CN Rail outperforming in growth and market share: Bank of America

Key Concepts

• Velocity: A key rail performance metric measuring the average speed of trains.
• Terminal Dwell: The amount of time railcars spend sitting in terminals; high dwell times indicate congestion or operational inefficiency.
• Revenue Ton-Mile (RTM): A standard unit of measure for freight transportation, representing one ton of freight moved one mile.
• Intermodal: The movement of freight in an interoceanic container or trailer using multiple modes of transportation (e.g., ship, rail, and truck).
• Fuel Surcharge Lag: The delay (typically 1–2 months) between rising fuel costs and the ability of a rail company to pass those costs to customers via contract adjustments.
• Cyclical Exposure: Investing in companies whose performance is tied to the broader economic cycle.

1. Investment Thesis for Canadian National Railway (CN)

Bank of America Securities upgraded Canadian National Railway (CN) to a "Buy" rating based on a combination of macroeconomic recovery and internal operational improvements.

• Economic Indicators: BofA’s bi-weekly truck shipper survey, which has tracked volume growth since late December, suggests a rebounding economy.
• Valuation Gap: CN was trading at a three-turn discount to its peers (18x forward earnings vs. 21x for the industry average). The upgrade reflects the expectation that as CN closes its service performance gap, its valuation multiple will expand.
• Outperforming Targets: Despite management’s conservative guidance of "flat" performance for the year, CN has already achieved 3% growth in revenue ton-miles, signaling that volumes are trending ahead of expectations.

2. Operational Turnaround

CN has struggled over the past two years with service levels, often missing earnings and volume growth targets. The current upgrade is predicated on specific operational improvements:

• Velocity Gains: CN has improved its train velocity by nearly 7% year-on-year, a rate double the industry average.
• Efficiency: By addressing previous issues with terminal congestion and operating plans, the company is successfully converting improved service into tangible volume growth.

3. The Impact of Fuel Prices

Ken Hoexter describes the impact of rising oil prices on rail stocks as a "double-edged sword":

• Near-term Headwind: Due to the 1–2 month lag in fuel surcharges, rail companies absorb immediate cost increases before they can be passed on to customers.
• Long-term Competitive Advantage: Higher fuel prices increase the cost of trucking, which is less fuel-efficient than rail. This widens the price gap (currently 20–25% in favor of rail), incentivizing shippers to convert from truck to rail, particularly for intermodal volumes.

4. Competitive Landscape: CN vs. CPKC

The analyst provided a comparison between CN and its primary regional competitor, Canadian Pacific Kansas City (CPKC):

• CPKC’s Position: Following its merger with Kansas City Southern, CPKC is viewed as a top-tier performer, consistently delivering mid-teens earnings growth.
• CN’s Position: While CN is not expected to reach the same growth levels as CPKC, the upgrade is based on CN’s "catch-up" potential. The analyst notes that while CPKC remains a favorite in the sector, CN’s recent execution justifies a more bullish stance as it begins to show relative outperformance.

5. Synthesis and Conclusion

The upgrade of Canadian National Railway is a tactical move based on the convergence of a strengthening economy and internal operational recovery. While the company still faces a valuation discount compared to its peers—largely due to a two-year history of service underperformance—the data shows that CN is successfully improving its velocity and exceeding conservative volume targets. Investors are advised to view the stock as a "catch-up" play, where the narrowing of the service gap and the potential for truck-to-rail conversion in a high-fuel-cost environment provide a clear path for relative outperformance.