CN, Canadian Pacific and the power of the rail renaissance

By Tony Hatch

Although some skeptics seem to think the rail group is in a stall, given the mostly mediocre first-quarter financial and operating results relative to the rails' recent performance, a deeper look is required. The Q1 results, combined with other evidence — from rising consumer confidence to the earnings and pricing power demonstrated by key bimodal partners such as J.B. Hunt — offer hints of the brighter future to come.

Nevertheless, stock market skepticism certainly was evident during CN's April 20 webcast/conference call. The first two questions asked of CN President and CEO Claude Mongeau were about the wisdom of the Class I's announced 3 percent bump in planned 2015 capex! The railway financial audience is a tough crowd — they're not as short-term oriented as they're often characterized, but they're impatient with poor results. And the rails do seem to be "fighting the tape." But they won't be fighting it forever: The renaissance is alive and just waking from winter hibernation.

So far, it's the Canadians who are demonstrating the ongoing power of the rail renaissance. To be sure, they've been helped by the strong U.S. dollar. Regardless, it reinforces the lesson that it never really pays to bet against E. Hunter Harrison (EHH). Trying to make a case against the Canadian Pacific CEO's exceptionalism is getting harder to make. Nonetheless — or perhaps because of his professed "no interest" in M&A during the call (more on that later) — CP's shares retreated after its April 21 call, which was interesting. With all the attention shown to CP, it is CN, EHH's previous railroad, that is currently holding the best-in-class belt.

In Q1, CN reported by-now routinely terrific results that exceeded Street expectations. Most important, the railroad affirmed its 2015 guidance, even though volume growth is clearly slowing. CN showed strong growth in revenues (15 percent) and volumes (9 percent) compared with the same 2014 period. It also displayed its typical solid cost control, with a 390 basis point (bps) improvement in the operating ratio (OR) to 65.7.

Economic momentum is the only issue here — is it gone? Pricing power is there to stay (up 4 percent in Q1), barring regulatory regime change, which CN's vastly improved metric performance will forestall. In short: A longer-term view of CN likely will be as rewarded.

Whatever level to which the bar is raised, EHH, Keith Creel and team have managed to clear it. In Q1, CP's earnings per share of $2.26 represented a 59 percent year-over-year (YOY) improvement and beat consensus by 5 percent — it was "clean" as the large gain on the sale of real estate essentially offset costs associated with higher casualty expense and labor issues.

CP, too, affirmed guidance —without taking into account its new share buyback program. Volume grew 10 percent; revenue ton miles were up 5 percent and price/mix was up 1 percent. So: As CP improves operations (velocity up 22 percent, terminal dwell down 14 percent), there is room for improvement. There is also room for improvement in OR, which at 63.2 (down 880 bps YOY!) was CP's best-ever for Q1. CP also affirmed guidance for a sub-60 OR in the not-too-distant future. Bet against that? Not me.

Rail M&A no longer of interest?

In response to the expected question of EHH on railroad consolidation, he replied, as noted earlier, with a terse and completely unexpected "no interest." The investor/analyst response? Incredulity, and four questions, essentially all the same: "Really?" EHH's best answer: "Do you want a long ‘no interest' speech?"

My response? Focus on the myriad potential at CP and avoid the poor risk-reward ratio inherent in M&A at present — political, regulatory, cultural, operational, etc. But I admit, I also thought: Really? After all, later in the call, EHH said that shareholder activism in U.S. rails (à la Pershing Square/CP) was "long overdue" and "if I were a shareholder (in certain unnamed U.S. rails) I wouldn't tolerate some of it" — "it" being stock and operating performance, presumably.

Here's where EHH and I part ways: While the past six months have been rather lousy for U.S. rails, their Q1 results place them well into the upper tier of the S&P 500. They continue to spend to improve operations and service metrics are trending in the right direction. And they have beaten the stock market 14 years in a row.

Lighting fires under complacency every once in a while makes sense, and rails can do better. But it has been a pretty good century so far for the rail group, and I really don't see that changing.

Tony Hatch is an independent transportation analyst and consultant, and a program consultant for Progressive Railroading's RailTrends® conference. Email him at abh18@mindspring.com.