Harsh winters can bring key operations at railroads to a grinding halt. Canadian National Railway (NYSE:CNI), with its three-coast extensive network, wasn't immune to what was one of the most extreme and prolonged winters in North America. Yet CN's proactive move to press a larger fleet of locomotives and railcars into operation this winter helped it not only trump weather headwinds but even deliver record first-quarter carload volumes and revenue.

Let's dissect CN's first-quarter earnings report, which was released on April 29, to see how the railroad giant pulled off such a strong quarter and what management foresees for the rest of the year.

CN Q1 results: The raw numbers

While the table below reveals what a solid quarter it was for CN, critics will want to draw your attention to the two metrics that declined: operating ratio and free cash flow. Now let me explain why the declines shouldn't bother a CN shareholder. (Note that all numbers in the table are in CN's reporting currency, Canadian dollars.)

Metric Q1 2019 Q1 2018 Year-Over-Year Change
Revenue $3.54 billion $3.19 billion 11%
Net income $786 million $741 million 6.1%
Diluted earnings per share (EPS) $1.08 $1.00 8%
Adjusted EPS $1.17 $1.00 17%
Free cash flow (FCF) $286 million $322 million (11.18%)
Operating ratio 69.5% 67.8% (1.7 percentage points)

Data source: Canadian National Railway. Exchange rate as of April 30, 2019: CA$1 = US$0.74

Operating ratio reflects the operating expenses a company incurred as a percentage of revenue during a particular period. Railroads, therefore, strive to achieve a lower operating ratio, as any increase could reflect cost inefficiency. CN has traditionally been one of the most cost-efficient railroads in North America, but its Q1 ratio of 69.5% is on the higher side in the industry. What went wrong there?

A freight train.

Image source: Getty Images.

CN's operating expenses increased 14% year over year, partly because of weather conditions and foreign currency translations, both of which are outside of the company's control. The third reason was higher labor costs on two counts -- a higher headcount as CN acquired TransX in March and outsourcing of some services to battle winter woes. The fourth factor was a charge related to the replacement of a back-office system. Frankly, none of these factors should worry investors.

As for the fall in FCF, it's the effect of higher capital spending on new locomotives and the acquisition of TransX. CN's Q1 operating cash flow, otherwise, soared 32% year over year.

What happened with CN this quarter

  • CN's recent aggressive investment in equipment and capacity hugely helped it serve customers even in inclement weather.
  • Record carload volumes added CA$350 million to CN's top line.
  • A mix of higher volumes and freight rates boosted revenue from all end markets. Petroleum and chemicals and coal were the strongest, delivering 30% and 15% growth in revenues, respectively.
  • CN's operating ratio, adjusted for the system replacement charge, improved 0.6 percentage points in Q1.

Another highlight of the quarter was CN acquiring Canada's largest private transportation company, TransX, which had already been providing services to the railroad for nearly 20 years. While the terms of the deal weren't disclosed, TransX should strengthen CN's footprint in intermodal, which involves the transportation of goods using multiple modes such as trucks, ship, and rail. As of last count, TransX operated 1,500 trucks, 4,000 trailers, and 1,000 intermodal containers.

What management had to say

CN's management was mightily pleased with the company's Q1 performance, and it's not hard to see why -- Chief Operating Officer Mike Cory called the operating challenges this winter "some of the toughest" he'd seen over his career. By mid-March, CN's operations were back in full swing, and volumes are hitting record highs in April, as Cory revealed during CN's first-quarter earnings conference call (click here to read the full call transcript).

CEO JJ Ruest remains optimistic for the rest of the year: "We remain on track to deliver on our 2019 financial outlook and on our ability to bring long-term value creation to our customers and shareholders," he said. At the conference call, Ruest further elaborated how management's "approach to operating ratio and return on invested capital, which stood at 15.7% in 2018 is also balanced and long term focused."

Looking forward

CN expects high-single-digit growth in revenue ton miles, or RTMs, which measures the weight in tons and the distance of rail freight transported, in 2019 thanks to a favorable volume and pricing environment. The company also reiterated its full-year guidance of double-digit growth in adjusted EPS versus last year's adjusted EPS of CA$5.50.

As good as this quarter was, CN investors have a lot to look forward to, as Ruest plans to reveal the company's "growth opportunities for the next three years" at its upcoming investor day in June.

Check out the latest Canadian National Railway earnings call transcript.