For as long as there have been railways, there have been legends of the ghost trains, the passenger-less phantoms that ride the rails in the dead of night.
There is something just as illusory with the Canadian rail companies: The magnitude of their operational outperformance versus their U.S. brethren. This particular legend is about to be debunked, which is perhaps even scarier for Canadian investors than any spectral engine.
The phantom margins are courtesy of a rule in U.S. generally accepted accounting principles, which are used by both Canadian National Railway Co. and Canadian Pacific Railway Ltd. For years, U.S. GAAP has allowed companies with defined-benefit pension plans to take a particular pension credit in their operating expenses.
No more: In 2018, that credit will be moved further down the income statement. Net income will not change, but operating expenses will rise. And the Canadian railways will take a much bigger hit than the U.S. ones in their "operating ratios," a key performance metric.
"The changes won't re-rank the industry in terms of operating ratio, but the benefit that the Canadian rails have had over the U.S. rails is very apparent," says Mark Rosen of Accountability Research, the firm whose recent report on CP called this to my attention. "The gap between the Canadian rails and U.S. rails shrinks significantly."
We'll detail the accounting nitty-gritty in a moment. But first, let's make a couple things clear. One is that Canadian Pacific's multiyear turnaround, with an 18.4-percentage-point improvement in operating ratio from 2012 to 2017, was not purely a trick of pension accounting. And, as Mr. Rosen notes, the Canadian rails still will have better operating ratios than their U.S. counterparts when the accounting change goes into effect next year.
CP spokesman Martin Cej says even applying the accounting change retroactively to 2012, the company improved operating ratio by 16.8 percentage points. "Now that CP's operating performance is approaching industry best, the company is focused on long-term sustainable, profitable growth," he said. He added the company's incentive compensation programs have "evolved to provide less emphasis on operating ratio and more emphasis on growth-related indicators such as operating income and return on invested capital."
CN spokesman Patrick Waldron said the accounting rule change "is purely a reclassification of pension expenses which has no impact on CN's net income or earnings per share. … The operating ratio is just one measure of performance and even with the change, CN remains the industry leader in operating ratio, as it has for many years."
However, the accompanying table, which details the operating ratios for the five major North American railways for the first half of 2017, and what those ratios will be under the new accounting rules, should open the eyes of Canadian rail investors.
CN's operating ratio, at 57.2 per cent, is six to nearly 11 percentage points better than the U.S. railways. (Lower is better in a measure of costs as a percentage of revenue.) With the accounting change, CN loses 2.4 percentage points, and its spread over the U.S. competitors falls to less than four points over Union Pacific Corp. and nine points over Norfolk Southern Corp.
CP loses 4.2 percentage points in its operating ratio. Instead of a five-point margin over Union Pacific, it would have less than a point's worth of difference under the new accounting rules. Its spread over Norfolk Southern drops from nearly 10 points to six.
How could this one rule change make such a difference? Here's how.
The GAAP rule allowed companies to take an estimate of the investment return on pension assets and use it as a credit against operating expenses. To be clear: Not the actual investment return from the pension fund in the prior year, but a long-term estimate that rarely changes.
For years, this has been a favourite red flag for investors with an eye on the financial fine print. In 2001, Morgan Stanley analysts exposed how Denver telecom Qwest Communications boosted its expected return on plan assets in 2000, giving itself a bigger benefit, even as markets were falling.
For CP, according to Mr. Rosen, the math works like this: CP employees earned $51-million (U.S.) in pension benefits in the first six months of 2017. Then, there's another expense based on the "time value of money," $226-million because CP's pension liabilities are another year closer to coming due. However, CP's estimate of investment returns delivered a $446-million credit to the pension line item. When a couple of other line items are then tallied, CP reported a $95-million benefit to operating expenses for running a pension.
CN and CP's big benefits don't come from aggressive expectations, necessarily: CN's expected rate of return is 7.0 per cent, while CP's is 7.75, according to S&P Global Market Intelligence. The three major U.S. railways use rates of return of 7 per cent (CSX Corp.) 7.5 per cent (Union Pacific) and 8.25 per cent (Norfolk Southern).
Instead, it's the large size of the Canadian plans that create the difference. The expected return is multiplied by the plan assets to create the annual credit, so bigger pension plans create a bigger credit, regardless of similar expected returns. And, in U.S. dollars, according to S&P, CN ($13.3-billion) and CP ($9.1-billion) each have more pension-plan assets than the three U.S. railways combined ($8.4-billion). The reason? The U.S. has a special federal-government railway-worker retirement program that replaces Social Security and company pensions for most of the U.S. companies' employees.
Hence, while CN and CP will see their operating ratios change significantly when the pension credit is moved out of operating expenses, the U.S. railways will only see changes of zero to 0.6 per cent.
To Mr. Rosen, this is one example of why, despite the market's "laser focus" on operating ratio, the statistic "is not a very good measure of fundamental performance, because of the impact of so much accounting noise, like pension income and one-time asset sales. CN and CP have benefited from this over the past few years, which has misdirected the market, but now they will pay the price, so to speak."
Will Canadian investors, too, pay a price when this pension benefit is exorcised from the operating ratio?
An accounting change will cause the magnitude of the Canadian railways' outperformance versus their U.S. counterparts to shrink in 2018. Here's how all five major North American rails' operating ratios would have changed in the first half of 2017 had the new rule already been in effect:
|Canadian National Railway||CNR-T||57.2%||59.6%||2.4%|
|Canadian Pacific Railway||CP-T||58.4%||62.6%||4.2%|
|Union Pacific Corp.||UNP-N||63.4%||63.5%||0.1%|
|CSX Corp. (non-GAAP*)||CSX-Q||66.1%||66.1%||0.0%|
|Norfolk Southern Corp.||NSC-N||68.1%||68.7%||0.6%|
* Adjusted to eliminate a large restructuring charge in the second quarter of 2017 Source: Accountability Research