CN Rail: Past, PReseNt aNd FutuRe akeaways CoNveRsatioN

CN Rail: Past, PReseNt, aNd FutuRe takeaways FRom a CoNveRsatioN with JaNet dRysdale

A special report by the Portfolio Advisory Group

For Required Disclosures see page 8. Priced in CAD as of September 21, 2015, unless otherwise stated.

SEPTEMBER 2015

Tasneem Azim-Khan, CFA – U.S. Portfolio Advisor [email protected]; RBC Dominion Securities Inc.

Lindsay Brent – Associate [email protected]; RBC Dominion Securities Inc.

2 PORTFOLIO ADVISORY GROUP SPECIAL REPORT | December 20142 PORTFOLIO ADVISORY GROUP SPECIAL REPORT | December 20142 PORTFOLIO ADVISORY GROUP SPECIAL REPORT | September 2015


In mid-August, the Portfolio Advisory Group hosted a Deeper Dive call with Janet Drysdale, vice president, investor relations at Canadian National Railways (CNR). This report highlights the key takeaways from the call. Overall, she provided a deeper understanding of the company’s key competitive advantages that underpin CN’s leadership position in the North American Class I rail sector. We continue to underscore CN as a best-in-class company amongst the North American railroads and, indeed, the North American industrials sector. We would advocate for core positions in this name in well-balanced portfolios.

NoRth ameRiCaN Class i Rails—aN oveRview The North American rails provide best-in-class service versus their global peers and typically benefit from having the best margins and efficiencies in their operations. North America’s rail infrastructure was created in the late 1800s and early 1900s. Replicating that infrastructure today is likely impossible, creating what is essentially insurmountable barriers to entry. As such, the rail landscape in North America has changed little in the recent past and will likely maintain its structure into the future.

The industry is made up primarily of seven large “Class I” railroads—a classification by the Surface Transportation Board (STB) in the U.S., indicating a railroad having annual carrier operating revenues of $250M or more. Six of the seven are quite large— Union Pacific Corporation (UNP), CSX Corporation (CSX), Norfolk Southern Corporation (NSC), and Burlington Northern Santa Fe (Private) in the U.S., and Canadian National Railway Company (CNR) and Canadian Pacific Railway Limited (CP) in Canada. The seventh and smaller railroad is Kansas City Southern (KSU), which is more-regional in focus. Amongst the big six, the industry is effectively operating in three natural duopolies: CNR and CP in Canada (though both have exposure to the U.S. to differing degrees); UNP and Burlington Northern in the western U.S.; and NSC and CSX in the eastern U.S.

the CN diFFeReNCe—diveRsity aCRoss GeoGRaPhy, eNd maRkets, aNd CustomeRs

CN has differentiated itself through three major facets: geography, segments, and customers. Such diversity supports sustainability of earnings growth through a cycle.

�� “Geography Matters”: CN is the only rail to serve the three North American coasts. Such geographic diversity has proved a key competitive advantage for the railroad.

�� Well-diversified Book of Business: CN has a well-diversified portfolio in terms of the commodities it transports as well as good diversity in terms of the economies to which it is exposed i.e., mainly Canada and the U.S., but also some exposure to Asia. Intermodal1 is CN’s largest segment, at roughly 23% of revenues. It is typically consumer-sensitive and is expected to grow at a pace above average volume growth over the next few years, particularly if the U.S. economy remains healthy. Fortuitously, only 5% of CN’s revenues are exposed to coal—far lower than the industry average. Such well-balanced exposure has allowed CN to outperform relative to the average price performance of its peer group on a year-to-date basis . The company acknowledges that it is unlikely all verticals will be performing positively at the same time. However, there are natural trade-offs in the portfolio as a result of its diversity that reduces volatility in volume growth through a cycle and provides greater earnings visibility.

1Intermodal freight transport involves the transportation of freight in an intermodal container or vehicle, using multiple modes of transportation (rail, ship, and truck), without any handling of the freight itself when changing modes.



�� Low Customer Concentration: No one customer accounts for more than 2%–3% of revenues, while CN is also the originating carrier for 85% of the traffic that moves on its network. What this effectively means is that CN has the relationship with the customer in the majority of the movements that are occurring on its network. Building strong working relationships with customers has resulted in market share gains and delivery of incremental top-line growth.

An Extensive North American Network

Global West 24%

Domestic Canada 18% Global East 4%

Transborder 34%

Domestic U.S. 17%

Well Diversified PortfolioIntermodal 23%

Petroleum and Chemicals 20%

Grain and Fertilizers 16%

Forest Products 13%

Metals and Minerals 12%

Automotive 6%

Other Revenues 5%

Coal 5%

Based on 2015 H1 revenues

A Great Franchise

Vancouver

PrinceRupert

Calgary

Edmonton

Winnipeg

Saskatoon

Halifax

Moncton

Montreal

TorontoDetroit

New Orleans

Memphis

Jackson

Chicago

TSX: CNR NYSE: CNI

Unique three-coast access

Originating carrier for ~85% of traffic moving on CN’s network

Close to 70% of traffic originating and terminating on CN’s network

Well diversified: economic exposure; products; geography; customers

Global South 3%

Source - Canadian National Railway Company

evolutioN oF CN’s stRateGy uNdeRPiNs ability to GRow iN aN uNCeRtaiN eCoNomiC eNviRoNmeNt

Over the past five years, under CEO Claude Mongeau, CN evolved its focus from cost management to one of balancing cost management with customer service, what CN’s calls “Operational and Service Excellence.” By taking an end-to-end supply chain approach to customer service, CN is focused on growing the top-line faster by gaining incremental discretionary freight from its customers.

Yet, driving top-line growth through greater volume share is only one part of the equation. Management believes there is value in CN’s superior service i.e., CN is not growing volume for volumes sake but rather is negotiating value for service and capacity. This is measured in terms of same-store pricing, which has been very consistent at 3%–4% for CN.

According to the company, it was this change in philosophy and the transformation of the company from a cost-focused railroad into a supply-chain enabler that ultimately allowed the company to grow volumes at a pace above that of economic growth and doing so at low incremental cost. Concurrently, CN can leverage its industry-leading service to maintain price increases and deliver same-store pricing above inflation. Add in consistent share buybacks, and the end result is a resiliency with respect to earnings growth even in a relatively weaker economic growth environment.


This is has been born out in past performance as CN has grown annual earnings at a 15% average, while maintaining its industry-leading operating ratio at 63% on average over the last five years. For 2015, CN has guided to double-digit earnings growth over the 2014 adjusted diluted EPS of $3.76, despite the commodity headwinds that have buffeted the sector’s year-to-date earnings performance. Such growth is based on CN’s assumption of flat-to-negative volume growth alongside inflation plus same-store pricing.

CN’s CaPital alloCatioN stRateGy

Creating and growing shareholder value has been an integral part of CN Rail’s success as a company. The first call on cash for CN is reinvestment in its business that enhances efficiency and fluidity in the network.


Reinvesting in the Business

• Unwavering focus on safety and plant integrity

• Supporting growth, service and productivity

• Investing in operational productivity and network capacity, particularly in the Edmonton-Winnipeg and Winnipeg-Chicago corridors

Capital Investments (2014-2015)(in millions $ Cdn)

2,297

2,700

Other

Growth and Productivity

IT

Rolling Stock

Basic Capital

Reinvesting~20% of revenues


Following from this, management remains committed to growing dividends. Since its IPO in 1995, CN has grown its dividend by a 17% CAGR. This year, the company raised the dividend 25% in an effort to continue dividend growth at a pace faster than that of earnings growth, and increased its dividend payout ratio to 35% from 30%, which it expects to achieve over time. After dividends, CN reserves the use of cash for share buybacks. Though it is the last call on cash, CN has consistently returned value to shareholders in the form of buybacks. Since 2002, the only point in time that the buyback program was temporarily halted was in 2009, at the height of the financial crisis.

However, it was also in 2009 during which CN completed the acquisition of the Elgin, Joliet & Eastern Railway (EJ&E) while many of its competitors were cutting capex to preserve cash. However, CN saw an opportunity and used cash to acquire the EJ&E in Chicago—a key bottleneck

Rewarding Shareholders

436 474 503 585 652 724 818412 502

1,021 913

1,420 1,400 1,4001,505

730833

2008 2009 2010 2011 2012 2013 2014 H1-14 H1-15

Share Repurchases

Dividends

2323

$22.39$28.67

$40.08 $45.17

Total Shareholder Distribution(in millions $ Cdn)

Dividend Payout Ratio

25% 31% 26% 27% 27% 28%

$60.56

$69.40

31%

~75% of net income returned to

shareholdersannually

$72.06

29%26%

$80.02



for the U.S. rail networks. As a result of this acquisition, CN is able to bypass Chicago, resulting in faster transit times and more reliable service for customers.

the ComPetitive laNdsCaPe: CN stRikiNG the RiGht balaNCe aNd ahead oF the CuRve The competitive landscape has intensified over the last few years as the industry has made concerted and successful efforts to reduce costs. As a result, the gap with CN’s industry-leading operating ratio has been narrowed. CN acknowledges that the structural differences between the rails are not so significant as to justify a 3- to 4-point gap.

As costs have come down, CN’s peers have begun to shift their focus to accelerating top-line growth. A good example of this is CP Rail which is now operating substantially better under new management. However, unlike CN, its competitors have not yet invested in customer service or data monitoring/tracking systems to enhance efficiency across the entire supply chain. This service-oriented and data-driven approach to managing and improving customer relationships is engrained in CN’s culture. This is not the case for competitors that continue to be, on balance, more focused on the operations aspect of the business rather than service and marketing. While CN acknowledges that the focus of competitors may become more balanced between these factors, such a transition will likely take years, and CN remains well ahead of the curve in this regard.

outlook FoR Coal, CRude-by-Rail, aNd GRaiN volumes �� Energy – The dramatic pullback in energy prices came as a surprise to CN, particularly given the strong growth

the sector had experienced in 2014. With a deceleration in energy-related volumes (crude, frac sand, and drilling pipes), CN had to act quickly to recalibrate resources to deal with a lower volume environment. This resulted in the layoff of about 600–700 employees, and the storage of several hundred locomotives.

With respect to crude, CN believes a price differential between the Western Canada Select and Brent of about $20+ should drive greater crude volumes on to rail out of Alberta and into the U.S. Thus far, the recent widening of spreads has been encouraging though absolute volumes remain lower year over year and quarter over quarter.

Frac sand volumes are still down on a year-over-year basis, though recent volume trends suggest a sequential improvement since April/May of this year. CN indicated that if Canada can make progress on an LNG export terminal on the Canadian west coast, this would be a meaningful step function increase in the company’s sand business.

�� Coal – Coal constitutes about 5% of CN’s revenues—lower than that of its peers that have exposure in the range of about 10%–20% of revenues. The lower relative exposure to coal has allowed CN to outperform its peers on a price performance basis in the face of a secular decline in coal volumes over the last half decade. Nonetheless, in January of this year, CN indicated a headwind of $100M of revenue related to closure of some met coal mines in western Canada. This production was intended for steel-making in Asia; but, with the economic slowdown in China, management does not expect this volume to come back in the near term. With respect to thermal coal, CN’s exposure is predominantly to U.S. Illinois Basin coal where the demand outlook, particularly given prevailing natural gas prices, is formidable in the company’s opinion. Overall, CN expects coal to be a headwind into 2016 though perhaps not of the same magnitude as experienced in 2015.

�� Grain – In 2014, Canadian grain experienced a bumper crop of about 77M MT versus the approximate 58M MT five-year average. As a result, 2015’s grain volume comparables have been challenging as the grain crop is normalizing back towards the five-year average and demonstrating a more-typical seasonal pattern. The current-year crop has been negatively impacted by hot weather in Western Canada and is currently predicted to be around 55M MT. As the majority of the grain will be moved in Q4 2015 and Q1 2016, we believe that the deepest impact of the lower grain crop will be felt the most in Q2 and Q3 2016.



aReas oF FutuRe GRowth CN considers itself a North American railroad (as opposed to purely Canadian) given its considerable exposure to the U.S. economy. Roughly 10% of its revenues are tied to the U.S. housing market which continues to improve. Similarly, CN is seeing strength in the automotive market which is directly tied to an approximate 5% of the company’s revenue, and has broader impacts for other commodities such as steel, plastics, aluminum as well as intermodal shipments.

The improving health of the U.S. consumer has positive implications for CN’s intermodal business, which constitutes about 23% of CN’s revenues. Particularly, the international intermodal business is seeing traffic increasingly directed to the U.S. Thus far this year, about 50% of the containers that arrived through Canada’s west coast ports were destined for the U.S. versus about 40% last year. With employment, wage growth, and lower fuel prices contributing to consumer confidence, CN believes the international intermodal business is poised for above-average growth. In contrast to the international business, the domestic intermodal category is down 2%–3% in 2015 as a result of weakness in the Canadian economy.

For next year, CN is focused on the opening of the new Panama Canal. The company has entered into service level agreements with the Port of Mobile and the Port of New Orleans to try to grow its intermodal business through the U.S. Gulf Coast up into the Midwest. CN believes such proactive agreements position it to gain market share from NSC, and CSX.

A Competitive Advantage in International Intermodal

• New services, starting August 2015:

• Maersk adds Port of Prince Rupert as first call in transpacific service

• G6 adds export call at Halifax

• New Gulf Coast gateway to U.S. mid-continent leveraging:

• Panama canal expansion mid 2016

• Port of Mobile on-dock rail in service spring 2016

• Port of New Orleans on-dock rail expansion early 2016

• Pre-marketing West Coast port expansions:

• 500k TEUs at Prince Rupert in service Q2 2017

• 650k TEUs at Vancouver expected H2 2017

Overseas Intermodal ContainersWest Coast Discharge

(TEUs)

33%32%43%

International intermodal: 64% of total intermodal revenues; average length of haul 1,900 miles

42%

Exclusive access to Prince Rupert –North America’s closest port to Asia

42%

40% 49%

CAGR 14%

To CanadaTo U.S.

Arcadia




In addition to this, Maersk Lines, one of the largest global shipping lines, has agreed to ship goods through the Port of Prince Rupert which is exclusively served by CN. Virtually all goods that arrive at Prince Rupert get loaded on a CN train bound for a final destination. More recently, this traffic is increasingly bound toward the U.S. market. Such an agreement marks an important component of the company’s growth in Q4 2015 and into 2016.

Looking beyond 2016, CN believes both the Ports of Vancouver and Port of Prince Rupert will see incremental capacity coming on-line. This should provide a further source of growth for the intermodal business into the U.S. market.

the imPaCt oF Cad/usd oN eaRNiNGs PeRFoRmaNCe The lower Canadian dollar has an immediate benefit to CN in terms of financial translation: about 55% of revenues and about 50% of expenses are priced in U.S. dollars. In addition, the vast majority of the company’s debt is U.S.-denominated. These three components combined translate into a sensitivity of $30M in net income or $0.03-$0.04/share for every $0.01 move in the CAD/USD. CN’s current guidance is based on the assumption of an average $0.80 CAD for full year 2015. More recently, the FX rate is closer to $0.76–$0.77, which may provide a tailwind, helping to confirm CN’s earnings growth for 2015.

With respect to end-market outlooks, loonie weakness has improved the competitiveness of the Canadian lumber producers, provided a shock absorber of sorts for Canadian oil sands players who pay costs in local currency, and at the margin benefitted base metals, ore concentrates, and aluminum producers. While the current pullback in the loonie has yet to translate into a meaningful improvement in manufacturing in eastern Canada based on volumes tracked from this region by CN, overall it has been helpful to results.

siziNG uP the ComPetitioN

From an investment point of view, Union Pacific is the strongest competitor in North America. The strength of the U.S. railroad is underpinned by the considerable size of its network—UNP covers 23 states across the western two-thirds of the U.S. In addition, CN considers UNP to be a benchmark in the industry with respect to portfolio diversification and capital allocation.



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Pricing as of September 21, 2015: RBC Capital Markets has fundamental research of:

Canadian National Railway Company (CNR; Outperform; $76.71)Canadian Pacific Railway Limited (CP; Sector Perform; $196.24)CSX Corporation (CSX; Outperform; US$28.10)Kansas City Southern (KSU; Outperform; US$94.80)Norfolk Southern Corporation (NSC; Sector Perform; US$79.57)Union Pacific Corporation (UNP, Outperform; US$88.25)


As of June 30, 2015

Rating Count Percent Count PercentBuy [Top Pick & Outperform] 935 53.16 293 31.34Hold [Sector Perform] 707 40.19 124 17.54Sell [Underperform] 117 6.65 6 5.13

Investment Banking Serv ices Prov ided During Past 12 Months

Distribution of Ratings - RBC Capital Markets, LLC Equity Research


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D I S C L A I M E R

Portfolio Advisory Group personnel, including the portfolio advisor or any individuals directly involved in the preparation of the report hold(s) or exercise(s) investment discretion over a long position in the common shares of Canadian National Railway Company.

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CN Rail: Past, PReseNt aNd FutuRe akeaways CoNveRsatioN