Canadian National Surpasses Canadian Pacific

Canada’s two biggest railways are under pressure from government and customers to reduce delays, with investors profiting from Canadian National Railway Co. (CNR)’s performance and losing on Canadian Pacific Railway Ltd. (CP)

Transport Minister Denis Lebel is promising legislation to give rail customers a faster way to settle disputes and the right to a service agreement. Sixty-two percent of shippers said they lost money because of late trains in 2009, according to a March government report on the industry.

The rail companies say case-by-case service contracts with customers will ensure more timely delivery than regulation would. CN shares have given investors a total return of 12.7 percent so far this year, while CP shares have lost 6.3 percent as earnings were hurt by delays linked to winter storms and flooding. Canada’s benchmark stock index has fallen 1.5 percent over the same period.

“There has been some tangible evidence of improvement with CN,” said Stephen Boland, an equity analyst at Vancouver-based investment-management company Odlum Brown Ltd., which oversees C$7.5 billion ($7.7 billion). “CN did a very good job working through the challenging weather, whereas for CP there was a significant impact on earnings.” He rates CN shares a “buy” and doesn’t rate CP.

Canadian National Railway's second-quarter earnings will probably grow 11.7 percent versus a Canadian Pacific Railway gain of 4.8 percent, according to Bloomberg consensus estimates combining 26 responses. Photo: Norm Betts/Bloomberg Close

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Canadian National Railway's second-quarter earnings will probably grow 11.7 percent versus a Canadian Pacific Railway gain of 4.8 percent, according to Bloomberg consensus estimates combining 26 responses. Photo: Norm Betts/Bloomberg

CP’s first-quarter earnings fell 65.6 percent from the year-ago period. The company cited “unusually severe winter weather, decreasing shipping volumes and increasing costs.” Chief Operations Officer Ed Harris retired April 1 after less than a year. CN first-quarter earnings rose 12.5 percent.

Earnings Forecasts

CN’s second-quarter earnings will probably grow 11.7 percent versus a CP gain of 0.3 percent, according to Bloomberg consensus estimates combining 26 responses.

Standard & Poor’s cut its debt rating on CP to BBB- from BBB on May 17, citing “the company’s slower pace of deleveraging relative to our previous expectations.” S&P rates CN debt A-, three steps higher.

The world’s 11th-biggest economy is the sole Group of Seven nation that’s a major commodity exporter; those goods made up half of foreign shipments last year and 16 percent of gross domestic product amid growing demand from emerging markets.

“The railroads needed someone to say to them that 70, 85 percent service isn’t acceptable” said Chris McIver, vice president of sales at West Fraser Timber Co., North America’s largest maker of lumber for building construction. To improve service, “our preference is to do it between ourselves and the railroads, and have government there as a bit of a watchdog.”

Found Bottlenecks

Vancouver-based West Fraser ships about half of its production using CN Rail. McIver says it has also found bottlenecks with trucking companies and at ports where lumber is reloaded into containers.

Shares of West Fraser have fallen 17.6 percent since a May 3 earnings report showing first-quarter profit of C$0.30 per share, below analyst estimates of C$0.87 per share. Lumber shipments were 11 percent below production in the first quarter because of transport difficulties and weaker demand, President Henry Ketcham said on a May 4 earnings call.

West Fraser said 30 percent of its spruce, pine and fir exports went to Asia in the first quarter, up from 20 percent a year earlier and almost nothing five years ago.

“We would do probably more business over there if we could make the logistics work,” McIver said. “We have missed some opportunities and we are all trying to miss as few as we can.”

Declining Satisfaction

West Fraser isn’t alone: 45 percent of rail customers surveyed in 2009 said their satisfaction had declined in the prior three years, according to the government rail review. Grain shippers received 90 percent or more of the cars they requested only about half the time.

Prime Minister Stephen Harper’s parliamentary majority following his May 2 re-election makes it easier to resist opposition demands for heavy regulation, Royal Bank of Canada analyst Walter Spracklin said in a June 10 telephone interview from Toronto. He has an “outperform” rating on both CN and CP shares.

Ralph Goodale, an opposition Liberal Party lawmaker from the wheat-growing province of Saskatchewan and a former agriculture minister, said legislation should be passed this year to address “chronic complaints.”

“There is no commercial discipline in the system that evens up the bargaining power,” Goodale said in a June 7 interview in Ottawa. “The shippers have a right to have contracts.”

Hard Facts

“Burdensome regulation targeting railways alone is not the solution,” CN Chief Executive Officer Claude Mongeau said in a March 18 statement. The review panel “failed to act on the hard facts” showing good rail service. Mark Hallman, a spokesman for the Montreal-based railroad, said June 2 that executives weren’t available to comment further.

“Many of the benefits already achieved have been masked by the unusually severe winter and spring operating conditions,” CP Chief Executive Officer Fred Green said at a June 13 investor presentation in New York. “We have to earn back the credibility that we’ve had for a long time and we will get there.” Green called the government review a “rather abysmal piece of work.”

Bill Gates, the world’s second-richest man according to Forbes magazine, is the biggest CN Rail shareholder through Cascade Investment LLC, regulatory filings show. Michael Larson, chief investment officer of Cascade Investment in Kirkland, Washington, didn’t return an e-mail message seeking comment.

‘On Top of This’

“There could be legislation or regulation, but the rail companies in Canada are on top of this,” said Michael Simpson, a portfolio manager at Sentry Investments in Toronto, which manages about C$7 billion, including CN shares. “They will reach out to their shippers. Railways generate a lot of free cash flow and CN has a history of raising their dividends. As the economy expands they will expand.”

He cited CN as being “proactive” in dealing with customer complaints, and said he holds more of its shares than CP, without giving details.

Railways were crucial to Canada’s formation and settlement. The CP railway came from a pledge that Sir John A. MacDonald, Canada’s first prime minister, made to entice British Columbia to join the country. Canadian National, a state-run company the government created in 1919, was sold to investors in 1995 in what was then the country’s biggest initial share sale.

Canada is seeking more reliable cargo movement as the government negotiates trade agreements with India and the European Union. Harper said during the election campaign he wants to sign trade agreements with India in 2013 and the EU next year, giving access to markets with 1.7 billion people.

Voluntary Agreements

Between the two of them, CN and CP this year have signed voluntary service agreements with companies and institutions including the Montreal Port Authority, Port Metro Vancouver, grain handler Viterra Inc., Tembec Inc., West Fraser, Squamish Terminals Ltd., Canfor Pulp Limited Partnership and Daishowa Marubeni International Ltd.

Teck Resources Ltd. says a “landmark” 10-year agreement announced in October with Canadian Pacific will help it meet foreign demand. The railway will buy new equipment to match expanded coal production, said Ron Vance, Teck’s vice president of corporate development, on a May 26 investor call.

“An efficient rail network from mine site to port is absolutely essential” Vance said.

To contact the reporter on this story: Greg Quinn in Ottawa at gquinn1@bloomberg.net.

To contact the editors responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net; David Scanlan at dscanlan@bloomberg.net.

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