Three months after reporting a record-setting first quarter, Canadian National Railway (NYSE:CNI) delivered an encore after the market closed Tuesday, when it revealed record results for its second quarter. Wait: It wasn't just a record second quarter, but the best quarter ever in the company's history.

Yet management said they were only "cautiously optimistic" about the rest of the year and next, and will be staying "mindful of market volatility." What volatility is CN referring to, and could that affect the company's full-year guidance? Here's what you need to know.

CN Q2 results: The raw numbers

CN's revenue, GAAP earnings per share (EPS), and adjusted EPS hit record highs in Q2. But what about the slump in its free cash flow (FCF) and the marginal improvement in operating ratio despite the big rise in top line? Well, there's nothing to worry here.

(Note: All numbers in the table below are in CN's reporting currency, Canadian dollars.)

Metric Q2 2019 Q2 2018 Change
Revenue  $3.96 billion $3.63 billion 9%
Net income $1.36 billion $1.31 billion 3.8%
Diluted EPS $1.88 $1.77 6.2%
Adjusted EPS $1.73 $1.51 14.6%
Free cash flow $513 million $974 million (47%)
Operating ratio 57.5% 58.2% 70 basis points

Data source: Canadian National Railway. Exchange rate as of July 24, 2019: CA$1 = US$0.76.

You see, operating ratio reflects cost efficiency as it measures a railroad's operating expenses against its revenue. So a lower operating ratio is good news. That said, you might've expected an even better number from CN given it 9% revenue growth. Blame that on operating expenses, which rose 8% year over year.

Then again, there's no reason to doubt CN's efficiency here, as a large share of the higher labor and material costs it incurred in Q2 were related to its March acquisition of TransX. TransX was Canada's largest transportation company, and it brought 1,400 employees to CN's payroll in March.

As for free cash flow, CN's capital expenditures were high this quarter as it received delivery of 125 new locomotives. The company has outlined a capital spending budget of CA$3.9 billion for the full year, CA$1.6 billion of which will go toward track and infrastructure maintenance.

A freight train.

Image source: Getty Images.

What else happened this quarter?

Other highlights from CN's Q2 worth noting are:

  • CN's carload and revenue ton miles (RTM) improved 2% each. While carloads reflect the quantity of goods carried, RTM measures the weight and distance of rail freight transported.
  • A breakdown of end-market activity reveals 26% growth in revenue from petroleum and chemicals due to higher crude shipments. TransX contributed largely to CN's 15% growth in intermodal revenue. Grains and automotive were also strong segments.

Management revealed some other interesting developments during the Q2 earnings conference call. First, TransX's integration into CN appears to be on track, based on the growth in intermodal revenue. Also, after that acquisition, CN struck a deal with Canadian retail major Hudson's Bay to handle all its domestic intermodal business.

Second, CN started construction of a new auto port facility in Vancouver. One customer slated to utilize it will be General Motors, which recently extended its agreement with CN. GM is also expected to add business to CN's under-construction auto compound in Minneapolis from 2021.

Third, two major export supply chain projects came online in the quarter. CN shipped the first trainload of thermal coal from Coalspur Mines' Vista Mine in Alberta, as well as the first trainload of propane via AltaGas' Ridley Island Propane Export Terminal. Each of these projects should add good volumes to CN as they ramp up in the coming months.

What management had to say

CEO JJ Ruest said he is "optimistic on CN's volume prospects in the second half of the year" and will maintain "vigilance on costs."

While management is banking on key end markets like crude, propane, grain, coal, and intermodal for growth in the second half of the year, they are cautious about the consumer products market, and concerned about strained trade relations between China and the U.S. On the cost front, CN continues to lay off contractors and outsourced workers, and reduce headcount at the managerial level. There were 6,900 management jobs at CN in mid-October; that number is expected to drop to 5,700 by the end of 2019.

During the conference call, Ruest stressed how CN is "in good position to have good results going forward," even as it strives to achieve its recently announced three-year financial goals.

Looking forward

CN downgraded its full-year RTM guidance range slightly to mid-single-digit percentage growth from the high-single digits, but retained its adjusted EPS growth outlook at low double-digit percentages. In other words, even if volumes fall below expectations, management is confident that profits will grow. Or, as Ruest said during the call,"At the end of the day, volumes are volumes. What we are focused on is to protect earnings."

With management also expressing confidence in the company's prospects for hitting three-year goals of low-double digit diluted EPS growth, FCF surpassing profits, and dividend growth in line with earnings, CN shareholders have a lot to look forward to.

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