroads Citibank Legg Mason STB 5 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% 16% Dividend Yield 1.52% 14% 12% Dividend Yield 10% Growth Growth 8% 13.66% 6% 4% 2% 0% DCF Components 6 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 7 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% 8 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% Contribution of Traffic with R/VC above 180% 100% Traffic Above 180% 90% 80% Traffic Above 180% 70% Traffic Above 180% 60% All other Traffic 50% All other Traffic 40% 30% All other Traffic 20% 10% 0% Revenue Operating Profit Source: Snavely King Estimates 9 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 10 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% 11 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. 12 Snavely King Majoros O’Connor & Lee, Inc. February 15, 2007 STB Ex Parte 664 Hearing Presentation www.Snavely-King.com
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