Stock Investing

It still sets the standard for railroad profitability.
By Keith Schoonmaker | 12/03/12

Canadian National Railway Co. CNR sets the standard for railroad profitability; its operating ratio has led the pack for a decade. By transport industry convention, operating ratio is operating expenses divided by revenue; thus, a lower value indicates a higher margin on earnings before interest and taxes.

About the Author
Keith Schoonmaker, CFA, is director of industrials equity research for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. Before assuming his current role in 2012, he was an equity analyst covering the transportation industry. Prior to joining Morningstar in 2007, Schoonmaker worked for more than a decade in product development and consulting in the paper industry. Schoonmaker holds a bachelor’s degree in chemistry from Wheaton College and a master’s degree in business administration from Northwestern University’s Kellogg School of Management. He also holds the Chartered Financial Analyst® designation. In 2011, he ranked first in the industrial transportation industry in The Wall Street Journal’s annual “Best on the Street” analysts survey.

As we show in the graph below, all large railroads except Canadian Pacific CP -- CSX CSX, Kansas City Southern KSU, Norfolk Southern NSC and Union Pacific UNP -- have improved their operating ratios materially since 2003, but CN's were still 10 to 20 percentage points better than peers for most of this period. Even with strong improvement, CN's profitability is still 7 to 8 percentage points higher than most others. We don't believe higher margins at other rails hinder CN. However, management expects that a $120-million increase in pension expense will hurt the 2012 operating ratio by about 1.25 percentage points, or about a 4% headwind to earnings per share. This stems from pension accounting assumptions, chiefly the low discount rate and loss amortization.

CN is not resting on its laurels, but continues to drive down its operating ratio, which was 63.5% in 2011. The firm does not offer rebates and targets inflation-plus pricing -- it increased core prices about 4% in 2011. The firm applies its fuel tariff universally and does not discount, but says it offers the cheapest fuel surcharge in the industry thanks to its excellent fuel efficiency (it claims 15% better than the industry and a 3% fuel productivity gain in each of the past three years). The company also shuns incremental capacity pricing (like airlines offering cheap fares to fill every seat, then eventually flying a plane full of discount tickets).

In operations, the firm is consolidating Chicago yards by expanding Kirk Yard, building long sidings in key locations, adding double track and new connections to recently acquired Chicago congestion bypass route EJ&E, and continuing to make broader use of distributed power -- nearly half the high-horsepower fleet will be DP-equipped by the end of 2012. The railway also is attempting to reduce gaps between double-stacked containers on intermodal cars to improve aerodynamics and fuel economy.

CN continues to emphasize its first-mile/last-mile initiatives. For instance, scheduled trains for grain, potash and coal enable CN's clients to hire labour when rail cars will be on hand, scheduling adequate personnel perhaps on 24-hour shifts to quickly turn rail assets. CN is establishing shared key performance indicators and real-time scorecards with its partners (like port operators) and customers, and increasingly managing customer car fleets. An example is the scheduling of iron ore deliveries to serve mines and steel mills well by putting one CN logistics enabler in charge of watching inventories, then scheduling CN trains to meet arriving Great Lakes ships to optimize utilization of all assets while avoiding supply depletion at the end user. Another example is pulp and lumber customers' ability to have short-lead-time car orders fulfilled with greater frequency. Previously, under the precision railroading model, customers had a Wednesday noon cut-off to place orders for the following week. But now clients still can obtain 65%-70% fulfillment for extra orders placed with just three or four days' lead time, and at any time the CN truckload fleet can haul containers to flex supply.

Customers want information on their box arrival times and duration until their boxes arrive at the destination dock, not CN's average network-wide performance. CN's provision of such specific information, coupled with velocity and reliable delivery schedules, helps shipping lines win business from beneficial owners of cargo. The strategy seems to be working; since 2009, CN has increased West Coast (Rupert and Vancouver) container volume 65% in the United States and 32% in Canada, or 38% overall. CN recently purchased 2,000 containers, including 1,200 heated and 400 superinsulated boxes, to protect shipments from arctic Canadian winters.

CN is training its sights on myriad growth opportunities. CN targets doubling its coal franchise by 2016. While coal constituted just 7% of the 2011 revenue portfolio, terminals CN serves at Prince Rupert, Vancouver and New Orleans are all increasing export capacity. Unknown just a few years ago, new oil and gas mining techniques demand frac sand, and CN's track is well placed to serve sand sources in Wisconsin. Indeed, management says frac sand could be a $300-million business by 2016. Potash also holds great potential.

While CN had about 60% of the domestic potash shipping market share in 2009, the larger 4.3 million-ton export market has been dominated by Canadian Pacific. CN aspires to expand its share to half of the exported potash market by 2016 from nil in 2009. This would increase sales from $55 million in 2009 to around $300 million in 2016. The firm believes it has ample runway to increase volume.

Importantly, CN is highly exposed to a commodity it calls a sleeper, one we've considered a call option on a housing recovery. At 20% of revenue just a few years ago, CN is more exposed to lumber and paper products than are other railroads; while the paper market is in secular decline, we believe the U.S. homebuilding market will eventually recover and rekindle lumber demand -- requiring CN's services and sparking earnings growth.

We don't think the shares are currently undervalued, but we do think CN is the low-risk option among railroads. CN already produces the best operating ratio of its peers and continues to execute without faltering. The range of margin outcomes is narrowest at CN, in our opinion. In 2012, CN projects it can increase carloads at a mid-single-digit pace (faster than the economy) and raises prices faster than inflation to produce 10% earnings per share growth despite the $120-million pension headwind.

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