CN, Under Siege from TCI, ‘Redefining.’ Will it Work?

Sir Chris Hohn, TCI Fund Management Ltd.

“Railroads cannot achieve long-term prosperity and remain viable businesses through massive cost-cutting—rather than cost controls—and providing shareholders instant gratification through share repurchases,” noted one industry observer to Railway Age. “You cannot get trapped in the ‘Cult of OR,’ as analyst Tony Hatch has coined it, and the world of stock buybacks and price/earnings ratios of 20x to 22x. The employees who will lose their jobs under CN’s plan will be, in the slim chance the shareholders reject TCI’s takeover bid, collateral damage resulting from a power struggle. Of course, there are no guarantees that TCI will not insist upon similar draconian measures.” 

THE COWEN INSIGHT

Jason Seidl

“In what we view as an attempt to fend off an activist push to replace the CEO and Board members, CN announced some aggressive initiatives that are set to take place over the next year,” comment Cowen and Company analysts Jason Seidl (Managing Director and Railway Age Wall Street Contributing Editor), Matt Elkott and Elliot Alper. “These initiatives—with activists breathing down its neck—include cost reductions, getting more aggressive on taking rates up, larger share repurchase plans, lowered capital spending and strategic reviews for several non-core assets. In total, management expects these actions to yield EPS grow of 20% in 2022. 

“CN management called for mid-single digit growth in revenue ton-miles for 2022, despite a Canadian grain harvest that has been very disappointing. Indeed, the prior outlook for up to a 5% increase for Canadian grain has been shifted to a drop of about 37%. Management appears primed to lean into pricing a bit more for next year as there was a subtle but notable change in forecasting language. In prior calls, the railroad called for pricing ‘above rail cost inflation’ but now is calling for ‘pricing well above rail cost inflation.’

“CN got even more aggressive in its outlook for reducing its OR. It is now calling for an OR of 57% next year, well ahead of our prior 60.2% estimate and ~5 full points better than our forecast for 2021. While growing volumes and getting more aggressive on pricing will be two of the levers the railroad utilizes to achieve its new lofty goals, cost-cutting is also expected to play a large part: $550 million in total costs are targeted, with $250 million coming from salaries/wages/benefits, $250 million from lowered purchased services—cutting all consultants at the railroad—and $50 million in insurance/other costs. A large part of the reduction in salaries/wages/benefits should come from headcount reductions where the company is targeting 650 jobs coming out of management/back office and another 400 unionized operational jobs slated for the proverbial chopping block.

“CN is also conducting a strategic review of all its non-core assets. In total, these businesses are accretive to earnings and generate free cash flow but decrease the company’s OR by about 200 basis points. Based on its comments, it appears CN will either sell or shut down its small freight forwarding operation while tweaking how some operating companies conduct business.

“Management threw some proverbial shade on CP’s proposal to acquire the much-coveted KCS asset by saying it was far from a ‘slam dunk’ that would pass regulatory review. Although CN clearly tried to spin its failed bid to acquire KCS as a positive—getting breakup fees and learning about potential revenue opportunities from its customer base during due diligence—it was not an overall positive for the Canadian rail giant. We believe the CP/KCS transaction will ultimately receive regulatory approval and close, thereby making CN’s largest competitor stronger. 

“CN has historically been one of the best-run North American railroads. However, cost headwinds may prevent it from posting margins that some of its peers appear poised to achieve. The company reaffirmed its 2021 outlook and targeted 20% EPS for 2022. While we are choosing to be somewhat more cautious. We are raising our 2022 EPS forecast to C$6.70 (US$5.40) from C$6.50 (US$5.25). This represents a roughly 15% improvement over our forecasted 2021 estimates and calls for an OR of ~59%. We are also raising our multiple a turn to 22x to reflect a more focused outlook for the railroad. This brings our price target to $119 from $110, and we reiterate our Market Perform rating.”

THE BLAZE PERSPECTIVE

Railroad economist and Railway Age Contributing Editor Jim Blaze offers this perspective on the pros and cons of share repurchases:

“Good deal or bad, considering the balancing of the long term outcome of these public/private rail freight franchises? 

“Companies that generate the free cash flow (FCF) required to steadily buy back their shares often have the dominant market share and pricing power required to continuously boost the bottom line. A buyback often signals that a company believes its stock is undervalued, and that a buyback represents the best use of its cash at that time. In many cases, a company’s optimism about its future pays off handsomely over time—but not necessarily. 

Jim Blaze

“On its balance sheet, a share repurchase will likely reduce a company’s cash holdings—and consequently might reduce its total asset base—by the amount of cash expended in the buyback, unless offset by buying debt. The buyback could simultaneously shrink shareholder equity on the liabilities side by the same amount. As a result, performance metrics such as return on assets (ROA) and return on equity (ROE) typically improve subsequent to a share buyback. Will that occur for the PSR railways?

“Danger signals: The proportion of buybacks funded by corporate bonds reached as high as 30% in both 2016 and 2017, according to JPMorgan Chase. The International Monetary Fund’s Global Financial Stability Report, issued in October 2019, highlights ‘debt-funded payouts’ as a form of financial risk-taking by U.S. companies that “can considerably weaken a firm’s credit quality.’

“It can make sense for a company to leverage retained earnings with debt to finance investment in productive capabilities that may eventually yield product revenues and corporate profits. Taking on debt to finance buybacks, however, might reflect poor management tactics, since little investment into new revenue-generating investments are made that can allow the company to pay off the debt. 

“In addition to plant and equipment, a company needs to invest in expanding the knowledge and skills of its employees, and it needs to reward them for their contributions to the company’s productivity. These investments in the company’s knowledge base fuel innovations in products and processes that enable it to gain and sustain an advantage over other firms in its industry.

“The investment in the knowledge base that makes a company competitive goes far beyond R&D expenditures. In 2018, only 43% of companies in the S&P 500 Index recorded any R&D expenses, and only 38 companies accounted for 75% of the R&D spending of all 500 companies. Whether or not a firm spends on R&D, all companies have to invest broadly and deeply in the productive capabilities of their employees in order to remain competitive in global markets.”

‘FULL SPEED AHEAD,’ IN CN’s WORDS

“The plan announced [Sept. 17] builds upon CN’s January 2021 strategic plan to lead on safety, customer value, operational excellence, sustainability and social inclusion, while also delivering industry-leading shareholder returns,” CN said. “CN is a unique franchise with 19,500 miles of railroad network connecting Canada’s Eastern and Western coasts with the U.S. South. As the only railroad with this three-coast access, CN has the best rail network in North America to drive long-term, sustainable, profitable growth. 

“CN has outlined a plan that is both ambitious and achievable. Our focus will be on redefining railroading, driving profitable growth and making structural improvements for the next generation. CN has conducted an extensive review of all revenue and cost levers and has targeted C$700 million of operating income improvements to drive future growth. To achieve these improvements in 2022, CN intends to use a balanced approach that includes a strategic review of non-rail businesses and an optimization of labor productivity. For 2022, CN expects to grow operating income and EPS) by approximately 20% and improve its operating ratio to 57%. Additionally, CN is reviewing its capital structure and financial leverage with a view to increasing total shareholder distributions. 

“CN is committed to operational excellence and delivering value for its shareholders by: 

  • “Resuming share repurchases: CN will recommence share repurchases under the plan previously approved by CN’s Board of Directors in January 2021 and expects to complete the remaining C$1.1 billion of share repurchases by the end of January 2022. 
  • “Increasing shareholder returns: CN is reviewing capital structure and financial leverage with a view to increase total shareholder distributions, including share repurchases in the range of C$5 billion for 2022. 
  • “Reducing capital expenditures: CN expects to reduce capex to 17% of revenue in 2022 as a result of the current good condition of its network and the Company’s continued absolute commitment to safety and customer service. CN expects to maintain capex at 17% of revenue for 2023-24 unless there are significant market shifts. 
  • “Producing compelling financial returns: CN is committed to driving top-quartile Total Shareholder Return (TSR), leading the industry in organic revenue growth driven by CN’s intermodal business and showing continuous improvement on its operating margin. 
  • “Lowering its operating ratio: CN is targeting an operating ratio of 57% for 2022 by: 
  • “Prioritizing rail operations, including car velocity, train speed and train length, and committing to pursuing strategic alternatives for adjacent non-rail businesses that are not best-in-class. 
  • “Rationalizing its cost structure by streamlining management, especially support functions, to improve labor productivity by accelerating speed and quality of decision making. 

“CN believes an operating ratio of 57% is optimal for a world in which customers and regulators are putting a greater emphasis than ever on expanding customer choice, service and reliability. 

“As part of its strategic and financial plan, CN is reaffirming its 2021 financial outlook targets of double-digit adjusted diluted EPS growth vs 2020 adjusted diluted EPS of C$5.31, capital investments of approximately C$3.0 billion and free cash flow in the range of C$3.0 to C$3.3 billion.”

Robert Pace

CN said it will add two new directors in 2021, along with its March 2021 announcement that Board Chair Robert Pace will not be seeking re-election when his term expires in 2022, and that it is “setting a target of at least 50% of non-management directors coming from diverse groups, including gender parity, by the end of 2022.” 

Commenting on the Canadian Pacific-KCS merger, CN said it has “secured an incremental US$700 million in break-up fees” and “will continue to engage with market participants, railroads and shippers to ensure that all regulatory rules are enforced fairly, and customers do not suffer anti-competitive effects arising from a combination between Canadian Pacific and KCS.” 

CN made a number of “economic and market assumptions” in preparing its 2021 outlook:

  • “North American industrial production for the year will increase in the high-single-digit range.
  • “U.S. housing starts of approximately 1.45 million units and U.S. motor vehicle sales of approximately 16 million units. 
  • “For the 2020/2021 crop year, the grain crop in Canada was above its three-year average and the U.S. grain crop was in line with its three-year average. The Company now assumes that the 2021/2022 grain crops in both Canada and the U.S. will be below their respective three-year averages.
  • “Revenue ton-miles (RTMs) in 2021 will increase in the mid-single-digit range vs. 2020, compared to its July 20, 2021 assumption of an increase in the high-single-digit range. 
  • “Continued pricing above rail inflation. 
  • “In 2021, the value of the Canadian dollar in U.S. currency will be approximately $0.80.
  • “The average price of WTI (West Texas Intermediate) crude oil will be approximately US$60 per barrel. 

CN’s economic and market assumptions in preparing its 2022 targets:

  • “North American industrial production for 2022 will increase in the mid-single-digit range.
  • “U.S. housing starts of approximately 1.57 million units and U.S. motor vehicle sales of approximately 16.9 million units. 
  • “The 2021/2022 grain crops in both Canada and the U.S. will be below their respective three-year averages. 
  • “RTMs will increase in the low-single-digit range vs 2021. 
  • “Continued pricing above rail inflation. 
  • “The value of the Canadian dollar in U.S. currency will be approximately $0.80.
  • “The average price of WTI crude oil will be approximately US$65 per barrel.”
“Man must explore.” Railroads must invest.

Editor’s Note: Apollo 15 Commander Dave Scott, when he set foot on the surface of the Moon after emerging from Lunar Module Falcon on July 30, 1971, said, “As I stand out here in the wonders of the unknown at Hadley Rille, I realize there’s a fundamental truth to our nature: Man must explore. And this is exploration at its greatest.” There is a fundamental truth to railroading: Railroads must invest—wisely—in people, in customers, in R&D and in growth capital. – William C. Vantuono

It doesn’t look like CN’s attempted “relaunch” will be as successful as Apollo 15’s July 26, 1971 liftoff from Cape Kennedy. Odds are that it will be scrubbed, permanently, according to observers and analysts with whom Railway Age has spoken.

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