Canadian rail duopoly is on the right track, Mawer manager says

Barriers to entry have led to "better pricing power" for CN and CP.

Diana Cawfield 10 November, 2016 | 6:00PM

Over the past 30 years, the Canadian railway industry has evolved into a steady-Eddy, boring business, says Vijay Viswanathan, "and that's exactly the type of business model we look for."

Viswanathan, who co-manages Mawer Canadian Equity, is director of research and portfolio manager, large-cap Canadian equity, at Calgary-based Mawer Investment Management Ltd. The fund has a 5-star Morningstar Rating for its historical risk-adjusted returns and a Gold rating from Morningstar's manager-research team.

Viswanathan says consolidation, deregulation and better management have contributed to a "renaissance in rail profitability." In Canada, there is essentially a duopoly between  Canadian National Railway Co. (CNR) and  Canadian Pacific Railway Ltd. (CP), both held in the fund. "Decreased competitive intensity within the industry," says Viswanathan, "usually leads to better pricing power and better profitability."

The regulatory environment for railway pricing was once very onerous, restricted by a complex system for setting shipping rates, says Viswanathan. Reforms over the past three decades have allowed for a greater range in pricing without close regulatory restraint. There is still a lot of regulation around grain-shipping rates, but for the most part the railways and the shippers are able to come to commercial terms on moving goods, adds Viswanathan.

Management teams have also improved significantly over time. The idea of "precision railroading," pioneered by CP's chief executive officer, Hunter Harrison, has been a game changer, says Viswanathan. Precision railroading is based on five values that serve as CP's vision: improving customer service, controlling costs, optimizing asset utilization, operating safely, and valuing and developing employees.

CP had been on Mawer's watch list for a certain time, but it wasn't until the company brought in Harrison and his leadership skills that the investment managers initiated their position in the portfolio in 2012. Currently among the top 10 holdings, CN has been held in Mawer Canadian Equity for more than two decades.

Both CP and CN meet several of Mawer's key criteria for its bottom-up stock-selection process. First, the railways have been wealth builders over time. By this, Viswanathan means that they have been able to earn return on capital that is greater than their cost of capital.

Mawer also favours companies that have excellent management teams and competitive advantages. "What's great about the rail business in Canada," says Viswanathan, "is that you have a massive barrier to entry which leads to a sustainable, competitive advantage. You have two very strong entities competing hard with one another, but both are competing from a position of strength." That competitive landscape, where the actors are rational, leads to pricing power over time, "which is probably one of the most important things in business."

Valuation is also important to Mawer. Viswanathan believes the two Canadian railway companies are fairly valued, based on their price/earnings ratios, or by looking at the companies from the perspective of Mawer's discounted-cash-flow model.

Despite its positive views concerning CN and CP, Mawer's investment team is cognizant of risks in the industry. For one thing, Canadian railways have a large exposure to shipments of commodities. If Canada produces fewer bulk products, such as potash, coal and crude oil, that can have a negative impact on shipping revenues.

The Mawer team keeps a close eye on rail-shipping volumes, says Viswanathan. First, it's the main driver of top-line growth. Secondly, volumes can drive prices. If the volumes aren't growing, it's harder to implement price increases.

Historically, CN and CP have been able to increase their prices by about 3% to 4% a year, and that seems to be moving now to 2% to 3%, says Viswanathan. Part of the decrease is because the growth and volumes haven't been there as they have been in the past. "So that is something that we are watching for sure, the pricing environment and volume," says Viswanathan.

The managers are also watching the regulatory environment. "Risk is always out there with the regulator," says Viswanathan, "so we would call that a stroke-of-a pen risk."

The railways could face new regulatory requirements, such as those related to preventing loss of life or property losses from accidents. The most prominent example of failure by a railway to take appropriate precautions was the devastating fire and explosion in Lac Mégantic, Quebec, in July 2013, caused by a runaway train operated by the Montreal Maine and Atlantic Railway.

In addition, the rail companies have gradually taken away market share from trucking due to higher fuel costs, but this trend could be reversed if fuel costs fall.

Looking ahead, "it seems unlikely that the rail industry will be replaced anytime soon by some revolutionary advancement in transport," says Viswanathan. "At this point in time, there is nothing scalable that can compete as efficiently at moving heavy things great distances across land as trains."

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Canadian National Railway Co117.05 CAD-0.18
Canadian Pacific Railway Ltd315.82 CAD-0.06

About Author

Diana Cawfield

Diana Cawfield  Diana Cawfield is an award-winning writer who has been a regular Morningstar contributor since 2000. Her numerous publication credits include the Toronto StarAdvisor's Edge and Chatelaine, as well as the Canadian Securities Institute's online educational services.