Canadian National Railway (NYSE:CNI) is facing a unique problem: too much demand that it can't seem to handle. Severe capacity shortages and delay in deliveries last quarter proved costly for the railroad, as evidenced by its just released first-quarter earnings report.
In fact, the situation got hot enough for CN to oust its CEO Luc Jobin abruptly in March, and the company is still searching for a leader even as Jean-Jacques Ruest has taken over on an interim basis. The first quarter was also Ruest's first as the CEO, and while it appears the road ahead won't be easy for CN, Ruest is taking the challenges head on to win back the confidence of customers and shareholders alike.
CN results: The raw numbers
CN released its first-quarter 2018 numbers after market close on April 23, and going by the stock's positive reaction, it seems the market is willing to give the railroad a chance.
CN's first-quarter report and earnings call gave great insight into what management is doing, but before I tell you more about it, here's a snapshot of the key numbers from the quarter. Note that all numbers in the table below are in CN's reporting currency, Canadian dollars.
|Metric||Q1 2018||Q1 2017||Year-Over-Year Change|
|Revenue||$3.19 billion||$3.21 billion||NA|
|Net income||$741 million||$884 million||(16.2%)|
|Diluted earnings per share||$1||$1.16||(13.8%)|
|Free cash flow||$322 million||$848 million||(62%)|
As is evident from the above table, high costs ate into CN's top line. In fact, CN's top-line growth would've been stronger if not for the infrastructure bottlenecks.
What happened with CN this quarter
CN's carloadings, or the total amount of freight it carried, improved 3% year over year during the quarter. However, CN's revenue ton miles (RTMs), which measures the relative weight in tons and the number of miles it is transported, declined 4% because of challenging operating conditions.
Harsh winters and a surge in freight traffic, backed primarily by a large grain crop and an uptick in activity in the oil and gas sector, caught CN off guard as it didn't have enough capacity.
To be fair, CN wasn't the only railroad to face congestion and capacity constraints. But because CN has the widest rail network among peers and had driven its operational efficiencies high enough in recent years to emerge as the most cost-efficient railroad in the industry, its failure to deliver faced severe customer backlash.
CN's operating expenses climbed 9% year over year during the first quarter, driving its operating ratio up six percentage points to 67.8%. Because the operating ratio measures a railroad's operating expenses against revenue and denotes efficiency, a higher ratio is negative as the table above reflects.
CN knows it has to work harder to make up for lost opportunities.
What management had to say
During its first-quarter earnings call, Ruest acknowledged that CN's service "has been challenged since last fall" and it was evident in its numbers. To catch up on volumes and ensure it doesn't face a rerun of service constraints, CN is ramping up investments in infrastructure, primarily tracks, locomotives, and new hires. As CFO Ghislain Houle reflected:
In the railroad industry, if now you lack infrastructure, it's nothing you can fix quickly because you have to build it and it takes time to build it. This is why I said that one of the key lessons learned is that we need to be ahead of the game, ahead of the investments.
In line with its goal to improve operational capacity, CN bumped up its capital spending plans for 2018 by CA$200 million to CA$3.4 billion, out of which CA$400 million will be invested in new track infrastructure. That may not sound like a lot, but there's only so much the company can build at a time.
CN expects the second quarter to be a challenging one, the third to be flattish, and the fourth to be a positive one in terms of year-over-year operating metrics. That's primarily because the company doesn't expect the new tracks, locomotives, and hires to be fully functional before the fourth quarter.
As a result, CN downgraded its full-year adjusted earnings outlook to CA$5.10-CA$5.25 per share from its previous outlook of CA$5.25-CA$5.40 per share. Its revised target would still mean an improvement of around 4% from 2017. But with new capacity likely to come online just in time for the next winters, it remains to be seen whether CN's incoming CEO can avoid an encore.