David George-Cosh

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BMO Capital Markets is downgrading its view on Canadian National Railway Co. with its analyst saying the railroad operator's strategic plan announced last week may fall short of tapping into the company's full potential.

BMO Analyst Fadi Chamoun reinstated coverage of CN Rail with a "market perform" rating, down from an "outperform" following a restriction period as the bank was involved in a debt deal to help the company finance its now-terminated purchase of Kansas City Southern (KCS). Chamoun also hiked his 12-month price target for CN Rail's shares to $155 from $150.

"We believe that a pivot in strategy – with a focus on revenue quality – is needed to restore profitability levels and we estimate that the upside opportunity could be substantial," Chamoun wrote in a report to clients on Monday.

CN Rail announced a wide-ranging strategic plan on Friday following its failed takeover bid for KCS, including a target of 20 per cent earnings-per-share growth by 2022, $700 million in new operating income, and lowering its operating ratio - the percentage of revenue consumed by operating costs - to 57 per cent from around 61 per cent currently. The plan comes amid an activist campaign by TCI Fund Management Ltd. that seeks to put four new independent directors on CN Rail’s board and ultimately replace Chief Executive Officer JJ Ruest with industry veteran Jim Vena.

But Chamoun thinks CN Rail - described as one of the "strongest physical networks in the rail industry" could do better. Chamoun sees CN Rail's operating ratio falling as low as 53 per cent - which would be the lowest amongst major North American railroads - if the company changes its revenue mix.

"The opportunity for improvement is large. We believe that with a focused strategy on improving both the yield and unit cost, the company can likely deliver a low-50 per cent operating ratio, though that might require de-emphasis on some lower margin revenues including non-rail assets segments," he said.

Chamoun highlights how CN Rail remains an industry leader on train fuel efficiency while noting that unit costs have increased rapidly since 2016 and its emphasis on "purchased services,” driven in large part from growth in intermodal shipping, has led to a 180-basis-point deterioration of its operating ratio over the past five years.

While CN Rail's growth has come largely from expanding its intermodal or container shipping business, it also generates smaller margins than other shipping lines and is typically the lowest-profit segment for railroads.

"Some of the highest margin merchandise segment business – such as chemicals/petrochemicals, forest products, autos, and metals – have lagged for CN Rail," Chamoun said.