For What It’s Worth – Q1/19 CN Earnings Shortfall Reveals Underlying Strength

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I think it’s time we stop, children, what’s that sound?  Everybody look what’s going down….

What’s that sound?  Canadian National’s Q1/19 (slight) earnings shortfall made it the second railway – and the second, of two, Canadian Railway, to report below-consensus results – but, as with CP, they harsh winter added to the other distortions (trade, Albertan market interference, etc) to make this quarter’s results hard to decipher and less important than CN becoming the second Canadian to reiterate full-year expectations despite the slow start.

A field day for the (cold):  CN’s CEO JJ Ruest informed us that CN faced ~7 weeks of Tier 3 and even Tier 4 cold – in light of that a 17% increase in adjusted/diluted EPS and an 11% revenue increase that, matched the cold-brewed 11% expense increase was actually pretty darned good  (1% of the expense was a PTC charge).  The (adjusted) OR actually improved 60bps to 67.2% - but remember last year was the congestion-winter of CN’s discontent.  Volume was up 1% - you can track the weather impact on their slides, plus the “nosedive” in CBR due to the provincial government’s heavy-handed market interference.  Operating metrics declined in many categories (train velocity down 1%) but showed improvement in dwell (-12% versus last year’s congested performance) and car velocity (up 8%).  The injury and accident rates ticked up, too.  CN didn’t delineate the winter hit to earnings, which on the one hand would have made all of our lives easier, but on the other is a cool way of saying this is just….the rail business.

There’s something happening here:  Resiliency and recovery – along with “railway” one of the Three Rs of CN.  The railroad is now fully fluid, the outlook looks bright – high single digits for the FY19 means quite a strong last 8 months of the year – but CN believes that will happen even if CBT doesn’t ramp back up to December (pre-Albertan interference) levels.

Getting so much resistance from behind:  There was the expected avalanche of questions on both OR and Capex.  CN is in so many ways not only the PSR “mothership” but also the post-Hunter, PSR 2.0 model.  And that costs money – Capex at $3.9B will be solid-mid-twenties (as a % of revenue), for locomotive fleet renewal as well as capacity – including “surge” capacity, yes – additions.  The Capex surge years were planned at 2018-19 – but expect a steady, higher than average (~20%) level on an ongoing basis.  But their growth rate (upper-single digit RTM guidance, despite starting the year at +3%) will be at the top and their ROIC (15.7% for 2018) clearly justifies the expenditure. 

There are battle lines being drawn:  After the Nth question on OR, CN’s CEO Ruest decided to explain their philosophy:  See their ROIC, above.  Lower OR can be achieved, for sure (and CN has the most annual gold records in this category in modern times) – but it “depends on how much risk you want to take on”, defined here as risk of demand as well as “harsh conditions” (to which I would add political).   Describing OR as a “one-trick pony” (and the new PSR-led focus on it a “limbo contest”), Ruest continued: “What you’re seeing from CN is a more balanced scorecard – EPS growth and especially ROIC - than strictly pure PSR”.  OR isn’t unimportant or useless, it’s just not the be-all and end-all (see “OR, Cult of”)….

Paranoia strikes deep? OK, there are always risks.  I, for one, do not place Capex/growth focus in the risk bucket, but there are some things there.  One is off-rail investing - TransX, a ~C$400mm acquisition, was a hot topic and Halifax’s new port operator is “known to” CN, but isn’t CN.  Maybe….that’s a good thing.  Another is the recent surge in management changes/restructuring, which was covered to some degree by an appendix slide,  but requires more information and exposure.  So….

Singing songs and carrying signs – CN is raising the (or, the more experienced might say, restoring) the bar for Investor Relations by hosting an Investor Conference June 3-4 in Toronto  - their second in two years– and one not inspired by a historic change in operating plans, but because it’s what they should do.  I am sure we’ll hear about technology as well as growth plans both on and near their network….


Anthony B. Hatch
abh consulting