CPKC and CNI/TCI - Endgames?

Greetings;

There was a lot going on at IANA/Intermodal Expo in Long Beach, and we’ll get to that ASAP (while at NEARS in the real Portland, today) because the world, rather strangely, didn’t stop spinning while I was in Cali….and in fact, started spinning faster in Canada and in the Midwest….

From the Tweets:

As expected KSU terminated the CN deal & pivoted back to  original dance partner CP – likely  the LAST RR big merger; Smart move by CN to bow out gracefully, take $1.4B ($700mm net) & face its a new issue, TCI, & the future; in retrospect new vs old rules too big an obstacle

Reflecting on CN’s strategy (TCI defense) call - it was too defensive (not defending their growth plans & “feed-the-beast” deals, which add 210bps to the published OR, & increased capex/capacity +160bps) & too tactical (big OR progress  in ’22 – where’s the 5-Yr-Plan?)

TCIvCNI – an existential fight underway in Montreal, might be the Last Stand of the “Cult of the OR”- any pivot AWAY from growth to margins is so-PSR 1.0, not reflective of the new RR focus, nor in broader terms of the shifting supply chain – and govt/regulatory -worlds

Introducing CPKC - Canadian Pacific and Kansas City Southern meet in KC and make their combined, renewed case – They expect the Voting Trust to be established (and the KSU shares purchased by Q1/22 and the STB review done (“full control” established) by H2/22 – which seems optimistic (STB Vice Chairman told us at NEARS that they would, in effect, take their time and do comprehensive due diligence on the first (in 20 years) and last (Class One) merger before the “Surf Board”.  On their combined call they reiterated their synergy expectations, recently raised, of $820mm (and hinted that partially based on their CMQ experience, they expected to find more). 

• More numbers will follow, but it was interesting to note that CEO Keith Creel reiterated that the OR was “an outcome” of a balanced strategy in response to questions of the synergies leading to a possible sub-50 OR in the mid-2020s (the sound you just heard was that of STB Chairman Marty Oberman’s head exploding).
• They continue to expect that “line around the block” of stakeholders – shippers, other rails (add CN to that line), labor, communities – with their hands out, most of which will be behind closed-doors demands….
• “I’m not here to go to war with Union Pacific (or BNSF or CN or CSX or NSC”/CP CEO Keith Creel, National  Post
• One area where CP raised its synergies, beyond the Ag/Energy sectors, was intermodal.  At IANA Intermodal EXPO last week I ran a panel with the domestic IM VPs of NS and CP, and the UP’s head of Premium.  In response to my question about CPKC IM growth, CP responded that auto parts and other IM from the US/Canadian Midwest linked to the Southwest/Mexico was a prime target.  Interesting – especially since that is prime-time UP (Pacer) business….UP didn’t respond.  I am assuming that a fair bit of capex is required to make a go of that and that UP, so far unheard from will be pushing for gateway guarantees (as will BNSF & CN).  The largest share, remember, of Mexican-bound rail business on KCS comes from the UP….to that end I asked some experts on the CP positioning on autos/parts:

• • CSX hauls Michigan origin intermodal (automotive traffic) out of Detroit and interchanges with UPRR for movement to Mexico destinations as does NSC somewhat. Current service routings now offer border interchange or beyond before such traffic would reach Shreveport,La if routed via a potential CPKC out of Detroit. Right angle routes are not necessarily expeditious and especially when Chicago and Kansas City are the turning points.  
  • CP enters Michigan on NS from Elkhart in the Wabash line to KC.  They do not access any auto in MI.  If in containers, then access is much easier. They have a terminal on the NW side of Detroit
  • CSX hauls Michigan origin intermodal (automotive traffic) out of Detroit and interchanges with UPRR for movement to Mexico destinations as does NSC somewhat. Current service routings now offer border interchange or beyond before such traffic would reach Shreveport, LA if routed via a potential CPKC out of Detroit. Right angle routes are not necessarily expeditious and especially when Chicago and Kansas City are the turning points.
  • They have zero carload access in Michigan. Overhead trackage rights via NSC between Chicago and Detroit and haulage via CSX via the same city pair. They do have a “postage stamp” intermodal ramp on CSX in Detroit and CSX switches same under contract.
  • CP of course recently purchased the entirety of the Detroit River Rail Tunnel (which isn’t double-stack cleared)

Also:

• Canadian Pacific CEO's Gamble Pays Off With Successful Merger - Bloomberg
• Canadian Pacific's acquisition of KCS railroad back on track (apnews.com)

Canadian National and the railways, in general, face an existential battle – CNI started its defense by, well, playing defense, in an investor call that to these ears sounded, in its headlines, too reactive.  Activist Investors are 3-0 versus incumbent rail managers this century (CP and CSX, twice), and each time the incumbents proposed a defensive plan that sought to preempt the activists' big cost-cutting plans for the railway.  All failed.  Of course, those three had OR “gaps” of 1200-1500bps, not ~300.  Here are the new 2022 Strategic Plan highlights:

• Issuing a plan to bring their OR down 300bps or so to 57% next year
  • Targeted $700mm in “additional” Operating Income  in 2022 despite a big Ag headwind – mostly from headcount reductions (cue Oberman explosion #2) including 650 from management, which has already started apparently
  • Holding Capex at 17% of revenues (boom!)
  • Re-starting and expanding their share repurchase plan (bang!) including $5B beginning after the current plan expires in January
  • Bring in some new Board members including Chairman (the “who” will be telling)
  • Initiated a “strategic review” of non-rail/non-core assets including some that they only acquired recently as part of their FTB (“Feed the Beast”) program….so it sounded like a lot of undoing of what had been CN’s strategy.  Freight Forwarding appears to be being closed, the GLT ships will be on the block, and even some/part/all of TransX might be sold or spun, and it seemed like they just got here….

• Defending their attempt to merge with KCS (which, with the benefits of 20/20 hindsight, was an impossible goal under the new rules and under this STB)

What CNI did not do is OWN their growth story, and defend that as the key to the future of rail.  I suspect they will in days to some.  The headlines and bullet points sound defensive and reactive and were treated as such by TCI, but in the discussion, a different theme was beginning to emerge.  In the Q&A session, CEO JJ Ruest did a better job of:

• Explaining the accounting issues (depreciation 160bps) and non-rail asset (210bps) impact on the OR – not to mention the mix (IM) factor!  I would have preferred a true outline of the “core OR” followed by a bold discussion of why OR is just one measurement, and shouldn’t be the object of the Cult.  TCI will likely focus on the OR (targeting low 50s?), so while left unsaid, this is the battle of ROIC vs OR for railroad investor perception and I would have liked to see a starker positioning by CN, a ”line in the sand”.  After all, CN is targeting a 15% ROIC, and that added depreciation is capacity being filled by (for example) higher OR IM business from BC ports that help the ROIC.
• JJ also fought to define a 57% OR as the right balance, given the IM growth and the regulatory environment – was anyone listening?  The Q&A featured questions on changing “philosophy of running a railroad” (sic) suggests that the terms of battle will be defined by the OR unless CN can change the discussion….
• CN also showed that they are hardly outliers on a unit/cost level, nor on operating metrics, safety, and fuel expense….
• CN faces grain headwinds in 2022 but should (will?) focus on a multiyear strategic growth plan, not a (just) 2022 tactical response….
• The bump in capex (and depreciation) came from the massive reinvestment program of 2018-20 (capex peaked at ~27% of revenues that came after a period of what turned out to be underinvestment ~2015-17 (when the COO was one Jim Vena).
• CN got a win when the huge Caisse investment firm, so important in Quebec and Canada, came out in favor of CN and noted that TCI was playing both sides, as the top (or close) shareholder in CP and in CNI – as I mentioned previously, shades of Jay Gould
• TCI has stated that CN management has a “basic misunderstanding of the railroad industry and the regulatory environment” (Globe & Mail) – harsh words for the Mothership and while the last part (regulatory) might have related to the M&A plan, a focus on margins overgrowth is a back-to-the-future plan that hardly fits the regulatory environment (POW!); we await their next move….

Anthony B. Hatch 
abh consulting
http://www.abhatchconsulting.com 
abh18@mindspring.com
Twitter @ABHatch18