Anemic Intermodal and Wage Inflation Constraining Canadian National's Near-Term Performance

Senior Equity Analyst

Matthew Young

While peers have caught up over the years, especially Canadian Pacific, Canadian National was long the highest-margin (lowest operating ratio, or OR) Class I railroad due to being the precision railroading pioneer in the 2000s. Recall that PSR architect Hunter Harrison left CN in 2009 and subsequently ended up applying his playbook at CP. Historically speaking, CN bolstered its velocity by making greater use of distributed-power locomotives and extending sidings at port staging areas. Running a scheduled railroad requires commitment to on-time train departures from both employees and customers queuing cars for departure. We think PSR is still in CN's DNA, though we sense management was focused more on growth than margins between 2019 and 2021, before the 2022 leadership changes (albeit growth was tempered by external events like congestion, strikes, blockages, tough weather, and so forth). 

Railroads generate solid cash, and CN is no exception with free cash flow in the high-teens as a percentage of sales on average over the past decade. CN's mix is richest in intermodal, agriculture, and chemicals, though forest products and autos contribute meaningfully to results. CN has historically had limited reliance on coal, but its exposure increased over the past few years due to a few contract wins (9% of volume in 2022; 6.5% in 2021). 

A railroad's competitive advantages are inseparable from its geography, and CN's network boasts a unique three-coast system spanning Canada coast to coast, and down through the U.S. to New Orleans. CN's EJ&E line that bypasses Chicago has boosted its velocity at a major choke point over the years, benefiting network reliability and asset turns. Also, CN enjoys exclusive access to Canada's port of Prince Rupert, which has contributed to its intermodal franchise growth prospects. We suspect CN is slightly less exposed to U.S. regulatory risk than the U.S. Class I rails because on its U.S. route, the option to ship by barge on the Mississippi River makes customers less captive than those of inland rails.

Business Strategy & Outlook

In our view, each of the North American Class I railroads we cover, including Union Pacific, enjoys a wide economic moat rooted in cost advantages and efficient scale. Core pricing and margin resilience in past freight recessions and in the face of substantial coal volume losses over the past decade-plus are a testament to the rails’ robust competitive positioning. With near certainty, we expect the rails to continue to leverage their two core moat sources into economic profit for the next 10 years and more likely than not 20 years from now. 

Cost advantage is a key driver of CN's wide economic moat. While barges, ocean liners, aircraft, and trucks also haul freight, railroads are by far the low-cost option where no waterway connects the origin and destination, especially for freight with low value-per-unit weight (bulk commodities). Along those lines, railroads enjoy roughly quadruple the fuel efficiency of trucking (per ton-mile of freight), and through greater railcar capacity and train length, rails make more effective use of locomotive assets and manpower despite the need for train yard personnel. Rails can also carry significantly more freight at once. Even for freight that can be shipped by truck, we estimate railroads enjoy a 10%-30% discount on a similar lane (on average). Even for intermodal container freight, which is largely made up of consumer-related products, rail has historically been cheaper than its key competitor truckload shipping on average over the cycle thanks to the rails’ aforementioned fuel efficiency and more economical use of labor. 

Furthermore, route density plays a role in rails’ cost advantage relative to a would-be new railroad entrant in a given corridor. We don’t expect any new mainlines to be built in the future, but the incumbent Class I providers would enjoy vastly lower unit and marginal costs than an upstart given immense network/lane density—the existing seven North American Class I railroads have thousands of customers across myriad end markets and geographies that drive significant freight volumes across their networks.

In addition to cost advantage, CN and its Class I peers benefit from efficient scale. That is, would-be rational competitors have little incentive to enter because massive upfront infrastructure costs and the potential for creating excess capacity amid limited demand would preclude economic profit and destroy value. The network of track and assets that the North American Class I railroads have in place is essentially impossible to replicate. CN's system is a unique three-coast, Y-shaped network, spanning Canada from east to west and stretching from north to south in the Midwestern United States. CN's rights of way and installed track across the full width of Canada and top to bottom of the U.S. form a nearly impenetrable barrier to entry. Railroads occasionally build new spurs, but we anticipate no new mainlines will be built given massive entry barriers.

Efficient scale followed industry consolidation escalated by the 1980 Staggers Act, which permitted extensive rail line sales, abandonment, and combination while allowing for private contracts and rate setting based on market demand. In 1980, more than 40 Class I rails operated across North America, and today there are only seven; by definition, a Class I rail generates at least $475 million of revenue. Consequently, on all but the busiest lanes, a single railroad often serves an end-of-the-line shipper, only two railroads operate in most regions, and the rails have been able to reinvest while becoming quite profitable. In fact, we suspect that absent government intervention the rational number of competitors on the continent would be two, via additional consolidation. This is because in most regions customers already have only two capable providers that service the market effectively and efficiently.

Wide

Economic Moat

Canadian National Railway Company

Canadian National Railway Co. engages in rail and related transportation business. The firm services include rail, intermodal, trucking, supply chain services, business development and maps and network. Its offers their services in automotive, coal, fertilizer, food and beverages, forest products, dimensional loads, grain, metals and minerals and petroleum and chemicals industries. The company was founded on June 6, 1919 and is headquartered in Montreal, Canada.

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Canadian National Railway Co. engages in rail and related transportation business. Its services include rail, intermodal, trucking, supply chain services, business development and maps and network. Its offers their services in automotive, coal, fertilizer, food and beverages, forest products, dimensional loads, grain, metals and minerals and petroleum and chemicals industries. The company was founded on June 6, 1919 and is headquartered in Montreal, Canada.

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