Efficiency Gains Will Run Out of Tracks

Tuning an instrument like a violin is an exact science, where the end result can be measurable perfection.

Tuning a company to prevailing business conditions is far less precise. The most laudable achievements in efficiency are by nature non-recurring, since the result is a company moving ever closer to perfect pitch.

Canadian National Railway (NYSE: CNI  ) this week reported a 13% earnings decline over prior-year levels. The earnings result beat analyst expectations by over 5% even as revenues missed by about the same margin. Beneath that achievement lie an 18% reduction in operating costs and a noteworthy 460 basis point improvement in the operating ratio from 67.3% in the second quarter to just 62.7% in the third quarter.

Quarter after quarter, I have watched with amazement as the railroad industry has squeezed every ounce of profit imaginable out of deteriorating revenue streams by fine-tuning costs and operating efficiency. Despite my cautious fundamental outlook on the sector, leading operators like Burlington Northern Santa Fe (NYSE: BNI  ) and CSX (NYSE: CSX  ) merit some recognition for the effective adaptations they have made thus far to this challenging financial climate. Like Diana Shipping (NYSE: DSX  ) in the dry bulk sector, cargo haulers of all shapes and sizes remain in a race to adapt.

With a big move into future efficiency gains, Canadian National announced this week that it will purchase 70 new high-efficiency locomotives over the next several years. Of those, half will be from General Electric's (NYSE: GE  ) Evolution series, which matches the horsepower of 16-cylinder engines while running on only 12. Although I believe that hybrid locomotives -- like those being developed by GE or Norfolk Southern (NYSE: NSC  ) -- will lay tracks to the most optimal efficiency gains of all, the 15-20% reduction in fuel consumption that Canadian National anticipates from these efficient diesel locomotives adds another feather to this hauler's engineer's cap.

Short of screaming "danger" from the rooftops, Canadian National CEO Hunter Harrison echoed the theme of moderating expectations for a swift recovery, stating: "I think we have bounced across the bottom and now we are starting to float to the top." Indeed, the prospect for further deterioration of the greenback vis-a-vis the Canadian dollar threatens to erode earnings in the fourth quarter. Oil's creeping price appreciation raises another red flag.

I continue to view Canadian National Railway as a top competitor from an operational standpoint, but I consider a warm bench at the train station the best position for investors just now.

More than 1,300 Motley Fool CAPS members, including 578 All-Stars, expect five-star pick CNI to outperform the S&P 500. In all, the CAPS community has shared its collective insight on 35 "road and rail" companies. Join the free CAPS community today and share your views on how the rail industry will fare throughout these persistent economic headwinds.

Fool contributor Christopher Barker has never hopped a freight train, but he thinks it would be a fun place to learn the harmonica. He can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He also tweets. He owns no shares in the companies mentioned. Canadian National Railway is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy never plays on the tracks.


Read/Post Comments (3) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 23, 2009, at 9:59 AM, KanataMark wrote:

    This type of negative talk indicates that it’s time to invest on these companies. Keeping costs down is a good thing. Commodity prices are an indication that world demand is growing for commodities and goods and services. The railroad network is the most efficient way of transporting commodities, people and products.

    You have to ask if there is a hidden agenda behind these articles. For example, Diana Shipping has been put down by the analyst ”pundits” and at the same time “the smart money” is accumulating the stock. So there is a glut of new bulk ship orders, this is an opportunity for the well run companies not a problem.

  • Report this Comment On October 23, 2009, at 2:12 PM, gibbswtr wrote:

    I have known Hunter Harrison for years and if he tells you something it is likely to be the truth. CNI has one problem that it needs to watch out for and that is investment in oil sands. CNI hauls a majority of the heavy equipment into the oil sands area so they are very tied to investment there. New investment in oil sands seems to be triggered by oil prices reliably over $70. The lack of shipment affects CNI general merchandize category and shipments to the oil sands are very profitable.

    The new engines are a bigger deal that they seem. CNI route structure has lower grades than CP so they can use less motive power per train, with the flex engines they can use even less which leads to less crew and higher engine utlitization.

    When I started following rails in the 1980's an operating ratio of 90 was considered unbelievable now an 80 is grounds to dismiss the management!

  • Report this Comment On October 23, 2009, at 5:04 PM, XMFSinchiruna wrote:

    gibbswtr,

    Thank you for that interesting insight! I hadn't given consideration to average grades in the respective railroads' route structure. I always appreciate new metrics to consider!

    It's nice to think that CNI's exposure to oil sands-generated demand could serve to counteract some of the negative impact of higher oil prices on their cost structure ... another great point!

    This is why I love the Fool!

    KanataMark,

    You speak of world commodity demand as if it were homogenously allocated among the continents. Because decoupling is the unavoidable reality of our time, North American commodity demand will lag that which is presently driving prices ... namely demand from China, India, and the emerging economies bolstered thereby.

    As to your suggestion of a hidden agenda ... that concept is foreign to Fools. I write what I see, because the Fool is investors writing for investors. Incidentally, I own shares of Diana Shipping, though I haven't offered many encouraging words for the dry bulk sector at large.

    Thanks to both of you for reading and commenting.

    Fool on!

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