Takeaways from CN investor day: Jason Seidl

Based on CN’s top line and productivity initiatives, Cowen and Company Managing Director and Railway Age Wall Street Contributing Editor Jason Seidl is “very confident in CN’s ability to meet, if not exceed, its goal of 10% EPS growth over the next five years. CN’s creation of an operations technology division underscores its historical ability to be one of the best forward-thinking supply chain focused companies.”

“CN’s investor day affirmed our positive views of the company, which we believe has the right plans in place to continue to be the best rail operator for the foreseeable future,” Seidl said. “While we do not see a compelling reason to change our estimates for 2017 and 2018, we are raising our PE multiple modestly to 20x from 19.5x due to our increased confidence in the company’s execution as well as continued positive signs in the North American industrial economy. This raises our USD price target from $81 to $83 based on the new multiple and our unchanged 2018 USD EPS estimate of $4.17.

“A low 50s operating ratio may be attainable over the next five years, in our opinion, though the company’s official guidance is for an average OR in the mid 50s over this period. Based on top line and productivity initiatives, we are confident in CN’s ability to meet, if not exceed its goal of 10% EPS growth. We came away with our constructive view reinforced.

“Before delving into its vision for the next few years, CN highlighted some key achievements. From 2010 to 2016, the company enjoyed a 6% revenue CAGR (compound annual growth rate), a 770 bps OR improvement, a 14% CAGR in adjusted EPS, and a 19% CAGR in dividend per share.

“Going forward, the company has a goal of continuing to outgrow the economy and the railroad industry, and to achieve inflation-plus pricing. Based on various discussions and presentations, we believe outperforming the economy could mean average volume growth of roughly 3% over the next five years. We are modeling for 6% growth in 2017 off easy 2016 comps and 1% growth in 2018.

“As far as CN’s goal of inflation-plus pricing, this likely means 2-3% increases for the foreseeable future if current market conditions persist. That said, we would not rule out 3-4% pricing sometime in 2018. Indeed, if the current rail volume growth proves sustainable, it could combine with a likely tightening in truckload capacity to drive both trucking and rail rates. With many trucking fleets having frozen their capacity growth over the past couple of years, and with ELD (Electronic Logging Device) implementation set to begin in 2018, conversion from the highway could start picking back up as shippers look to secure intermodal capacity for the long term. We estimate ELDs could reduce overall truckload capacity by 3-5% when they are fully in place.

“Investment in innovation and technology was a key theme, with the company creating an operational technology division. CN expects to invest C$500 million over the next five years earning at least the company’s threshold of a 12% return. We view this as critical for the railroad as it eyes potential long-term disruption from automated trucks. Other railroads may (and should) take notice of CN’s actions in this arena.

“CN also spent some time discussing its ‘secret sauce.’ This is a six-part approach to working with customers and helping them optimize their business opportunities, thus creating a win-win situation. The six parts are: helping customers win the total transit time contest, lowering round-trip cost instead of just focusing on price, helping customers win in higher margin markets, helping customers win the reliability contest, focusing on big ships and big alliances, and digital transformation for supply chain superiority.

“There does not appear to be a shortage in revenue opportunities for CN to pursue. One key area was international intermodal. For instance, CN expects C$280-300 million in incremental revenue from DP World at the Port of Prince Rupert from 2018 to 2020. It also sees C$225-250 million in incremental revenue from Global Container Terminal at the Port of Vancouver. In domestic intermodal, the company sees C$250-375 million in incremental revenue from market share gains, wholesale partnerships, innovation and new markets.

“On the Canadian grain front, CN expects an incremental revenue range of C$100-150 million from 2018 to 2022, with the company’s export grain share growing from 52% in 2017 to more than 55% by 2022. Management notes that the majority of new grain elevators have chosen to invest on the CN network, and expects to service 16 out of 20 new elevators by 2020.”