Canadian National Railway Co Q1 FY2021 Earnings Call

Welcome to the CN's First Quarter 2021 Financial and Operating Results Conference Call. I would now like to turn the meeting over to Paul Butcher, the Vice President, Investor Relations. Ladies and gentlemen, Mr. Butcher.

Well, thank you, Christina. Good afternoon, everyone, and thank you for joining us for CN's first quarter 2021 financial results conference call. I would like to remind you about the comments already made regarding forward-looking statements. With me today is JJ Ruest, our President and Chief Executive Officer; Ghislain Houle, our Executive Vice President and Chief Financial Officer; Rob Reilly, our Executive Vice President and Chief Operating Officer; and Sean Finn, our Executive Vice President, Corporate Services and Chief Legal Officer. I do want to remind you to please limit yourselves to one question so that everyone has the opportunity to participate in the Q&A session. The IR team will be available after the call for any follow-up questions. It is now my pleasure to turn the call over to CN's President and Chief Executive Officer, JJ Ruest.

Well, thank you, Paul, and good afternoon to everyone. I hope you all had a safe, healthy, and constructive start to 2021. Here at CN, we're off to a strong running start. The underlying performance of CN has been strong, and this is thanks to our dedicated colleagues. Our railroaders delivered despite severe winter operating conditions, unprecedented demand in markets like port and grain, and ongoing challenges during the pandemic. As you can see from Slide 5, CN is on track to become the premier railway of the 21st century. We are focused on our role as an engine of North American economic growth and prosperity, as well as a supply chain and environmental leader. We pioneered and were the first to implement precision scheduled railroading across our network, and we are a clear industry leader in ESG. Our strong balance sheet is a testament to operational excellence, and we continue to prudently invest in the business and our strategy as we grow and expand our reach. CN has a long-standing successful track record of strategic acquisition throughout North America, which has resulted in successful integration of our current rail network. In line with our existing strategy, CN made a superior proposal to acquire KCS. This is the right next step for both CN and KCS towards becoming the premier railway of the 21st century. Turning to Slide 6, we are confident that together with KCS's experienced and very talented team, we will be able to continue our success from the combination of CN and KCS to the benefit of both companies. Specifically, this offer will deliver superior value to KCS shareholders.

All right. Thank you, JJ, and thank you to the talented employees of CN who helped deliver a very solid quarter.

Yes, thank you, Rob. My comments will start on Page 16 of the presentation, which will give a bit more color on some of the highlights of our first quarter performance that JJ discussed earlier. During the quarter, we booked a non-cash benefit of $137 million to recover part of the charge we recognized on the non-core branch lines we put up for sale in Q2 last year. Recall that in Q1 of 2020, earnings also included an income tax recovery of $141 million, resulting from the CARES Act. Excluding these nonrecurring items, adjusted net income was around $870 million, essentially flat, with adjusted diluted EPS of $1.23, up 1% versus last year. If we adjust for the impact of fuel lag and a stronger Canadian dollar, our adjusted EPS would have been up 11%, so quite a solid underlying performance.

Thank you, Rob, and thank you Ghislain Houle, and thank you for all of you for joining us today. It's a proactive approach with the way we propose economic growth in this merger, connecting more sellers and buyers. And I would like to take a moment to reiterate some of the highly compelling aspects of our proposal; by combining with KCS, we would compete head-to-head on all three coasts at lower costs, safer service, and better fuel efficiencies for Mexico through the heartland of America. This will result in a safer, faster, cleaner, and stronger railway. Additionally, we will bring our leading ESG and operating expertise to KCS's business to the benefit of both companies' stakeholders, as mentioned in our April 20 announcement. Based on our conservative and preliminary analysis of publicly available information, the combined company is expected to achieve EBITDA synergies approaching $1 billion, with the vast majority coming from additional revenue opportunities. The strong cash flow generation of the combined company will allow it to rapidly deleverage following the close of this transaction. We anticipate the transaction will be accretive to CN's adjusted diluted earnings per share in the first full year following the termination of the voting trust and CN assuming control of KCS, with double-digit accretion of full realization thereafter. We are confident in the strength of our business and strategies and progress toward becoming the premier railway of the 21st century. We look forward to engaging constructively with the KCS board and all relevant stakeholders to deliver a superior transaction with KCS. To deliver greater choice and efficiencies for customers, and enhanced opportunities for employees and local communities. Overall, we have a better bid, better way, better partner, better railway, and the best solution for KCS and the North American economy. On that note, we will start to take some questions.

And your first question comes from the line of David Vernon with Bernstein.

Good afternoon, guys. So, JJ, I want to kind of ask this question again a little bit. I know we talked about this when you made the bid. But looking at this transaction, why is now the right time to come in with a competing offer here? Like, what's changed in the market that makes this such a better deal than might have been two or three or five years ago at a lower price point?

So there are many reasons why now, and I covered those earlier last week. But the main reason why now is that the Board of KCS, after a very thorough consideration, has decided it's time for them to crystallize the value for their shareholders. Therefore, they're willing at this point to entertain doing a merger with a strategic partner or a merger with another railroad. The timing of that is also very much dependent on whether or not you have a partner with whom you could engage. From an economic point of view, we're at the beginning of a post-economic recovery; the GDP forecast for North America looks very promising. We had the USMCA, which was renewed, bringing additional value to the combination. Depending on whom you believe, this might be the decade of Mexico in terms of near-shoring. Given the challenges between North America and China, and the rising labor costs in China, Mexico might present a better opportunity. When you put all that together, as well as the fact that long-term money is affordable, it suggests to CN that now is the time to make a good offer to the KCS Board for them to consider seriously.

That's very clear. Maybe if I can just kind of squeeze one little follow-up in here. As you think about the unique drivers of value, is it more about getting CN rail connections further west or further south?

So the driver of value here is really about being successful; we need to create a superior product that can efficiently compete with long-haul trucking. On that point, I could ask Rob to comment on that. Right now, the rail network in North America is not designed to be as successful as it could be for long-haul distances, such as from Mexico City all the way to Detroit and Toronto in the East, or Mexico City to Wisconsin and Calgary in the West. In order to achieve this, combining two railroads makes it exceedingly appealing. Rob, would you like to add something about the product we have in mind?

Yes, sure, JJ. David, when you look at it, as JJ just mentioned, the USMCA contract finalized last year creates a need for a strong transportation option. We don't have a direct route to Mexico, but certainly KCS does. This allows us to become the true North American railroad, effectively connecting the continent. We bring a lot of options to the table across different industries. The auto industry, for instance, would gain a second line of service between Detroit and Kansas City, enhancing options. The intermodal service from Mexico to the upper Midwest and Southern Ontario is currently being trucked on I-35. By shifting this off the highway, we save fuel and emissions, significantly increasing choices for shippers. For farmers in the Midwest, states like Iowa, Illinois, Wisconsin, and Indiana would see better access to the Mexican market. Our reach and port access would open gateways for KCS shippers to connect to global markets, from the Atlantic to the Pacific in the Gulf. For Canadian aluminum producers, this would create direct access to markets in Southern US and Mexico. This combination really unlocks opportunities for lumber and panel buyers in Texas, allowing us to optimize and better utilize our fleet of over 10,000 center beams and boxcars. I could keep going, but there are numerous benefits this combination would bring, enhancing choices for shippers and customers and serving as the backbone of the USMCA.

Yes, we're very pro-choice, pro-competition, and very focused on growth. Thank you, David.

And your next question comes from the line of Scott Group with Wolfe Research.

Hey, thanks. Good afternoon, guys. So I want to ask about the operating ratio, just because it does look like this will be the worst among the rails this quarter. I know you talked about maybe a sub-60 OR earlier in the quarter; is that now in this higher guidance? And then longer-term, CP talked about maybe a low 50s OR pro forma with KCS. How do you think about your OR longer-term on a pro forma basis? And do you see opportunities to leverage some of the success that KCS has had with PSR to get your margins back on track?

Maybe I can start, and then Ghislain can add. When we look long-term, we examine the North American network focusing on the economic trial I mentioned earlier, with significant growth coming from intermodal. So in a world of growth, particularly from intermodal, CN's focus will be much more on EPS than solely on achieving the lowest OR possible. For instance, if we were moving a lot of crude or coal.

Yes, and just to add to that, JJ, we are indeed proud of our results for this quarter. When you look at our earnings being up 1%, while other rails are down, including our Canadian competitor, who stated their earnings increased, if you exclude the $50 million of one-time land sales, their earnings are actually down 5%. So we are up 1%. When considering the underlying fundamentals of the business, we would have seen an 11% increase when accounting for the fuel lag and FX impact, so we are indeed proud of our EPS. And this is where our focus lies.

Can you just…

Go ahead.

No, sorry to interrupt. Go ahead, JJ.

As I said, we are focused on EPS. That's what we want to optimize.

Okay. And Ghislain, can you clarify where the guidance is on OR though?

No, I mean, our guidance—we're quite proud. We've upped our guidance; we're quite bullish on the economy coming forward. We've upped our guidance to target double-digit EPS growth, backed by mid, high single-digit RTM growth. That's our guidance. Thanks, Scott, for the question.

Thank you.

Your next question comes from the line of Cherilyn Radbourne with TD Securities.

Thanks very much. Good afternoon. I wanted to ask in relation to the increase in guidance for the year, and particularly the increase in your volume outlook. Obviously, intermodal has been very strong, so maybe that's the upside. But we'd love to know if you're starting to see some signs of life in the carload side of the business, which I think would be helpful from a mix standpoint. Thanks.

So Rob, do you want to talk about what we expect to move between now and the end of the year?

Yes, so Cherilyn, we actually see some positive movement here, particularly in the second half of the year, is really where we see the upside as the economy starts to enter a strong phase. We are moving considerable amounts of gas, exporting through the port of Prince Rupert. The second gas terminal just opened up. The forest products group has continued to stay strong, and we talked about grain. I think the carload franchise really starts to gain momentum in the second half of the year, that we see as the significant upside.

Yes, it's pretty broad-based.

Your next question comes from a line of Tom Wadewitz with UBS.

Yes, JJ, thank you for the question here. I wanted to try to get your sense of the kind of negotiation with KCS. And how you address maybe some of the concerns that they potentially have regarding the regulatory process. So I guess in particular, CP now has visibility with the waiver that they would be able to engage in a voting process. You don't yet have that visibility. Is this a significant barrier to an agreement with KCS? Are there things that you can do in terms of negotiation that would address concerns that they might have that they reached an agreement with you? But then STB comes back and says no, we're not going to allow you to conduct a voting trust.

Thank you for the question, Tom. So we've only put in an offer to KCS last Tuesday, and it was only this morning that we filed for the voting trust. We fully intend to address every regulatory issue and concern that KCS has. So maybe Sean could brief us on where we're at in the process with these various components.

Sure. Thanks, JJ. Sure, Tom, I'm happy to do so. Obviously, we signed a nondisclosure agreement with KCS, and now we have access to the data room. We're going to start a dialogue in the coming days with them. I think you saw today we filed with the STB a letter outlining our views on the process that the STB will take in ruling on the voting trust. First, we also filed a petition for our voting trust, which is identical to the one that was filed by CP. Our application is straightforward; we're just asking the STB to rule on both voting trusts at the same time. So with the same standard, the same track, and ultimately come to a decision on both CP's voting trust and our voting trust simultaneously. We're very confident that, working with KCS—or obviously, they would want both parties' voting trusts approved—will result in a fair, transparent, and equitable process. We believe the STB will follow through with this. We've asked them to rule by May 31, which puts us in a position where both voting trusts have been approved by the STB prior to the KCS shareholder vote sometime in June. This dialogue is ongoing; we will be able to demonstrate to KCS that when it comes to the voting trust, our position is identical to CP's.

Do you need a prior agreement first for them to review it, or would that not necessarily be required?

No, not at all. We filed—we initiated our proceedings last week and submitted the voting interest. It is not required that you have a finalized agreement signed before they approve the voting interests.

Your next question comes from a line of Allison Landry with Credit Suisse.

Good afternoon. Maybe just following up on Tom's question. There seems to be some disparity between CN's view of what the public interest standard actually means concerning the voting trust compared to CP's outline of the same standard. Could you walk us through your understanding of the STB language and what you think it means? Basically, CP is arguing that competition will be considered, whereas CN seems to be suggesting it's more about financial fitness and the divestiture of the asset. I'm hoping you can provide clarity on your view regarding the public interest standard, specifically for the voting trust. Thank you.

Sean, do you want to address these technical points?

Sure, I’m happy to. First, Allison, our position is that our bid is pro-competitive, which will provide choices for customers and therefore is not a competitive issue. I also want to comment that there are no insurmountable regulatory problems. Historically, issues raised in STB applications have been mitigated and resolved through the STB process with customers. The standard with regard to the voting trust is very clear, and our trust is precisely the same as CP's, as a public interest standard; it focuses on the risk of financial harm to the applicant carriers. This includes if, for whatever reason, the transaction must be unwound, both carriers, in our case, KCS and CN, must remain financially viable post-transaction. We are very confident that both companies are robust and would not encounter issues following a denial of the voting trust, ensuring proper control of KCS. It's also evident in our voting trust that control remains with CN. The trustee, Dave Starling, is an independent trustee with extensive knowledge of both the rail industry and KCS, and we appreciate his independence in this role. Thus, we are optimistic that the public interest standard will be analyzed by the STB accordingly. We also want to ensure that our application requests the same standards and criteria apply to both voting trusts, so we expect the STB to grant approval.

Your next question comes from the line of Ken Hoexter with Bank of America.

Hey, great, good afternoon JJ, Rob, Ghislain, and team. Looking at the cost side of the 66 OR again, what are your thoughts on employee costs relative to your flat performance in the quarter? How do you think you ramp as volumes increase throughout the year? Also, could you share your thoughts on synergies between top line and the cost side? Thanks.

Thank you, Ken. Maybe I can start, and then Rob can add. February was an expensive month for the railroad, especially with the polar vortex. We discussed yields with same-store price increase of 4.2%. That's a positive trend. The volume outlook is promising, alongside a positive economic outlook. When reviewing KPIs, we've continued to make progress across nearly all fronts.

Yes, Ken, in terms of our operations this quarter, we found that even though the volume was up 6%, our operations headcount was down 6%. In operations, we employed roughly 800 fewer people while managing freight movement. Additionally, our labor productivity was up 9%. As we emerged from the depths of the COVID impact in Q2 last year, we didn't bring back all resources one-to-one. We've maintained that approach through the second half of last year and into the first quarter this year. Now as we look ahead to Q2 this year compared to last year, we are indeed seeing growth, so we are hiring conductors as we prepare for the second half of the year. We're optimistic about the upcoming volume.

To add, Ken, the increase we observed in Q1 labor costs was primarily attributed to incentive compensation, as our average number of employees during the quarter was down 3%.

Your next question comes from line of Brian Ossenbeck with JPMorgan.

Hey, good afternoon. Thanks for taking the question. Just a quick one on the end markets. Could you remind us what impact you anticipate from the ELD mandate when it becomes effective in Canada mid-year? We’ve heard concerns regarding the availability of certified devices. Is this something you're concerned about potentially impacting your end markets that overlap with trucking?

I can take this one. Most trucking firms in Canada needing to do cross-border work already have the required equipment due to U.S. laws. Therefore, only fleets that operate solely in Canada must meet the mid-year mandate. Overall, I would categorize the impact as slightly positive. A large portion of the fleet has already been converted due to cross-border requirements, so the impact appears limited. The broader economic strength will likely outweigh the effects of ELD implementation.

Your next question comes from line of Jason Seidl with Cowen.

Hey, JJ and team. Thanks for taking my question. I want to discuss customer overlap that may exist and how you plan to appease the STB and customers moving forward with the deal.

The overlap is well known between Baton Rouge and New Orleans, where both CN and KCS have a parallel line. We are aware of this detail, and we believe we can address this effectively, as Sean mentioned earlier—none of these issues are unsolvable. Rob, do you want to add any further insights?

Yes, you nailed it. As we noted on Tuesday, the overlap is strictly between Baton Rouge and New Orleans, where we have a few customers whose options will reduce from two to one. We're aware of this from the beginning, and we noted that it represents less than 1% of the combined railroad's network. We will address this with several options, which may include divestiture of the line when necessary. Of course, there are other locations noted that have no two-to-one overlaps—Jackson, Mississippi; E. St. Louis; Springfield, Illinois; and Council Bluffs. The Port of Mobile, Alabama also remains supportive of our merger proposal. If any issues arise, we will collaborate with our customers to find solutions, as we always do. As JJ said, we received over 500 letters of support in just over three business days, which is significant.

I hope this helps clarify everything that’s been discussed about the merger topic in the past week. Thank you for the question, Jason. Next question?

Your next question comes from the line of Justin Long with Stephens.

Thanks, good afternoon. I wanted to ask about the 75 locomotive orders you mentioned. I believe you received board approval for that. Could you provide details about the expected timing of those units and when they should be delivered? Is this contingent on the merger being approved, or is this based solely on the standalone business growth you anticipate?

Just to clarify, the board approved the green fleet expansion and locomotive fleet expansion prior to the KCS offer.

That's correct; it’s entirely based on growth and the growth prospects we see in the next 12 to 24 months. In terms of timing, we expect to receive around 25 of those units in the second half of this year, and the other 50 in the first half of next year. We may be able to adjust timing depending on volume needs.

Our focus on Canadian grain and support for Canadian farmers remains unwavering. We're investing significantly, adding and renewing 3,500 new low-cube high-capacity hopper cars. The 75 locomotives come with flexibility in terms of timing, allowing us to prepare as growth arrives. It’s essential to contribute to the recovery efforts post-COVID.

Your next question comes from the line of Chris Wetherbee with Citi.

Hey, guys, thanks for taking the question. A couple of things here. First, regarding the voting trusts and the desire for the STB to follow a similar approach in reviewing both. I want to ensure I understand the rationale behind seeking your yield's evaluation through the new merger rules rather than pursuing a waiver. What drives the preference for applying the same rules to the trust versus potentially the deal? Additionally, if the acquisition of KCS proceeds, how do you believe it might shape the industry going forward? Do you foresee this triggering more activity or do you think this would be a singular event?

Thank you, Chris. That’s a commonly asked question. I’ll defer to our expert, Sean, to address this.

In response to your question about the waiver, we believe we can close the transaction under both new and old rules. If the STB were to take that route, we’ve always maintained that we believe this transaction should be reviewed under the new rules. Our more than 500 support letters show that CN is confident in our capability to get this transaction approved. As for the voting trust, we strongly believe that the same standards apply with the same timeline for both voting trusts. Our application asks the STB to rule on both simultaneously, and we hope they will adopt a process that ensures an even playing field, while emphasizing fairness and transparency. We remain optimistic about receiving approvals for our voting trust.

I hope this helps provide clarity.

In terms of the downstream effects, if you were to acquire KCS, how would you foresee the industry adjusting?

Well, that’s something the board will assess based on new rules surrounding the overall transaction. We’ll address these elements as they arise. Our ability to demonstrate that the transaction is pro-competitive is essential, as Rob has articulated that there are no competitive concerns.

Your next question comes from the line of Jon Chappell with Evercore ISI.

Good afternoon, JJ. I want to ask about the ongoing developments at the Port of Montreal. This situation was somewhat anticipated, and it seems that some business has already shifted to Halifax. How well is your network positioned for this proactive shift in freight? Additionally, could you remind us of the impact from the prior strike, both in terms of volume and costs? How do you expect this current situation to be similar or different?

We've faced labor disruptions this past six months, so this is not the first. While the previous strike caught shippers by surprise, this time, due to the repetition and a specific deadline, customers are better prepared. The disruption last year led to unplanned costs; this time is different, and we’ve organized ourselves accordingly. Customers have proactively diverted freight to St. John and Halifax. Overall, this may not significantly impact our second-quarter results.

Your next question comes from the line of Brandon Oglenski with Barclays.

Good afternoon, and thanks for taking my questions. JJ or Rob, there's been significant public discussion regarding your potential combination being anti-competitive from a rail perspective, particularly about the shared line in Louisiana. Can you provide further outline in response to those comments, especially regarding potential underlying agreements that might be challenged going forward?

Our primary focus has always been on KCS and creating value for both KCS and CN stakeholders. The combination we propose is indeed pro-competitive. It is about developing new products and services that better enable competition. There’s nothing inappropriate about competition—it fosters innovation, and it connects more buyers and sellers. With CN's larger network, we can reach more destinations. All gateways will remain open, and we have no financial motivation to downsize our interchange business with other railroad companies. The vision behind a growth-focused merger is about expanding the total freight market in North America and not re-allocating existing market shares. We're pursuing growth and the bigger market around intermodal, less reliance on thermal coal and crude, which can be volatile, is a positive direction. I don’t know if you’d like to contribute further, Rob.

You captured it all well, JJ. As you outlined, our intention is to keep gateways open; we don’t plan on shutting them down. The inner line challenge is manageable.

Moreover, when taking into account all ports—from Mobile to New Orleans, Quebec City, Halifax, Vancouver, Rupert, Lazaro Cardenas, and Veracruz—this combination allows for even more potential to connect inland markets. You can reach St. Louis, Memphis, Kansas City, and all three coasts. Opportunities include transatlantic trade and the ability to connect goods from across North America, enhancing potential within finished vehicles and increasing the demand for parts that must move across borders. Thus, this merger aims to support our economy and create new products that foster trade and connection within the continent.

Your next question comes from the line of Amit Recruta with Deutsche Bank.

Thank you for allowing me to ask a question. JJ, I want to ask a previous question in a slightly different way, so bear with me. You've clearly done a lot of work to offer a compelling proposal, which is undeniable. However, the outcome is quite binary. I hope you can assist us with how CNI is impacted by a potential CP KCS merger, both regarding competitive implications for CNI and whether such an outcome would necessitate pursuing other acquisition opportunities to counterbalance that competitive implication.

Thank you for the question, Amit. This is a consideration we’ve discussed extensively over the years regarding the perceived 'end game.' Our current focus lies with the opportunity in front of us. KCS's Board has determined they wish to partner with another railroad, and during the initial privatization, we made an early acquisition of the Elanor Central and developed a marketing alliance with KCS. We've long maintained the perspective that NAFTA, now transformed into the USMCA, still holds significant value today. We will evaluate what various outcomes may mean for us down the line, but our current focus is on securing KCS as a strategic partner. This is the first time since I’ve been with CN that KCS is actively willing to consider a merger with another railroad, so let’s focus on the present transaction.

JJ, just a quick point on the voting trust. As of now, there's no specific date set for the KCS shareholder vote, but we are pursuing the approval of our voting trust in alignment with CP's application. We want to ensure the STB rules on both policies prior to the KCS shareholder vote later this year.

That’s an important factor to highlight. Thank you, Sean.

Your next question comes from line of Benoit Poirier with Desjardins Capital.

Yes. Good afternoon, everyone. We appreciate the in-depth view on the voting trust. Regarding the data room, could you elaborate on the timing for completing the data room analysis? I assume it's more virtual these days. Additionally, can you provide clarity on the timeline for making a binding proposal and finalizing a merger agreement? Thank you.

Sean, could you address that?

Yes, Benoit. We will start our due diligence in the data room shortly, likely tomorrow. As this is a virtual data room, we anticipate it will take us around two to two and a half weeks to complete our confirmatory due diligence. Once that is done, we can finalize the merger agreement. We already have a draft ready to go and will update it to reflect our findings as we engage with the KCS team over the next 30 to 40 days.

Thank you. I would like to turn the meeting back over to Mr. JJ Ruest.

Thank you for joining us today. Obviously, it's an important time in CN history. As we mentioned earlier, we're proud of our first-quarter results; the economy looks promising ahead. Our operating metrics are solid, and our fuel efficiency is strong. Moreover, our safety performance has seen significant improvement in personnel injuries and train accidents. There is much to be optimistic about moving into the coming quarters. From a long-term perspective, CN is very much focused on delivering the reasons necessary for KCS's Board to consider a combination with us. We will dedicate significant attention and effort to this in the upcoming weeks. Thank you for joining us today; more will come in the weeks and months ahead.

You're welcome. The conference has now ended. Please disconnect your lines at this time. And thank you for your participation.