Harrison Has Made CN, CP A Smooth Ride For Investors CSX, His Latest Turnaround Project, Is Stuck In The Station

Railway companies have been a solid investment over the past quarter century, particularly when Hunter Harrison has been at the throttle.

Mr. Harrison, 72, is a legendary railroad turnaround specialist known to Canadians for dramatically improving efficiency and profitability during stints as chief executive at Canadian National Railway Co. from 2003 to the end of 2009, and later at Canadian Pacific Railway Ltd. from mid-2012 to January of this year.

At both CN and CP, Mr. Harrison showed how a smaller, more versatile, disciplined workforce could run longer trains faster, with fewer stops along the way. The changes, coupled with the resulting sales of surplus land and locomotives, caused both railway’s share prices to more than double while he was there.

Mr. Harrison’s methods are still very much in effect at both railways, which makes them appealing to shareholders. CN’s shares (CNR/TSX) look like a solid holding, especially for those who subscribe to its dividend reinvestment plan (DRIP). Canadian Pacific (CP/TSX) is also attractive if you reinvest the dividends, although its debt levels appear worrisome. [Disclosure: I own no CN or CP shares, but I do have several CN and CP freight cars on my model railroad.]

Mr. Harrison’s most recent turnaround project is Florida-based railroad CSX Corp. News of his impending arrival at CSX came out in January and sent CSX shares (CSX/NASDAQ) soaring 33% in a week, to US$49 from US$37. Mr. Harrison joined CSX in March. Investors who might want to jump aboard the CSX turnaround train, however, should be prepared for a bumpy ride. Mr. Harrison’s health is not great (he uses a portable oxygen system), and this summer, shippers complained to the U.S. Congress about service delays at CSX, which Mr. Harrison blamed on employees who were resistant to change. The potential difficulties with customers and unions make CSX’s shares, at a current price of about US$54, appear fairly valued if not overvalued.

Mr. Harrison has spent his entire adult life around trains. He started his railroad career in the early 1960s as an oiler with the St.Louis-San Francisco or “Frisco” railroad, earning $1.50 an hour for crawling under freight cars with an oil can, lubricating axles. Mr. Harrison moved up the ranks at Frisco, and after that railroad was acquired by Burlington Northern in 1980, eventually worked his way up to vice-president. Mr. Harrison left BN in 1989 and moved to the Illinois Central Railroad, where he was CEO from 1993 until its acquisition by CN in 1998. When CN chief Paul Tellier retired on January 1, 2003, Mr. Harrison became CEO, guiding CN to excellent results until his retirement at the end of 2009.

In 2011, activist investor Bill Ackman at Pershing Square Capital Management identified Canadian Pacific Railway as a bloated, inefficient target ripe for improvement. Mr. Ackman knew who he wanted to turn things around and in the autumn of 2011, he called Mr. Harrison to persuade him to come out of retirement. Mr. Harrison agreed, and after a one-sided proxy battle, he became CP’s chief in mid-2012.

Four and a half years later, in January 2017, Mr. Harrison abruptly resigned from CP and began negotiations to join CSX, having been lured away by Paul Hilal, yet another activist investor who saw opportunity in an underperforming railroad.

Wherever he has worked, Mr. Harrison has preached his Precision Railroading philosophy, explained in his 2005 book, How We Work and Why: Running a Precision Railroad.

One example of Mr. Harrison’s methods involves reshuffling the lineup of cars in a freight train, called a consist. Like an aircraft stopping at an airport hub so its original passengers can catch new flights to different destinations, freight trains roll into yards so their cars can be redirected to new trains. Railroads don’t make money on this, so the fewer yard stopovers a train makes, the better. Mr. Harrison’s system calls for freight cars with a common destination to be coupled into blocks early in their journey, minimizing the need for yard reshuffling. The more often yards can be bypassed, the more yards can be closed, allowing staff to be laid off and land to be sold.

Mr. Harrison’s methods are aimed at improving operating revenue, or OR, which reflects how much a railroad spends for every $100 in revenue it takes in. An OR of more than 80 means a railroad is paying $80 in wages, maintenance and capital expenses for every $100 in fees it collects from shippers, while an OR of 55 or lower means near optimal efficiency.

The drive for efficiency is usually a boon for shareholders but is often painful for current and former railway employees, unless they’ve taken advantage of employee share purchase plans.

Canadian National

Thanks largely to the changes Mr. Harrison implemented, CN has been a gem for long-term, buy-and-hold investors who reinvest their dividends. An investor who bought $10,000 worth of CN shares 10 years ago -- two years before Mr. Harrison retired -- and reinvested the dividends would have about $50,000 today, for a total annual average return of 14.83%, say figures from Morningstar (morningstar.com).

CN bills itself as “North America’s Railroad,” an accurate description. CN’s 20,000-mile network runs across Canada from Prince Rupert, B.C. to Halifax, and down the United States from Chicago, through St. Louis and Memphis to New Orleans, together with a web of trackage rights achieved with deals with other railroads. The extensive network means it is the originating carrier for about 85% of its freight, speeding delivery and lowering costs.

CN’s operating ratio fell to 55.9% in 2016, making it one of the most efficient railroads in North America. The company’s acquisition of rail lines in Illinois means its trains can bypass the congested Chicago area, while its access to the Pacific coast port of Prince Rupert, itself under expansion, provides a key shipping and receiving point for freight moving to and from Asia.

No single commodity accounts for more than a quarter of CN’s total revenues, and its revenue is spread geographically between Canada, transborder, the U.S. and overseas. CN has about 15,000 Canadian employees, about 73% of whom are unionized, while its U.S. labour force has roughly 7,000 people, about 79% of whom are union members.

In 2016, CN had net income of $3.64-billion or $4.67 per share ($4.59 adjusted, diluted) on revenue of $12.04-billion. Rail freight revenue was down 5% from 2015 on weaker demand from shippers of crude oil, coal and frac sand. Despite the revenue dip, CN’s earnings were up $102-million or 28c per share (15c adjusted, diluted) from the previous year.

For the second quarter ended June 30, CN reported strong gains in revenue, free cash flow, and operating income, although operating expenses also climbed. CN’s second quarter net income of $1.03-billion was up 20% over the same quarter of 2016, while diluted EPS rose 24% to $1.36 per share. The railway’s operating ratio fell to 55.1% in the quarter.

Canadian National has consistently repurchased its shares ($2-billion to buy back 26.4 million shares in 2016 alone) and has steadily raised its annual dividend, most recently to $1.65, yielding 1.63% on a recent share price of $101.27.

Next year, CN says it expects to deliver adjusted diluted EPS in the range of $4.95 to $5.10 versus 2016 adjusted diluted EPS of $4.59. That means CN’s shares are trading at about 20 times 2018 earnings, reasonable for a railway.

Canadian Pacific

Canadian Pacific shares have also handily outperformed the index, although not as dramatically as CN’s. If dividends were reinvested, a $10,000 investment in CP made in 2007 would be worth about $35,000 today, for an average annual total return of 12.4%, the Morningstar.com site says.

Canadian Pacific is less than half the size of CN, with a market capitalization (shares times share price) of $30.76-billion, vs. CN’s $77.75-billion. CP has 14,000 miles of track (vs. 20,000 for CN) and about 12,000 employees (vs. 22,000 at CN.) Canadian Pacific’s network stretches from Vancouver to Montreal and to U.S. cities such as Chicago, Philadelphia, Washington, New York City and Buffalo.

Like CN, CP’s customers come from a variety of industries, including Canadian and U.S. grain, coal, metals, minerals and consumer products, and domestic and international intermodal (shipping containers), although one customer, Teck Resources, provides about 10% of revenue.

After Mr. Harrison left in January, he was succeeded by Keith Creel, a long-time student and disciple of Mr. Harrison.

“Most of the heavy lifting is done in transforming Canadian Pacific from worst in class to tied for best,” Morningstar analyst Keith Schoonmaker wrote in a July report. “We expect Creel to continue to guide CP on its margin improvement trajectory for several more years.”

In 2016, CP reported net income of $1.6-billion on revenue of $6.23-billion. The company’s revenue slipped $492-million or 8% in 2016 due to lower volumes of crude oil, Canadian grain, potash, metals, minerals and consumer products.

For the second quarter of 2017, CP’s total revenue climbed to $1.64-billion, up 13% over the same quarter in 2016, while its operating income rose 23% to $679-million or $3.17 per share diluted. Canadian Pacific’s operating ratio improved by 330 basis points to 58.7%.

Conclusion

Both Canadian National and Canadian Pacific have provided a smooth ride for long-term, buy-and-hold investors over the past few years, particularly if the dividends had been reinvested in more shares through a dividend reinvestment plan, and the outlook for both looks fine. There are already too many investors aboard the CSX train, however, and unless its problems with delays are overcome, CSX will be stuck in the station.

Richard Morrison, CIM, is a former editor and investment columnist at the Financial Post. richarddmorrison@yahoo.ca