CN Rail CEO says KCS acquisition about ‘following the economy,’ not just growing his company

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Executives are the most important economic actors, but that doesn’t automatically make them good stewards of the economy.

Consider the North American railroad industry and its obsession with the operating ratio, which measures operating expenses as a percentage of revenue. Canadian Pacific Railway Ltd. pushed its ratio all the way down to 54 per cent in the fourth quarter, setting it apart from its larger rival, Canadian National Railway Co., which had a ratio of about 61 per cent over the same period.

The former looks like the better company by that metric. Maybe it is. CP also has more cash and pays a higher dividend, both a per-share basis, than CN, according to data compiled by Canalyst, an analytics firm.

But the clear edge in growing the economy, and the company’s future prospects in the process, goes to CN, according to its chief executive, Jean-Jacques Ruest, who joined the Montreal-based company when it was privatized in 1996 and claimed the top job in the summer of 2018.

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“We want to be a company that grows, and grows volume,” he said in an interview. “Our emphasis is on growing the bottom line by moving more freight.”

The distinction matters more than it did even a few months ago.

Earlier this month, Ruest snatched Kansas City, Mo.-based Kansas City Southern from CP chief executive Keith Creel by convincing KCS to accept his US$30-billion offer, even though it had already agreed to sell its assets to CN’s historic rival for US$25 billion in March.

But winning the prize won’t be as simple as outbidding a smaller rival. Analysts assume CN will have a tougher time with regulators who might disapprove of one of the bigger railways gobbling up a potential challenger. A combined CP and KCS would still have been the smallest of the Class I railways, but it would have been better positioned to challenge companies such as CSX Corp., Union Pacific Corp. and CN.

On the surface, Ruest’s bid will weaken competition. He needs a story about why that won’t hurt the economy and the narrative he’s chosen is a compelling one: a bigger CN, because of the company’s philosophy, means a bigger economy.

“Most of our benefit, to justify the investment, comes from growing the pie of the marketplace,” he said. “If you grow the market pie, you can aspire to have a bigger piece. If you are just focusing on the operating ratio, at some point, you might have a profitable pie, but you might not be participating in the full size of what the market can offer.”

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If a railroad is hyper-focused on ensuring its locomotives leave the yard on time, or is willing to use the industry’s relative lack of competition to put shareholders ahead of customers, then the rest of us pay for it.

Goods producers are at the mercy of railways and their pinpoint calculations about how to keep their operating ratios low. That makes it harder for producers to get their merchandise to market. It also forces more stuff onto trucks, which clog the roads and increase carbon emissions. But at least shareholders are happy. CP’s stock price is about 40 per cent higher than it was a year ago, while CN’s shares have only increased about 14 per cent over the same period after falling about 10 per cent since announcing its intention in mid-April to bid for KCS.

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KCS owns tracks that extend deep into Mexico, setting CN up to become the first truly North American railway. Its weaker share price suggests some investors are skeptical that regulators will allow that to happen. CN has promised to pay KCS US$1 billion if it fails to win approval, which likely won’t be known for at least a year.

“You need balance where you have low costs, but there comes a point in your low costs where you are no longer a railroad for your customer,” Ruest said. “Investors and analysts are more focused on the short term. We’re focused on the long term, and to be a relevant, long-term company, we need to focus on the people whose product we move, who pay the freight: our customers.”

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A Canadian railroad that extends uninterrupted to the southernmost ports on the continent could mark the beginning of a new phase for the North American trading zone, which began with the original Canada-United States trade agreement, and later expanded to include Mexico in 1994.

Both Ruest and Creel said they made their bids for KCS because they sensed a change in the weather. Trade winds that have blown strongest across the Pacific Ocean for the past couple of decades are shifting, and both long-time shipping executives have said they anticipate a significant amount of factory production that had shifted to China will be “near-shored” in Mexico in the years ahead.

The new North American trade agreement appears to have quieted U.S. complaints about such an arrangement, removing political risk as a reason to proceed cautiously on making a big investment on north-south trade between Canada, the U.S. and Mexico. The attention of politicians in Washington has shifted to China, presenting companies that want to sell to Americans with an extra incentive to set up production inside the North American bloc.

Many of those companies would have been rethinking their supply chains anyway, because the pandemic exposed the risk of relying too heavily on low-cost factories located in only one part of the world.

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They also would have been assessing how to lower their carbon emissions, since consumers, investors and politicians have made it clear that operating a successful company now means being an active participant in the fight against climate change. That’s good for railways, because they can offer a greener alternative to trucks. Ruest talks about the trucking industry like he might a competing railway, pledging to do what he can to force thousands of the diesel-guzzling machines off the road if his acquisition of KCS is approved.

“We follow the economy,” he said. “We follow business where business is going next, and that’s why we’re calling this a growth story as opposed to a strictly operating-ratio story.”

Financial Post

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