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After a Derailed Merger, Canadian National Gets Back on Track

By Lou Whiteman – Oct 21, 2021 at 7:15AM

Key Points

  • Canadian National delivered earnings and revenue numbers that topped analyst expectations, and said it is on track to deliver on cost cuts heading into 2022.
  • For much of 2021 Canadian National was pursuing a deal for Kansas City Southern, but with that now behind it the railroad is focused on improving its efficiency.
  • The CEO is also retiring, a move that could prevent a proxy battle with a large shareholder.

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The railroad delivered a strong third-quarter report as the focus shifts back to operations.

Canadian National Railway (CNI 0.14%) delivered a clear message that the company is moving on following its failed attempt to acquire Kansas City Southern (KSU), reporting strong third-quarter results and announcing a management transition that should help appease a disgruntled shareholder.

The railroad has taken investors on a wild ride this year, in April launching an unsolicited $33 billion effort to break up Kansas City Southern's planned acquisition by Canadian Pacific (CP -0.21%). Canadian National temporarily secured Kansas City Southern's backing, but the target eventually returned to Canadian Pacific after U.S. regulators expressed concerns about the competitive impact of a Canadian National/Kansas City Southern deal.

The merger drama was a distraction for what has historically been a well-run railroad, and Canadian National's latest results are a reminder that the company remains on track to be an outperformer even without the added heft of the Kansas City Southern rails.

A Canadian National train makes its way through the Rockies.

Image source: Canadian National.

Outperforming in a tough environment

Canadian National reported third-quarter earnings of $1.52 Canadian dollars per share on revenue of CA$3.59 billion, beating analyst expectations on earnings by $0.10 per share and the consensus revenue forecast by 27%. Revenue was up 5% year over year despite a difficult operating environment due to supply chain congestion, a weak Canadian agriculture season, and summer forest fires.

The railroad showed strong pricing power, growing revenue despite carloads falling 1% year over year in the quarter.

"CN's dedicated railroaders produced strong financial and operating results this quarter, despite headwinds from severe wildfires in Western Canada that caused a prolonged disruption to CN's main line to Vancouver in July," CEO JJ Ruest said in a statement.

The company's operating ratio, a measure of how much it costs to earn one dollar in revenue, fell to 59% when one-time items like legal and merger expenses are backed out. Canadian National said it is on track to grow more efficient in the quarters to come, toward a goal of a 57% operating ratio in 2022.

Canadian National will get there in part through an overhaul announced in September that the railroad said should generate CA$700 million in additional operating income through a combination of revenue enhancements and cuts. The railroad said it is about 75% through the 1,050 job cuts announced back in September, including about 600 management jobs eliminated.

A change at the top

Concurrent to earnings Canadian National announced that longtime CEO Ruest would retire and step down from the board as of the end of January. Ruest has been with the company for more than 25 years and has been CEO since 2018, helping guide the one-time government-owned railroad's transformation into a North American powerhouse.

But this year Ruest has come under criticism from London hedge fund TCI Fund Management, the second largest holder of Canadian National shares. TCI is a large holder of both Canadian National and Canadian Pacific, and earlier this year had urged Canadian National to abandon its effort to acquire Kansas City Southern to allow for Canadian Pacific's more regulatory-friendly deal to proceed.

Ruest and Canadian National ignored that advice, and this summer TCI started a campaign to replace four Canadian National directors. The fund has also pushed for Ruest's removal.

Although Canadian National did not name an immediate successor, it appears longtime rail executive Jim Vena could have the inside track. Vena, who has worked at a number of railroads including Canadian National and Union Pacific, was TCI's suggested candidate to replace Ruest prior to the CEO announcing his retirement.

Should the board look elsewhere, it could prompt a prolonged proxy battle with TCI.

On the post-earnings conference call with investors Ruest declined to answer a question on whether Canadian National intends to engage in talks with TCI. But he said he believes the investment fund is "getting closer to what CN's long-term strategy is" and does not expect a major shift in focus post-CEO change.

Canadian National is back on track

In hindsight, the decision to chase Kansas City Southern was regrettable and likely is at least in part responsible for Ruest's sudden retirement. Canadian National, which is larger than Canadian Pacific and Kansas City Southern combined, always seemed a long shot to get its bid approved by competitive watchdogs and managed to enrage a major shareholder in the process.

But fortunately for investors, Canadian National did not remain sidetracked for long, and with the encouragement of TCI, the company is now firmly focused on operations and improving shareholder returns. Canadian National expects to repurchase $1.1 billion in shares through the end of 2022.

Railroads including Canadian National have been caught up in the supply chain issues plaguing ports and truckers, but thanks to their huge capacity and 24-hour/seven day a week operating schedule, they are likely to be a key part of the solution heading into 2022. The congestion should also mean strong pricing power for North American railroads, helping to boost earnings into 2022.

KSU Chart

Railroad stock data by YCharts

Historically, an investment in rail is designed to be a steady counterweight to buying into sectors that are more volatile. Over the past year, however, Canadian National has produced a surprising amount of drama that has helped contribute to the stock underperforming both the S&P 500 and a number of other railroads.

It appears that drama is now mostly behind us. For Canadian National holders, the railroad seems to have a clear path to climb from here.

Lou Whiteman has no position in any of the stocks mentioned. The Motley Fool recommends Canadian National Railway and Union Pacific. The Motley Fool has a disclosure policy.

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