Quick Note: What Does Profitability Mean?

The 2012 business plan for California HSR, in addition to admitting to wanton cost overruns, also promises that the system will be profitable. Or does it? I did not want to comment on the plan’s notion of profits, but I see via California HSR Blog that several outfits have seized upon that part and treat the release as much better news than it actually is.

The plan says, e.g. on page 15 of the PDF, that the system will generate operating profits even on the lowest-ridership scenarios. This has led Treehugger and others to crow that this will not be a disaster. But a careful consideration suggests the opposite. The medium scenario posits $1 billion in revenue in 2025 versus $539 million in annual operating costs. But those operating costs exclude depreciation; by then the project is expected to expend about $50 billion, which at even a mild depreciation schedule is more than enough to put the system in the red.

The problem is that people in the US are used to judging transit and rail profits using transit agency metrics, by which other people pay for capital and therefore the main operating ratio excludes depreciation. This is not normal accounting; EBITDA is a much less important metric than EBIT (including depreciation but not interest) or net income (including everything) for a normal, profitable business. The profitability of HSR outside the US is measured in terms of net profits; in Taiwan, the system has had positive EBITDA since a few months after opening, but went bankrupt due to elevated interest charges.

The argument that the business plan proves something special because of the positive EBITDA may satisfy people who get their criticism of HSR from hacks who conflate capital and operating costs, but it should not satisfy people who occasionally bother to read railroad budgets. The higher the quality of a line, the lower the operating costs are excluding depreciation and the higher the depreciation and interest charges are. For example, see this breakdown of Madrid-Barcelona HSR costs and profits; infrastructure charges are dominated by depreciation and interest rather than maintenance, though rolling stock charges are more maintenance than depreciation.

Even state-of-the-art HSR infrastructure maintenance is cheap. The 2012 business plan a little more than $100,000 per route-km (cf. €30,000 per single track-km according to a 2008 study, which works out to about the same modulo inflation and a high Euro:dollar exchange rate). It’s a second-order term. The same is true of avoidable operating costs, such as rolling stock maintenance and labor. Of course ten second-order terms make a first-order term, and indeed the total operating costs of HSR are not negligible. However, they’re still lower than depreciation charges.

The importance of including depreciation is that HSR capital doesn’t last forever. Rolling stock has to be replaced. Viaducts and tunnels need to be refurbished. It’s hard to come up with exact figures since HSR lines have not yet depreciated in full in the 47-year history of the technology, but railroads all over the world have accountants who include depreciation terms in the budget. Of course, the problem is that if the capital cost is too high, then the depreciation and interest will weigh the project down. This hasn’t really been observed abroad, except in cases in which the interest rates were very high as in Taiwan, but judging by the business plan’s numbers, it could happen in California.

Finally, although the biggest bombshell in the plan is the cost overrun, the plan also has a ridership shortfall. It’s not a big shortfall, but on page 115 the plan mentions that the revised full-buildout ridership estimate for 2035 is 51-77 million, depending on fares, down from 69-98 million according to the 2008 environmental impact statement. This partly explains why the operating revenues are so low relative to full operating costs including depreciation.

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19 Responses to Quick Note: What Does Profitability Mean?

  1. Two questions:

    1. There will be 33 years of depreciation on large amounts of capital before the thing is even finished, right?
    2. Am I correct to believe that tunnels and viaducts, even if not used frequently, will depreciate faster than at-grade structures? That is to say, PB’s dreadful designs will end up driving up depreciation charges in addition to capital ones, right?

    • Alon Levy says:

      1. Yes, exactly.
      2. I think it’s the opposite. The reason is that physical infrastructure depreciates more slowly than trackwork, catenary, and system elements; pouring more concrete therefore increases the proportion of the capital cost that has low depreciation. Of course the overbuilding is going to raise depreciation in absolute terms, but I think it’ll reduce it as a percentage of the capital cost. But do not quote me on this; I’m basing this on depreciation schedules for urban transit (PDF-p. 14), and tunnels for HSR may incur higher depreciation charges.

      • Tom West says:

        I disagree… Both at-grade and elevated/tunneled tracks have tracks sitting on a load of ballast, sitting on something. Those tracks will have the same lifetime, regardless of what they are sitting on. The at-grade stuff is sitting on the ground, which doesn’t depreciate. The other stuff is sitting on/in structure which *do* depreciate.

        • Nathanael says:

          In actual fact:
          – maintained tunnels do not depreciate.
          – maintained bridges do, but at slow and unpredictable rates.
          – track & ballast lifetime is determined by the traffic running over it, not by time, and should probably be depreciated on a declining balance method. (Same with rolling stock, as long as it’s stored indoors.)

          Of course, NONE of the accounting is generally done this way. Which is why I ignore the depreciation when I read BNSF’s annual report, and instead keep track of their maintenance budget (if that drops, they’re juicing profits at the expense of future profits).

  2. Eric says:

    Some varieties of infrastructure do last pretty much forever. Mass transit tunnels from the late 19th century are still used in London, New York, and other cities and show no sign of obsolescence. Yes, they still need maintenance, but that maintenance is much cheaper than digging a new tunnel from scratch. So it is unfair to count all of construction costs within long-term operating costs.

    • Alon Levy says:

      Fair enough. The Thames Tunnel needed to be closed for long-term maintenance after 150 years, but even that has to be less than replacement cost (though perhaps more than the original construction cost).

      But, some parts of HSR infrastructure do depreciate, e.g. the various system elements and the rolling stock. Those aren’t a big part of the budget (about a third), but they could be enough to weigh down a lightly-traveled line.

      • Nathanael says:

        Unfortunately the rolling stock depreciates on an as-used basis, not on a yearly schedule. Therefore, totally impossible to predict in advance. Same with track.

        The “systems” (signalling and electrical) are even harder to run numbers for. Signalling does fail after a certain amount of time, but nobody seems to know for a relatively new signalling system how long that will be… until it arrives. If we installed 19th century signalling, we could predict how long it lasts, but if we install ERTMS, we can’t. And in practice signalling is generally replaced when people want to upgrade (perhaps driven by legal requirements), or when it becomes too rare and obscure to maintain, not when it wears out.

        Electrical is a little more predictable, but again it lasts forever with maintenance, or at least until people want to upgrade (more common). The one part which really does wear out, the abrasion of the wire, is again due to traffic rates, hard to predict in advance.

        I guess I’m saying that it’s unreasonable to include unpredictable costs of upgrades (because you’re just making up numbers then), and that the predictable costs are better included as a maintenance budget, rather than as depreciation.

  3. Danny says:

    I agree with what you are saying (net profits matter), but I do feel the need to say that accounting depreciation and actual depreciation are two separate matters. Accounting rules try to get things right, but there is a natural conflict of interest because depreciation can affect income so drastically. My company just revised a depreciation schedule on a single asset (one of 4 similar assets in the division) from 30 to 35 years, and that movement alone affected the directionality of net income. Furthermore, many depreciation rules are set by convention rather than by clear analysis of usage lifetime. If tax accountants are to believed (they aren’t), then cars disintegrate after 3 years and houses fall over after 30. The real world is much different.

    Of course this could mean that EBITDA and profits (from an abstract real world perspective as opposed to an accounting perspective) are much better than expected, but it could also mean that they are much worse. Given the credibility of CHSRA, my gut instinct is worse.

    • Nathanael says:

      Yep. As an investor I ignore depreciation in publicly reported documents, because it’s *meaningless*. I have to do my own estimate on lifetime of assets, maintenance costs, etc. — and worse, lifetime of assets is actually based on the company’s maintenance practices.

      At this point most serious investors look only at cash flow numbers, because the things added and subtracted to get the profit numbers (like depreciation) are simply too fudgeable. An investor has to analyze that sort of stuff — future cash flow requirements — on his (or her) own.

      The fact is that railroad infrastructure, if (a) built properly and (b) maintained properly, lasts for a very very long time; forever in the case of tunnels and earthmoving, hundreds of years in the case of properly maintained, unsalted concrete, and in the case of properly maintained stone bridges. Steel bridges, not as long but still decades. The railroad itself has weedkilling costs, and apart from that has to be renewed at a rate related to the tonnage passing over it.

      It’s not really even advisable to depreciate this stuff. Instead, good accounting practice is to work out the maintenance and “routine replacement” costs (which *are* predictable, assuming good materials) and include that in the operating costs.

  4. Just a note, but the HSR profitability outside the US link is borked, probably from leaving off the http:// when putting it in.

  5. Adirondacker12800 says:

    What Danny said. The accountants can’t make up their own rules. They are conservative in most cases. If you are selling 30 year bonds to build the Brooklyn Bridge you depreciate the bridge over 30 years. What’s the EBITDA on Interstate highways? Your median airport? Toll roads deal with costs much like a business, though they don’t have to pay much in taxes. Last time I looked it was 5 cents a mile to use the median toll road in the Northeast…..

    the plan mentions that the revised full-buildout ridership estimate for 2035 is 51-77 million, depending on fares, down from 69-98 million according to the 2008 environmental impact statement.

    How much of that is that ridership builds slowly? The 2008 business plan had the system opening in 2020. It would be a mature system by 2035. If it opens in 2033 ridership is still building in 2035. You have to compare 2022’s ridership to 2035’s ridership. There’s going to be some population growth in those 12 years complicating matters a bit. Has anyone calculated the costs of 13 years of congestion?

    • Alon Levy says:

      The business plan predicts that ridership will build up over 5 years from opening and then stabilize, complete with graphs of similar behavior on existing HSR lines in Europe. The assumption seems to be that growth after 2035 will be slow: in the footnotes to the table on page 115, they say that to compare 2035 numbers with 2040 numbers, they’ve reduced ridership by 0.5% per year. This is not very high growth.

      • Adirondacker12800 says:

        Five years after 2033 is 2038…

        • Alon Levy says:

          Most of the line is going to open in stages before 2033, giving ridership time to grow. That’s why the plan lists the LGV Sud-Est as having opened in 1981 rather than in 1983, when full high-speed service on the entire line opened.

          • Adirondacker12800 says:

            Opened in stages but was still a one seat ride wasn’t it? PATH to Trenton, an analog of BART to Livermore isn’t very attractive. Or the Raritan Valley line to Bridgeport an analog of change to Metrolink in Sylmar. The French has the equivalent of NEC Regional service to work with.

          • Alon Levy says:

            Yes, but the blended plan, scheduled to open in 2030, is still a one-seat ride.

  6. gelboak says:

    How plausible is a 51-77 million px / year ridership?

    I believe the NE corridor currently has a ridership of
    approximately 10 million px / year, and I think the
    CAHSR and the NE Corridor have not all that different
    population sizes in the respective catchment areas.
    And many of generally the metro areas in the NE Corridor
    have larger shares of their population in dense urban
    cores than is the case in the Bay Area, Sacramento,
    LA/Orange County & San Diego.

  7. Pingback: Do Not Compare NEC with HSR Ridership | Pedestrian Observations

  8. Nathanael says:

    Depreciation is economically real, but it’s also *a guess*.

    There are only a few things which have been around long enough for us to have accurate depreciation schedules for them. Things predicted to last 20 years last 10, or 5, or 50, or 100.

    Frankly depreciation is a guess, and a wild guess at that. A good depreciation schedule for earthmoving work, or for bored tunnels, is “it lasts forever, no depreciation”. A good depreciation schedule for *good* concrete work is 100 years (though some Roman concrete has lasted longer); while *bad* concrete work can fail after 5-10. And on and on.

    Depreciation is not even worth trying to compute on really large transportation projects. *Maintenance* you can compute (and should, and must, because deferring maintenance is VERY expensive), but depreciation relies on a guess as to useful life, a guess which is often off by an *order of magnitude*.

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