Where Are We Now
Updated on: 11/6/2021
CN Rail is the third-largest North American railroad, shipping unimaginable amounts of freight every year from coast to coast in Canada and through to the Gulf of Mexico. After a strategic shakeup that followed the failed acquisition of Kansas City Southern, it looks like CN Rail has brighter days ahead. However, we see shares as slightly expensive and would prefer to buy CP Rail today.
CN Rail aspires to return to its (strategic) roots by becoming the lowest-cost railroad operating in North America. We think management has the skills and resources to pull this off.
Long-term grain production, supply chains returning to North America, and general consumption growth will continue to drive growth at CN Rail.
The Canadian National Railway (“CN Rail”) offers rail and transportation services, operating as one of two Class I railroads in Canada and one of seven Class I railroads operating across the US and Canada.
CN Rail is competitively advantaged in three main ways: vast geographical coverage spanning three coasts, dense and capital-intensive network of rail, and strategical and technological innovation that constantly improves efficiency and operations. CN Rail is always one step ahead of its competition.
The railroad expressed much enthusiasm for an acquisition of Kansas City Southern ("KCS"), but this deal ultimately fell through when the Surface Transportation Board ("STB") denied CN Rail's proposed use of a voting trust. CN Rail has backed down and now has a renewed focus on costs and efficiencies, areas that CN Rail has historically addressed effectively.
With or without KCS, CN Rail has compelling growth opportunities – innovation in new technologies and strategies set the company up for margin expansion, growth in volumes and intermodal demand, and fleet expansion to support more growth.
Today, the company operates a network of railroads across Canada and the US, spanning almost 20,000 route miles of track across the two nations. CN Rail provides rail and related transportation services from coast to coast in Canada and south through to the Gulf of Mexico, the only railroad in North America with such connectivity. The railroad is considered a Class I railroad, transporting around 300 billion tons of goods to facilitate trade between importers, exports, farmers, retailers, manufacturers, and ultimate consumer.
In Canada, CN Rail operates in a duopoly alongside Canadian Pacific Railway. CN Rail also operates in a highly competitive and consolidated North American market among six other major railways:
Canadian Pacific Railway
Union Pacific Corporation
Norfolk Southern Corporation
Kansas City Southern
CN Rail Revenue by Segment (Q3 2021)
Source: CN Rail Investor Relations
CN Rail’s revenue sources come from two overarching segments. Freight revenues compose 97% of total revenues, with other revenues contributing to the balance.
CN Rail’s freight segment breaks down further into seven different product categories:
Intermodal (i.e., moving freight using two or more methods, usually in large standard-size shipping containers carried by shipping vessels, trains, and trucks)
Grain and Fertilizers
Petroleum & Chemicals
Metals and Minerals
Freight Revenue by Product (Q3 2021)
Source: CN Rail Investor Relations
CN Rail has enjoyed solid growth throughout the last decade.
Revenues have generally been growing at the mid single-digit level throughout the last decade. Despite the capital-intensive and competitive nature of the industry, CN Rail has impressively maintained operating margins around 40% consistently, alluding to the strength of its business.
CN Rail Revenue ($M) (Q3 2021)
CN Rail Operating Profit ($M) (Q3 2021)
CN Rail is the only railroad network in North America today that connects three coasts – the Canadian east and west coasts, down through the US Midwest to the Gulf of Mexico.
Operations and connections to ports across such geographical coverage presents CN Rail with a few distinct advantages. For one, the company can tap into a greater number of product verticals than other railroads. For example, CN Rail can transport oil from Alberta, Canada, and provide services for car parts and finished vehicles from Asia, Europe, and Mexico throughout North America.
Various product verticals and vast geographical coverage also means customer diversification – CN Rail collects roughly a third of revenues from US and Canadian domestic traffic, a third from transborder traffic, and a third from overseas.
The larger and more efficient the network, the more business a railroad wins. The more business it wins and the further it carries goods across its network, the more money it makes.
In the case of CN Rail, it has been hauling rising amounts of revenue ton miles (i.e., "RTM" or revenue earned for carrying one ton of freight over one mile). Additionally, it has been earning more revenue per RTM, showcasing the strong demand for CN Rail's transportation services across North America.
CN Rail Revenue Ton Miles (Millions) (Q3 2021)
Source: CN Rail Investor Relations
CN Rail Freight Revenue per RTM (Cents) (Q3 2021)
Source: CN Rail Investor Relations
There is no question CN Rail’s three-coast network provides one of the most attractive shipment options for customers, originating 85% of traffic on its network (as opposed to a transfer from another railway before the end destination is reached) and being the end carrier for over 65% of traffic. CN Rail currently only operates in the US and Canada, but it facilitates business from almost every continent.
Barriers to Entry
CN Rail currently covers almost 20,000 route miles of track across North America. This is the company’s most profound advantage when considered alongside its three-coast coverage. New entrants face four substantive barriers to entering the railroad freight business:
Large upfront investments to obtain regulatory approval, build the network, and differentiate routes from incumbents to capture customer interest, in a market that is already mature and vast.
Towering maintenance expenses to maintain productivity and the structure of the network. In 2020, CN Rail spent $1.6 billion on maintaining the safety and integrity of its network alone.
The Big 6 are allocating capital towards growth opportunities and technology. Expenditures are directed towards (1) increasing the capacity and flow of the network through track infrastructure, locomotive, and railcar investments, and (2) improving productivity, efficiency, and service reliability by investing in technology and physical capacity expansion efforts. CN Rail spent $1.3 billion in 2020 on such investments.
The Class I railroad market has been mostly consolidated. There are currently six main players in the market. In the early 1980s, 40 Class I railroads operated across Canada and the US. Industry deregulation sparked by bankruptcies, lowered productivity, and inefficient traffic in the 1980s set off a wave of consolidation that improved the pain points. Today, there are few opportunities to consolidate operationally, and a stringent regulatory environment is in place that discourages mergers and acquisitions in the industry. New entrants likely have negligible opportunities to partner with, or purchase Class I railroads in North America.
We believe that new entrants face near-impossible barriers to compete against incumbents, including CN Rail. Their investments would likely take years to pay off, not to mention the time it would take to build the network. Each railroad enjoys a geographical moat due to the capital intensity of their operations, density of established networks, and vast geographical coverage in this industry.
CN Rail pioneered Precision Scheduled Railroading (“PSR”), a strategy used by virtually all Class I railroads today. It uses point-to-point (i.e., direct transportation between two locations, avoiding any central hubs or stops) stops across its network of track and terminals to pick up and drop off train carts. The underlying idea of this methodology is to host a simplified network composed of many direct routes by using the same or marginally greater amounts of freight. Hunter Harrison, the ex-CEO of CNR, created this system to ensure each cart was used to its full potential.
PSR calls for the creation of a schedule to pick up and drop off carts at train terminals regardless of train length – the basis of traditional rail service – along any given route. This ensures carts are not sitting idle in a lot for extended periods of time, removes bottlenecks, uses physical and human resources to the greatest level of efficiency, and keeps the network flowing constantly. Rail companies that use this approach benefit from operating efficiencies, network speed, and customer satisfaction.
CN Rail is now building “Digital Scheduled Railroading” (“DSR”), another ‘’first” in the industry that builds upon PSR with an extra layer of advanced technology and automation to further improve the capabilities of its strategy. In simpler terms, DSR is PSR wrapped in technology. DSR has several important implications:
Improved Safety – Artificial intelligence and powerful sensors allow for more inspections at a higher standard of quality.
Depth of Fleet Inspection – Ultra HD cameras help detect minute defects before they become major issues and result in large retrofitting expenditures.
Customer Uses – Customers can tap into the DSR’s suite of interfaces to track shipments in real-time and gain greater visibility into their own supply chain systems.
CN Rail is benefitting tremendously from these efforts – the company is now able to inspect 20 times more track than the pre-DSR era, defects are identified on an automated basis before they become grossly destructive, and it boasts the highest fuel efficiency out of any Class I railroad, consuming 15% less fuel per gross ton mile than the average Class I North American railway peer.
CN Rail sees the way forward is to invest in technology to increase efficiency, keep customers satisfied, and enjoy higher revenues and margin expansion in the process. Other railroads are not as technologically inclined as CN Rail, granting the railroad with a unique technological advantage over other North American railroads. We expect operating metrics to continue to improve throughout the intermediate time horizon as these efforts translate into efficient spending and growing revenues.
Alleviating Truck Shortages
The COVID-19 pandemic sent a seismic shock across the world, changing how regular business is conducted. Although truck shortages were already a problem before the pandemic, the pandemic exacerbated these shortages as driving schools closed and adoption of ecommerce exploded. Companies choosing trucking freight to ship their goods currently face two main issues:
Delays in shipping
Heightened shipping rates, both of which negatively impact their business.
Companies, therefore, are looking to alternatives to ship their goods. A viable alternative to alleviate these concerns becomes an intermodal service for effective land transportation.
Intermodal rail services provide a cheaper, more efficient, and more environmentally friendly option versus trucking.
However, trucking is still important – rail cannot get to every destination as it is rather inflexible. CN Rail is on top of this trend – it operates CNTL Trucking Services and closed its acquisition of TransX – a Manitoba-based trucking transportation and logistics service with 1,500 trucks, 4,000 tractors, and 1,000 intermodal containers – in March 2019 to supplement its rail intermodal services and provide customers with efficient transfers between rail and trucks all the way from the ocean port to the warehouse.
We believe CN Rail will win as demand for rail intermodal services picks up amid unfavourable trucking pricing and operational dynamics. CN Rail’s three-coast network, rail-truck hybrid intermodal model, and rising domestic import volumes should drive its intermodal freight rates higher and increase market share as well.
Growing Against the “Grain”
A major part of CN Rail’s freight revenue is generated from grains and fertilizers. This is due to the growing demand and production of grains, primarily in Canada. In fact, the production of grain has grown by nearly 40% since 2005. This trend is not over – tight global grain supply and increasing global demand will continue driving Canadian grain production higher.
CN Rail’s consistent reinvestment into its business allows it to increase workloads and transport volume as more products seeks their network for distribution. To accommodate for the growing demand of grain, CN Rail has begun using high-capacity grain hoppers to substitute their traditional trains. These trains are shorter, lighter, and possess the ability to transport 30% more grain per cart. For now, CN Rail uses 4,200 hoppers. In traditional CN Rail fashion, this number will expand to 6,000 as part of a three-year expansion program CN Rail announced in May 2021.
CN Rail’s dominance is apparent in the Vancouver market, where farmers are increasingly turning to CN Rail to transport their grain. Nearly 50% of all grain transported from Vancouver is transported solely by CN Rail. The company saw this as a green light to open 24 new facilities to accommodate for this influx of grain transportation.
Full Speed Ahead
Earlier this year, Canadian Pacific Railway (“CP”) announced a proposed acquisition of KCS for US$29 billion (including debt). These plans quickly fell apart after CN Rail approached KCS with a ground-breaking US$33.6 billion rival offer, in the form of $200 per KSU share and 1.129 shares of its own stock.
Unfortunately, the STB rejected CN Rail's plan to use a voting trust in a release made on August 31, 2021. The voting trust was a key piece of the puzzle that KCS shareholders demanded from the get-go. Consequently, KCS accepted CP's raised bid of $31 billion made in August due to greater deal certainty - the STB had already approved CP's request for a voting trust in early 2021. Today, acquisition talks with CN Rail are officially off the table.
Now, the question investors are asking is - what's next for CN Rail? For one, CN Rail will recoup US$700 million that it paid to CP to cover the break fee between CP and KCS. Secondly, CN Rail will receive another US$700 million from KCS due to the deal falling apart. Lastly, on the strategic front, CN Rail is refocusing its efforts on other initiatives and doing more of what it already does great.
CN Rail's management team has subdivided its focus into three main initiatives: (1) Cost Optimization, (2) Leveraging Past Investments, and (3) Revenue Opportunities.
In light of the CN-KCS fallout and some short-term revenue weakness (see "Risks" below) expected primarily from the grain business, CN Rail will be allocating lots of resources towards bringing costs down and margins up.
Management intends to drive shareholder value - defined internally as achieving a 57% operating ratio (i.e., inverse of operating margin) by 2022 - using a cost optimization method by:
prioritizing rail operations (increasing car velocity, train speed, and train length) and
rationalizing costs (streamlining management, especially in support departments, to increase productivity).
As long as management executes according to plan, CN Rail shareholders could see $700 million in operating income expansion despite some short-term revenue weakness.
Leveraging Past Investments
A major component of CN Rail's "Full Speed Ahead" program is the ambition to maintain capital spending at around 17% of revenues through 2024 unless competition increases or other unfavourable events arise.
CN Rail has been wrapping its operations in technology to reduce costs and improve efficiency. These investments will especially come into play now as management looks to 2022 capital spending.
CN Rail's high-return investments both increase the opportunity for margin expansion and reduced capital spending, boosting operating margins and free cash flow, respectively.
If indeed it costs less to maintain its railroad network on a go-forward basis, CN Rail can retain more cash and return capital to shareholders.
The greater the amount and quality of free cash flow, the greater the odds are that management deleverages the balance sheet and opens up the floodgates for share repurchases and other growth-type business investments in the future.
According to CN Rail's plans, C$1.1 billion of share repurchases will be conducted by the end of January 2022 and total distributions (share buybacks and dividends) could be authorized for an amount of up to C$5 billion for the 2022 year.
Despite weak Canadian grain production between 2021 and 2022, CN Rail expects to support its cost optimization efforts with volume growth in 2022 and increasing pricing ahead of rail inflation.
CN Rail boasts a massive three-coast network with ancillary services to help many types of goods move around the North American continent. The company also has a relentless focus on making its operations as efficient as possible. Not only does this boost the bottom line, but customers love it too.
Efficient operations, a high-demand service, and a vast three-coast network are the factors that contribute to CN Rail's pricing power. As such, we believe it is possible CN Rail comes out relatively unscathed next year despite grain volume weakness. If it does, the $700 million operating income lift should be a breeze for the railroad operator.
Overall, we think the CN-KCS deal fallout may prove to be a good thing. Management appears to have a clear path towards greater profitability, outlining several avenues for margin expansion, capital spend reduction, and growth opportunities.
CN Rail is a fantastic operator and a true premier North American railroad with a vast network. "Full Speed Ahead" focuses CN Rail's efforts on what it does best - keeping costs down and providing outstanding freight services.
A Blessing and a Curse
While we believe CN Rail's grain-affected business will grow over the long run, the company is facing some headwinds in the near term.
The Canadian Prairies and west coast are experiencing lots of extreme heat, pulling forward crop harvesting and reducing crop yields. In 2022, CN Rail sees grain volumes dropping 35-40% rather than its initial forecast of +5%.
Grain and fertilizers make up about one-fifth of CN Rail's revenue. The substantial drop in grain volumes will certainly be noticeable and could put pressure on shares through the end of 2022.
CN Rail depends on chips for the transportation of automotive vehicles. This chip shortage has significantly decreased the incoming supply of vehicles. Although these effects are likely transitory, we are uncertain as to the length and extent that these shortages will continue and may pose a financial risk to CN Rail over a longer time horizon.
CN Rail Automotive Revenue ($M) (Q3 2021)
Source: CN Rail Investor Relations
Virtually all of CN Rail’s revenues are generated from industries that fluctuate significantly with the market. When the economy does poorly, or any of these sectors struggle, CN Rail’s financials could face strong headwinds in the near term.
Joe Biden’s recent executive order issued to the STB to examine rail competition may set a new precedent in the market that puts consolidation further out of favour and hurts profitability for the railroads.
This order may prevent railroad consolidation in the future, place a cap on freight rates, and increase costs for the railroads, including CN Rail.
The railroad industry has been heavily consolidated since the 1980s, leaving little room for further consolidation. The industry is mature and one of the only ways for a company to grow is through acquiring other companies. With KCS no longer a target, it does not appear there will be any compelling opportunity for consolidation for many, many years.
About 70% of CN Rail's workforce is unionized. Disputes relating to the renewal of collective agreements could result in strikes and major business disruptions, adversely impacting CN Rail’s competitive positioning and financials.
CN Rail has been the pioneer of in the railroad and transportation industry since 1919. It is among the ten largest companies in Canada by market cap, and with good reason – it is one of two Canadian railroad and one of six North American railroads that provides exceptional tri-coastal railroad freight coverage across North America, facilitating crucial domestic and world trade throughout Canada and the US.
CN Rail has grown to the powerhouse it is today because of its unique network of railroads, industry dynamics keeping competitors out, and its focus on continually improving the PSR and DSR technologies. These competitive advantages allow CN Rail to take advantage of current market opportunities – the growth of grain production, favourability in using intermodal services over more expensive trucking, and a clear path to greater profitability and shareholder returns. We believe the rails are compelling portfolio holds, and CN Rail is at the top of our list.