The North American freight rail industry operates as three duopolies, with two rail networks operating across the East, West and Central US into Canada. These rail networks have very high entry barriers, given the prohibitive cost and regulatory challenges associated with trying to lay a new rail network. More than half (55%) of rail industry revenue has no substitutes, while 45% of freight revenue could be substituted by trucking. Given this strong industry position, rail has been able to price above its cost inflation over the long-term.
Three important factors make it an attractive time to invest in the rail operators. Firstly, the rail companies have implemented Precision Scheduled Railroading, a method of operating the railroad more efficiently, which should allow them to improve their service levels and lower their costs. Secondly, rails are four times more fuel efficient than trucking, and with higher fuel prices, their relative price discount to trucking increases further. Finally, longer-term, the increasing need for supply chains to decarbonise, favours rail freight over trucking given its greater fuel efficiency. A 2% shift in volume from trucking to rail freight would increase the rail market size by 14%, given that the truck market is so much larger.
Canadian National has been undermanaged over the past three years and has an opportunity to refocus their operations on Precision Scheduled Railroading principles. They are working to be more disciplined on sticking to the rail schedule to improve asset turns and service levels, better curate the book of business they sell according to the schedule and ensuring that the operating and marketing teams work in lockstep. Canadian National trades at 17.6 times forward earnings and should grow earnings by 10% a year and offers a 3% forward dividend yield.