A Canadian Pacific train on the Bow River’s Morant’s Curve, near Lake Louise, Alta.

Depending on a client’s age and disposition, railways may seem like a relic: transcontinental networks built more than a century ago that fail to capture the imagination like the fibre, cellular and social ones driving the 21st-century economy.

“When you look at this company,” Edward Jones senior analyst Dan Sherman says of Canadian Pacific, “you think, ‘44% of their business is shipping bulk,’” such as grain, coal and potash. “That just doesn’t sound like a very interesting business.”

Maybe not, but railways are vital to the producers and manufacturers who rely on them to transport their goods to market. And the steady revenues they generate doing so makes them interesting to investors.

Canadian rails have also undergone dramatic transformations, with precision-scheduled railroading creating efficiencies and boosting profits.

After a fourth quarter that made 2018 a record year for revenue and operating ratio, this edition of How to Read looks at Canadian Pacific’s Q4 earnings to find out what keeps the company on track.

Operating ratio

“The holy grail for the rails is running lean operations,” says TD Asset Management managing director Michael O’Brien. He oversees two funds—the TD Canadian Equity Fund and the TD Balanced Income Fund—that hold Canadian Pacific.

CP followed its rival, Canadian National, into precision railroading in 2012, when E. Hunter Harrison took over as CEO. Precision railroading departs from the practice of holding trains until they’re completely full, instead prioritizing fast delivery and optimizing the railroad’s assets.

For Sherman, it means moving the same amount of freight while using fewer assets and less labour.

The measure of lean operations is the operating ratio: the percentage of revenues used to operate the railway. Lower is better.

CP’s operating ratio for the 2018 fiscal year was a record-low 61.3%, thanks to a 56.5% ratio in the fourth quarter. O’Brien compares that to the company’s 2011 ratio of 81.3%, calling the reduction “pretty incredible.”

The ratio, arrived at by dividing the company’s operating expenses by its revenues, is “really just the inverse of your EBIT margin, for all intents and purposes,” O’Brien says. “But I guess it sounds better when they call it an operating ratio.”

The Canadian rails have excelled at reducing their operating ratios, O’Brien says, and they’re proud of it: it’s the second bullet in the press release accompanying CP’s earnings.

“Pretty much anybody who read that bullet would know it was a good quarter,” he says.

How low can the operating ratio go? O’Brien says the company thinks it can maintain a sub-60 figure (rival CN was first to get there, he notes). But at some point there’s a tradeoff between growing volumes and being lean.

“Part of precision-scheduled railroading is you don’t just take everything that every customer throws at you: you maximize the flow to maximize your profitability, which means sometimes on the margin you might turn down some volume,” O’Brien says.

Table 1: Interim consolidated statements of income (unaudited) (in millions of Canadian dollars)
For the three months ended Dec. 31 For the year ended Dec. 31
2018 2017 2018 2017
Freight $1,964 $1,667 $7,152 $6,375
Non-freight 42 46 164 179
Total revenues 2,006 1,713 7,316 6,554
Operating expenses
Compensation and benefits 378 340 1,468 1,309
Fuel 247 197 918 677
Materials 46 48 201 190
Equipment rents 31 34 130 142
Depreciation and amortization 180 168 696 661
Purchased services and other 250 244 1,072 1,056
Total operating expenses 1,132 1,031 4,485 4,035
Operating income 874 682 2,831 2,519

Source: Canadian Pacific Q4 2018 earnings release

“That works really well when you’re going from an 80% operating ratio to a 60% operating ratio. When you’re at 60% already, there’s a question of to what extent do we want to focus on growing our volumes; in other words, growing the size of the pie.”

CP is a profitable business with an operating ratio in the low 60s, he says, and investors won’t see it drop to the 40s.

Rail data and pricing

Data about precision railroading are found in the Summary of Rail Data. The section contains measures including trains’ average weight, length and speed; the fuel consumed; the average dwell time in terminals; and the number of personal injuries per 200,000 employee hours.

The main revenue line (see Table 1, p. 26) reflects a combination of freight volume and the price CP received for moving its cargo. The railroads report carloads and revenue ton-miles (RTM) weekly, O’Brien says, so analysts aren’t surprised by volume numbers. RTM is the industry’s metric for the volume of freight transported, calculated by multiplying the total weight transported by the number of miles it travelled.

The rail data summary breaks down the volume of each commodity moved as measured in carloads and RTM, as well as the revenue per carload and revenue per RTM.

Freight revenue per revenue ton-mile is calculated by dividing the revenue by the RTM.

Freight revenue per revenue ton-mile calculation

“This is where you can get underneath the hood and see what’s really happening,” O’Brien says.

Building a revenue model starts with assumptions for each of the major commodities, he says—for example, the amount of grain CP is going to move and at what price.

“Typically, in a mature economy, your volume’s not going to be up or down by 20%,” he says (the exception is crude oil—more on that below). This makes pricing more important for growing revenues.

“In today’s market, pricing power is a rarity so that’s one of the things we really value for CN and CP,” O’Brien says.

Table 2: Summary of rail data
Fourth quarter Year
Commodity data

Freight revenue per revenue ton-mile (RTM) (cents)

2018 2017 Total change % change FX adjusted % change 2018 2017 Total change % change FX adjusted % change
Grain 4.46 4.21 0.25 6 4 4.25 4.10 0.15 4 4
Coal 3.23 2.82 0.41 15 14 3.00 2.78 0.22 8 8
Potash 2.77 2.62 0.15 6 3 2.65 2.61 0.04 2 2
Fertilizers and sulphur 6.27 5.91 0.36 6 3 6.00 6.27 (0.27) (4) (4)
Forest products 6.24 5.79 0.45 8 5 5.96 5.92 0.04 1 1
Energy, chemicals and plastics 4.74 4.10 0.64 16 13 4.47 4.21 0.26 6 6
Metals, minerals, and consumer products 7.24 6.32 0.92 15 11 6.72 6.44 0.28 4 4
Automotive 25.18 22.91 2.27 10 6 23.92 22.15 1.77 8 8
Intermodal 5.90 5.65 0.25 4 3 5.76 5.62 0.14 2 2
Total freight revenue per RTM 4.84 4.49 0.35 8 6 4.64 4.47 0.17 4 4

Source: Canadian Pacific Q4 2018 earnings release

Railways have a finite amount of capacity, which means running close to all-time highs on volume, as CP and CN were doing the last year or two, allows them to “be a bit more choosy” about their customers, he says. Demand gives the railways the upper hand when negotiating prices with customers.

Volumes typically fall as the economy slumps, making downturns a bad time to negotiate renewals. And, longer term, railways can add tracks or change cars to expand supply.

Analysts can forecast revenue roughly a year out based on volume assumptions, O’Brien says, combining those with management comments in meetings or conference calls and other factors in the broader economy. Excess capacity in the trucking sector, for example, would diminish the railways’ pricing power.

The term “price mix” is more suitable than “pricing,” O’Brien says, since the price varies by product. This can depend on the length of haul or the category’s competitiveness. Getting really good volumes on the most profitable commodity is a lot better than having the least valuable business propping up overall volume.

Grain is an especially difficult commodity because it’s politically sensitive, with price caps and limits on how much revenue railroads can generate from the product in a calendar year. The rules are designed to protect farmers from price gouging. Legislation passed last May, the Transportation Modernization Act, adjusted railways’ maximum revenue for grain and included financial penalties for not delivering cars on time. CP exceeded its revenue entitlement for the crop year ended July 31 by $1.5 million and was fined $75,000.

But the act also incentivized the rail companies to invest in special grain hopper cars by allowing them to deduct the full cost of car purchases from their grain cap. The hoppers hold more grain and are also shorter, allowing railways to fit more cars in trains of the same length.

CP announced in June that it was spending $500 million to buy nearly 6,000 hopper cars. The railway said the new cars will be able to handle 15% more volume and 10% more load weight than the old ones.

With grain accounting for nearly one-quarter of CP’s revenues, moving it more efficiently should lead to continued growth, Sherman says. “What we have is a railroad that’s already quite efficient and suddenly it’s going to free up extra capacity on its network,” he says.

Crude by rail

The commodity data shows revenues from energy, chemicals and plastics surged 49% in Q4 year over year, while the RTM for the category went up 29%. The bulk of the increase is from crude, O’Brien says, as oil producers facing pipeline delays once again turned to the railways.

“That would suggest to me that, all else equal, they probably got pretty good pricing on the crude business they picked up,” he says of CP. The revenue per RTM for the category increased from 4.10 to 4.74.

CP was patient securing commitments from oil companies after getting “left in the lurch” in 2013-14, O’Brien says, the last time they invested in oil transportation. During that period, CP “invested a lot of capital and then the moment the companies didn’t need them, they walked away.”

Sherman says CP is trying to make sure the oil companies or the government own most of the crude-by-rail assets, so the railway isn’t left with them when the business dries up. The railway may also be negotiating long-term contracts with oil producers for other products, such as chemicals used in extraction, “to compensate for them hauling the oil,” he says.

If CP secured a multi-year deal with oil companies before making the investments in its network, there likely won’t be a massive drop-off in 2019 if crude volumes drop again. And with major pipeline projects not expected to come online before at least 2021, oil companies will need the railways as a “bridge,” O’Brien says.

In February, the Alberta government said it would lease 4,400 railcars to get more oil to foreign markets until pipelines are built. *

“As long as they didn’t spend too much capital to ramp up this business without any sort of guaranteed volumes in return, I think it’s going to be a win for these guys. It’s just a question of how big the win is,” O’Brien says.

Capex and buybacks

Just as politically sensitive as the railways’ commodities preferences is what they do with their profits. Industry lobby groups are quick to cry foul when their products aren’t moved due to a lack of rail capacity, arguing the railways should be spending their profits to expand capacity rather than returning money to shareholders.

Shareholders, on the other hand, want to see a balance between money returning to them through share buybacks and dividends, O’Brien says, and network reinvestment to maintain a strong position.

“All else equal, you want to see your capex to sales ratio reasonably low and preferably declining. But too much of a good thing is a bad thing, because if you’re too lean on reinvesting in your network, you kind of strangle the golden goose,” he says.

The capital intensity ratio is calculated by dividing capex by revenue.

capital intensity ratio calculation

Capex is listed as “additions to properties” in the cash flow statement: CP spent $467 million in the fourth quarter and $1.55 billion for the year, a year-over-year increase of 16% or roughly $200 million.

The capital spending increase came in a year when revenues were up 12%, O’Brien notes.

“If your capital expenditures are growing in line with your revenue growth, usually investors are pretty comfortable with that,” he says. “If you get into a situation where your capital spending is growing two or three times as fast as your revenue growth, that can be a red flag that they’re investing inefficiently.”

CP’s guidance for 2019 capital spending is almost flat at $1.6 billion, with high single-digit revenue growth projected, O’Brien says.

The $1.55 billion in 2018 capex comes out of the $2.71 billion the company generated in operating revenues. After adding proceeds from property and asset sales and accounting for currency fluctuations, the company reported $1.29 billion in free cash flow—the “good stuff for investors,” O’Brien says.

The question is what they do with the free cash. For the year, CP paid $348 million in dividends and purchased $1.1 billion in common shares, so the amount they distributed to shareholders exceeded their free cash flow.

“Which means their debt actually went up a bit,” O’Brien says. “But their equity also went up a bit and their profitability is still high.”

For investors, he says, that’s about as good as it gets. “They’re generating a lot of free cash and they’re finding ways to give it back to us while still investing enough to keep the network strong—kind of all you ask from a management team.”

Table 3: Interim consolidated statements of cash flows (unaudited)  (in millions of Canadian dollars)
For the three months ended Dec. 31 For the year ended Dec. 31
2018 2017 2018 2017
Cash provided by operating activities 931 733 2,712 2,182
Investing activities
Additions to properties (467) (445) (1,551) (1,340)
Proceeds from sale of properties and other assets 62 13 78 42
Other 16 (2) 15 3
Cash used in investing activities (389) (434) (1,458) (1,295)
Financing activities
Dividends paid (93) (81) (348) (310)
Issuance of CP Common Shares 8 6 24 45
Purchase of CP Common Shares (544) (13) (1,103) (381)
Issuance of long-term debt, excluding commercial paper 638
Repayment of long-term debt, excluding commercial paper (9) (15) (753) (32)
Settlement of forward starting swaps on de-designation (22)
Cash used in financing activities (638) (103) (1,542) (700)

Source: Canadian Pacific Q4 2018 earnings release

*Correction: A previous version of this story stated that the Alberta government was leasing railcars from Canadian Pacific and Canadian National. The cars are being leased from other providers. Return to the corrected sentence.