Barely six to eight months ago, Canadian National Railway (NYSE:CNI) was staring at severe capacity constraints that hit deliveries, upset customers, and drove its operating costs higher. The railroad behemoth knew it was a call for action and reacted swiftly by pumping record capital investment into equipment and infrastructure to solve bottlenecks and keep up with demand.
CN's latest quarterly report for the third quarter shows the fruits of its efforts: It reported record revenue and double-digit growth in earnings. But much to investors' disappointment, CN didn't upgrade its outlook despite a solid Q3. Here's why.
CN results: The raw numbers
The table below, which gives a snapshot of the key numbers from CN's third quarter, reveals what a strong quarter it was for the company. (Note that all numbers in the table below are in CN's reporting currency, Canadian dollars.)
|Metric||Q3 2018||Q3 2017||Year-Over-Year Change|
|Revenue||$3.69 billion||$3.22 billion||14.6%|
|Net income||$1.1 billion||$958 million||18.4%|
|Diluted earnings per share (EPS)||$1.54||$1.27||21%|
|Free cash flow (FCF)||$585 million||$662 million||(11.6%)|
|Operating ratio||59.5%||57.2%||(2.3 percentage points)|
Yet CN shares are trending lower since the earnings release after market close on Oct. 23, and I see three reasons why: broader market weakness, unchanged full-year guidance, and a deteriorating operating ratio, which indicates CN incurred greater operating costs as a percentage of revenue. A challenging September is partly to blame.
What happened with CN this quarter
As I hinted earlier, CN is spending aggressively on infrastructure to ramp up capacity. During CN's Q3 earnings conference call (click here to read the full call transcript), CEO Jean-Jacques Ruest pointed out how the company was "completing many construction projects under heavy demand on the very busy western mainline corridor" last month, which hurt volumes. That, coupled with higher fuel and labor costs, drove the company's year-over-year operating expenses higher by 19% in Q3.
Nonetheless, demand was strong across all of CN's end markets, and management expects the trend to continue. Some key highlights from the quarter include:
- Commodity markets are driving growth, with revenue from petroleum and chemicals, and coal soaring 25% each, followed by 15% growth each in metals and minerals, and grains and fertilizers.
- Carloadings, or the total amount of freight carried, improved 3% year over year.
- Revenue ton miles (RTMs) -- a measure of the relative weight in tons and the distance of rail freight transported -- climbed 4%.
- CN reports numbers in Canadian dollars, but a large chunk of its revenue and expenses are denominated in U.S. dollars. Favorable foreign-currency translation added 26 million Canadian dollars to the company's bottom line.
So far, so good. But here's a head-scratcher: CN now foresees its fiscal 2018 RTM growth to come in at the lower end of its previously guided range of 5% to 7%.
What management had to say
CN's labor productivity was low in Q3, mainly because the company went on a hiring spree and was busy training its workers, even as it advanced expansion projects during a busy season.
2018, in fact, is turning out to be a big year in terms of capital spending, with CN bringing 22 projects online so far this year and striving to put another five into service ahead of winter. Limited usage of parts of its rail network amid construction activity, therefore, pretty much explains CN's muted full-year RTM outlook.
That's, of course, just a blip, as all of these projects should eventually increase CN's capacity and volumes and help lower costs. As COO Mike Cory put it on the earnings call, they're investments for the long haul.
As we stated many times, our ongoing capacity improvement plan is in place to support a long-term strategy of growth at low incremental cost. And we have a strong pipeline of opportunities across various segments. While we understand growth can be bumpy and not necessarily even spread, our network reach provides us these growth opportunities and they are clearly a large part of our strategy that we will deliver on.
In short, as CN's capacity projects become fully operational and hiring normalizes, it should see stronger volumes and lower costs and be able to deliver better operational-efficiency metrics.
Critics who are stuck at CN's high Q3 operating ratio and unchanged FY 2018 outlook are missing the big point: The costs the company incurs today on capacity expansion will bear fruits tomorrow. In any case, CN's projected adjusted EPS guidance of CA$5.30-CA$5.45 for the year is still a significant improvement over the CA$4.99 in adjusted EPS that it earned in 2017. In fact, I'd say CN's Q3 performance confirms, yet again, that the railroad is chugging along the growth track.