Canada's railways face increased risk from regulations

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The harsh winter that slowed freight trains and laid bare the tensions between the rail companies and their customers has spawned a new risk for Canada's two major railways – more regulations.

The federal government has ordered the railways to meet minimum weekly grain targets, and followed that with legislation intended to help farmers and grain companies move last year's record crop. For the railways, the most controversial of these measures is the expansion of a prairie rail customer's right to ship with another railway, known in the industry as interswitching.

Customers currently have the right to tell railways to switch their goods – at regulated fees – to another railway if they are within 30 kilometres of an interchange. The Fair Rail For Grain Farmers Act, or Bill C-30, widens this range to 160 km for all commodities, including oil and lumber.

The government and the companies that ship by rail say the wider access will give them more ways to get their goods to market after a winter that slowed rail traffic to a crawl, and hurt sales in a range of industries.

Walter Spracklin, an analyst with Royal Bank of Canada, said expanded interswitching poses several risks to the railways, including higher costs because of the challenge of complicated car movements, and the potential loss of customers to U.S. carriers. (Mr. Spracklin and the railways call this "poaching." The government and the shippers call it competition.)

"An added risk is that Bill C-30 foreshadows future regulatory intervention in the Canadian rail sector," Mr. Spracklin said in a research note to clients.

Claude Mongeau, chief executive of Canadian National Railway, told The Globe and Mail in early April expanded interswitching rights amount to a "re-regulation" of much of the country's rail corridors, given the unprofitable rates are set by the government. He said the change made "in the heat of the moment" would do nothing to address the backlog while giving U.S. rivals the right to take Canadian goods to U.S. ports.

"If I'm failing my customer today moving traffic, what does interswitching do? [Canadian Pacific Railway] can't handle [the extra traffic]. I can't handle it. To interchange traffic is an extra step in the journey … It adds inefficiency. It doesn't create any capacity," Mr. Mongeau said.

"The biggest risk for the Canadian rails is a sudden change in the Canadian rail regulatory environment," said Kevin Chiang, an equity analyst with CIBC World Markets.

"The concern is that shippers use the extreme winter conditions … as a metaphorical Trojan Horse to re-air their grievances in an attempt to herald in new regulations" he said. "While at this point it is too early to determine the regulatory risk that CN and CP face, one could safely assume that, were CN and CP forced to abide by new regulations that impact how they choose to run their networks or their ability to raise freight rates, there would be significant ramifications on their long-term operating plans, earnings potential and valuation."

For investors, Mr. Chiang said stricter regulations in Canada could erode the premium the stocks enjoy over their U.S. counterparts. CN and CP trade at about 15.8 times earnings consensus for 2015, compared with 13.9 for U.S. railways, excluding Kansas City Southern.

On Tuesday, both Montreal-based Canadian National and Calgary-based Canadian Pacific report earnings for the first three months of 2014, a period for which rail congestion and cold weather are expected to have reduced operating performances. CN is expected to report a per-share profit of 63 cents, according to a Bloomberg survey of analysts. CP is forecast to post a profit of $1.41 a share.

Editor's Note: An earlier online version of this article incorrectly stated the analyst consensus for Canadian Pacific Railway's adjusted first-quarter profit was $1.47 a share. It was, in fact, $1.41, a share. This article has been corrected.