RR Q2/19 Preview:/CP Out-performs - Better Late Than Never?

Greetings;

So, due to project work I am a day late and a dollar short with my Q2/19 Railroad Earnings Preview since….Canadian Pacific reported their excellent/positive surprise earnings this morning (see below), which we may come to look at slightly as a “false positive”. (suggested by CSX’ reported results, pre-webcast). At least I beat frequent leadoff batter CSX, dropped to the two-hole, who reports later today. The general trend of the rail group’s earnings will fall below CP’s leadoff standard – Canadian traffic was up for the quarter, US volumes down, for one thing, and their PSR journeys are several life cycles ahead, for another. But, in the scheme of things, given expectations of overall market (S&P 500) earnings being flat to down and against tough YOY comparisons, the consensus expectations of +6% EPS, aided by buybacks to be sure, seems pretty good (and will, as with CP, prove low by some 50%). Transportation analysts have been crying poor and cutting numbers all spring and summer, so far (FDX didn’t help) – but the rails, the only good performing transport sector, continue to outperform the broader markets (YTD S&P500 +19%, rails +~30-35% ex-GWR). That is not to say the volume trends (~--3% for the quarter but -5% in June) aren’t troubling – they are….before we look to that subject, here’s what we expect to hear and/or hope to have answered on the webcasts:

  • The state of the economy as the rails see it – this will be perfunctory

  • The level of (expected) guidance takedown – after the poor, rain-drenched results of Q1/19, the rails as a group reiterated their FY119 guidance – that looks less likely now….

  • In the US, the state of the PSR transformations, of course– remember NSC just this month began rolling out Top-21. I expect general positive commentary on productivity expectations and metric improvement trends – maybe this time investors will finally believe that UP, NSC and KSU are “in it to win it”….NSC is already showing solid metric improvements

  • The state of the competitive situation with trucking – in other words, why is intermodal doing so poorly, again? I/S rations a la H2/15? PSR? The coming peak season expectation has been described as “subdued” – from here and from a rail perspective, “subdued” seems aspirational!

  • An update on energy – Canadian and interline CBR; the level of government interference reductions in Alberta, etc

  • Updates on price (we expect still solidly “rail inflation plus despite the volume trend)

  • Updates on Capex, PTC and overall IT spend (the latter especially after CN has thrown down the gauntlet at their Investor Conference last month….).

  • Updates on line segment sales (and, perhaps, purchases). The gold rush in North American rails is on full-force and, in many ways, is the rail story of 2019 so far….

Volumes have been shockingly weak – we know there are six basic reasons. Here is the WSJ on “Railroads Carrying a Lighter Load as economy Slows”: https://www.wsj.com/articles/lighter-loads-weigh-on-railroads-11563235311?mod=searchresults&page=1&pos=1 ). The breakdown by rail is interesting – the Canadians are up (more so CP – up 6% to 1%); the Big 4 US all down ~4% (despite BNSF not “doing” PSR and CSX being the only one to publicly shed business). KSU was down “only” 1%. So, to determine what is going on, we need to determine how much weight we should put into each bucket:

1. The economy, still throwing off mixed signals - weakness in manufacturing (note autos, steel, housing) but “good jobs numbers”. Overall, consensus sees a slowdown, but not as bad as the usually correlating rail loadings would suggest.

2. Trade – yes, the recent threat to add tariffs to Mexican trade (in violation of NAFTA) was removed, for now, and there is a truce with China (note – that simply removed the (immediate) threat of further tariffs). But China has yet to resume purchasing US Ag (soybean)

products….see below. If nothing else, trade-by-tweet has severely disrupted the market. The dollar, meanwhile, was up 6% in Q2/19, which used to be good for international intermodal but….

a. China’s GDP growth for Q2 of 6.2% is both suspect and the lowest level in decades; US imports from the PRC are down 12% YTD-May. There is a lot of speculation about re-engineered supply chains away form China but the key issue is….to where? The answer seems to be – elsewhere in Asia, and to Mexico! But not re-shored – (The Economist) “There is little evidence of US manufacturing bringing production from China (back) to the US”.

b. Mexico – AMLO is going “off the reservation, as the whole imbroglio surrounding the resignation of his Finance Minister showed (see also B:oombergBusinessWeek on his $8B (self-estimated) vanity project, the Mayan Train. Meanwhile, the economy may be tilting toward a recession (although the biggest YTD gain in exports to the US was Mexico - +_$10B while China was -$25B).

c. Trade overall continues to be worrisome for rails (recall that well over half of the rail business is trade dependent or related). The OECD estimated global trade growth of 2.1% for this year; in 2017 it was almost 6% .McKinsey notes that 16 of its 17 “major industries” worldwide have contracted their supply chain….protectionism is on the rise of course, but the economy is slowing, threats (often IT-related) are increasing, ocean shipping getting more complicated (IMO2020) and erratic (slow steaming)….

3. Weather – It is the wettest year ever in the US and the Midwest is still drying out (estimated economic losses - $12.5B, worst of all-time) and the flooding disruptions still impacted Q2/19. In addition, the water-logged fields are leading to poor crop outlooks (the USDA reduced the corn production numbers by 8% - from May). CP noted in its call the unprecedentedly long duration of the flood problems….

4. PSR – the operating changes have two impacts on volumes, plus two stages.

a. The first impact is the hard-to-quantify volume share loss as (some) shippers try to avoid playing in the revolutionary stages of the PSR story; this may be less pronounced than recent history since essentially everybody is doing it (as Matt Rose warned), but CSX is ahead of NSC and BNSF isn’t playing (I can hear the chorus – “yet!!”). This share historically returns, in spades, as the metrics improve….

b. The second impact is planned volume loss (AKA de-marketing) – we haven’t heard much about this, partially given the heightened STB focus on the process (after CSX) – but we do know that CSX planned a second ~7% volume reduction this year in Intermodal (roughly its current run rate, BTW – are they therefore running flat without the planned lane eliminations, etc?)

c. The first stage of PSR is creative destruction – lane closures, using assessorial charges to “change customer behavior”, cuts in personnel, etc

d. The second stage of PSR – We the North! – is (to quote CP) the “pivot to growth”!

5. Trucking competitiveness – after a year (2018) of extreme capacity shortage, the world has turned upside down – with one immediate effect of shrinking the historic gap between truck and rail/intermodal pricing. This will not last forever….

6. Tough comparisons – mid-single digit growth in Q2-3/18, fueled of course and in part by….the tax cut.

Canadian Pacific Q2/19 Quick Takeaways – Slowdown? What slowdown?

While the industry and its investors is in general worried about volumes, CP grew volumes (both RTMs and, my preference, units) by 6% and revenues by 13%,, beat the Street(s) by 15 cents and Q2/18 (adjusted) by fully 36%. By holding operating expenses (FXA) to a slight (1%) increase, they dropped their OR by 580bps – to 58.2%. and – kudos! – they announced their LTM ROIC was 16.8%. That – the result and the announcement of it – was huge. Other highlights:

  • All 6 operating/safety metrics improved, the latter, after a tough, cold Q1, by 25-30%

  • They raised the DPS by 28% and stated they could raise their FCF Conversion rate from ~55% to ~75% in the next few years

  • CEO Creel et al faced off on 3 basic questions, asked a few different ways:

    • o Comparisons get tough in H2 (just as the economy may be cooling) – can you handle it. A: Yes – both in terms of lowering variable costs (and always reducing fixed costs) and due to planned growth in areas like autos, where business development led to 5% unit growth (+12% revenues) in Q2/19 – significantly better than auto traffic industrywide.

    • So, aren’t they being too conservative in their OR projections (-100bps/year to the “mid-fifties”)? Perhaps….

    • CBR – how big and when? CP wont gamble capital on a short term business but expects a solid H2 (enough, along with autos, Forest Products, export coal and potash, and intermodal to make up for any overall slowdown this fall) and beyond – for 3-5 more years….

  • CP gained $35mm in incremental revenue from short lines YTD – a good yield from their renewed focus

Some other important rail news:

  •  CN, as promised, named its Chief digital Officer (David Trent)

  • CP names former AAR CEO Ed Hamberger to its Board of Directors – that is one great move.

  • BHP is considering divesting all of its thermal coal assets (a la Rio Tinto). ESG investing is….winning. is the plastics category the new Coal?

  • Logistics Management magazine listed its annual G75 green transport companies with 6 rails on the list (so, notable by exception are CP and KCS). Maersk and most notable IMCs made the list….

NOW ON TO CSX!

Anthony B. Hatch
abh consulting
http://www.abhatchconsulting.com
abh18@mindspring.com