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Canadian Railroads See Bevy Of Opportunity Amid Slowing Demand

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Canadian class I railroads were on hand to discuss the outlook for the industry in separate presentations at the CIBC 18th Annual Eastern Institutional Investor Conference held in Montreal. CIBC is a top-five Canadian bank.

Canadian National (NYSE: CNI) was represented by its chief financial officer Ghislain Houle, while chief marketing officer John Brooks represented Canadian Pacific (NYSE: CP)

On the economy

Brooks said he was "pleased" with CP's operating performance. He said that the company's financial performance was quite strong in July, August and into September, even with softer revenue. He believes that some of the current obstacles in a couple of commodities is short-term in nature and that the outlook for 2020 is positive. He went on to say that he sees a "clear path to the double-digit EPS [earnings per share] guidance we provided."

CNI's Houle said that recent volumes are "much weaker than expected," down 1 percent year-over-year, but still favorable compared to the U.S. rails, which are down 6 to 8 percent. Houle said that "we're at the end of an expansion cycle," stopping short of calling it the precipice of a recession. He highlighted weakness in industrial production as the reasons for declines in carloads, but said that low unemployment and the strength of the consumer have been offsets. He said that Canadian National is not assuming a recession at this point. While there are near-term demand headwinds facing the railroad, Houle said that he "sees very favorable structural opportunities that are in front of us that will feed this network for the next five, 10, 15 years."

Intermodal Opportunities

Brooks said that CP's intermodal group stands to be the most impacted as trade tensions and competition from truckload (TL) carriers persist. He noted that CP is the dominant retail domestic intermodal provider in Canada and has regular conversations with all major retail shippers. "The general feeling is that maybe the economy in both the U.S. and Canada is not as bad as all the rhetoric you see," said Brooks. He said there will be some peak season volume this year, but maybe not as strong as previous peak seasons. CP's same store pricing is in-line with the company's third quarter guidance of 3 percent to 4 percent growth. "We won't grow for growth's sake," Brooks said when discussing how the company continues to be price disciplined.

Houle said that the growth at the container terminal at Prince Rupert is "the gift that keeps on giving." Currently the port is handing 1.3 to 1.4 million twenty-foot equivalent units (TEUs) annually, up 30 percent from last year. Additionally, CNI is likely to benefit further as global port operator DP World is adding capacity to handle an additional 250,000 TEUs by 2021 and another 200,000 TEUs by 2022. Houle said that he recently met with the Prince Rupert Port Authority and its members announced the possibility of another container terminal, which would add capacity to handle an additional six million to seven million TEUs annually.

Houle described the Halterm Container Terminal at the Port of Halifax as "the Prince Rupert of the East." Houle said that CNI has had talks with the CEO of the terminal's new owner, Singapore-based port operator PSA International, about plans for increasing container throughput at the facility. Currently, the terminal is running at only 16 percent of its 750,000-TEU capacity. Houle feels like this would be a good fit as its eastern rail network is "underutilized" as well. He believes that the container operations in Halifax could take market share from the ports of New York and New Jersey for intermodal freight destined for the U.S. Midwest.

Crude by rail noise

While up 60 percent, Houle noted that CNI's crude volumes were not as high as expected given government intervention and production curtailments. He said that Canadian National's crude by rail shipments were insulated by take-or-pay contracts, but that volumes have been impacted by the noise. He believes that the curtailments may ease in light of the recent attacks on Saudi Arabian oil fields.

On September 24, British Columbia was granted a temporary injunction against a law allowing Alberta to restrict the shipments of oil and gas to other provinces, including British Columbia. Alberta's use of the law to limit oil and gas flow has been viewed as a measure of retaliation against opposition from British Columbia's government to the Trans Mountain Pipeline expansion, which would nearly triple crude oil shipments from oil sands in Alberta to the coast of British Columbia. British Columbia opposes the pipeline's encroachment on environmental grounds, but depends on the oil products from Alberta that run through the pipeline.

Brooks said that Canadian Pacific has had good conversations with the government in Alberta and that the privatization on its contract is nearing a close. He said that CP has been fairly conservative on its crude oil by rail guidance. CP moved 25,000 crude oil carloads in the second quarter of 2019. He believes that the railroad will carry 27,000 to 28,000 carloads of crude oil in the third quarter and potentially 30,000 in the fourth quarter.

Coal headwinds and opportunities

Houle said that its U.S. coal business – thermal coal from southern Illinois to the Gulf Coast – was nearly 10 million tons last year. This year it's down to 3 million tons due to high water on the Mississippi River. While the water has receded, the cost dynamics are unfavorable. Thermal coal going to Europe, traditionally API2, is currently $58 per ton and he believes that the breakeven is close $50 to $55.

Houle said that the government's sale of its interest in Ridley Terminals, Inc. to an entity owned by the private equity firms of Riverstone Holdings and AMCI Group opens up the potential for substantial growth at the bulk commodity facility on Ridley Island in Prince Rupert. Houle said that the new owners are looking into increase capacity at the terminal to allow it to handle 16 million metric tons of export commodities, compared to the 10 million (mostly coal) annual run rate being transferred from railcar to ship currently. The terminal handled 7.7 million metric tons in 2018.

The longer-term potential could include plans for a new berth at the terminal, taking capacity for total commodities (to include potash) handled to 34 million metric tons. Houle said that CNI is the only railroad that serves the Ridley terminal. Additionally, the company will see a rise in coal carloads as a new coal mine spur was built in northern Alberta, which is expected to ramp to 8 million metric tons over time.

CP is working on a new mine with Riverdale Resources that is expected to produce 3 million to 4 million metric tons of production by 2022.

Grain harvest delayed

Both railroads reported record amounts of grain and grain products being shipped in the 2018-2019 season that ended in July. The Canadian railroads began investing heavily in western Canada infrastructure projects when the government revised the maximum revenue entitlement, providing incentive to improve their grain infrastructure.

Grain shipments are starting slower this season than last. Houle believes that the crop will be similar to the average for the last three years. This presents a bit of a revenue headwind this fall, but the grain shipping season will now carry a month or two longer in 2020, likely into July. CNI believes that its grain franchise is well positioned as 20 of the 21 new grain elevators coming online will be exclusive to the railroad.

CP's grain shipments are 20 to 30 percent behind schedule according to Brooks. He blamed wet and cooler weather as reasons the company has billed about 1,000 fewer carloads a week than normal over the last three weeks. He believes that this is a timing issue, because the harvest is expected to be robust at 70 million metric tons. Brooks said that CP's U.S. grain business has been negatively impacted by trade tensions. He said that the lack of soybean buying from China has impacted overall grain carloads. During the peak, CP was moving 60 to 70 trains per month; now it's closer to 15 to 30.

Capex to level off

CNI has seen some capital investment catch-up over the last few years, but believes that capital spending will return to historical levels moving forward.

Brooks believes that CP has a unique opportunity to grow in major metropolitan areas in Canada. He believes that capacity can be added in its service terminals without a significant increase in capital expenditures (capex). He expects capex to remain level at C$1.6 billion in 2019 and 2020 with the potential to decline beyond that as increased spending on hopper cars and remanufacturing locomotives tapers.

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