Pension changes not a big deal, eh?

Accounting rules will drive up operating ratios at CN and CP, but they'll still lead Class I railroads in the metric
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Canadian National and Canadian Pacific are likely to see their operating ratios rise this year — but for a reason that has nothing to do with the railways’ industry-leading efficiency.

An accounting rules change that went into effect on Jan. 1 will disproportionately affect CN and CP. As a result, CN’s operating ratio is expected to rise around 2 points, while CP’s may go up by as much as 5 points, pushing it above 60 percent, according to Mark Rosen, an analyst and co-founder of Accountability Research Corp. of Toronto.

Through the first nine months of 2017, CN reported an operating ratio of 56.4 percent. Under the new rules, that would rise to 58.8 percent. In the same period, CP reported an operating ratio of 57.1 percent, which rises to 62.1 percent under the new rules.

The operating ratio is shown as a company’s operating expenses as a percentage of its revenue. It is an often-used statistic investment analysts use to gauge how efficiently managers are running a railroad.

The changes don’t alter the operating-ratio rankings of the Class I railroads. CN remains first and CP second. But third-place railroad Union Pacific, which reported an operating ratio of 63.2 percent for the first nine months of 2017, is close on CP’s heels.

“On a fundamental basis, Union Pacific’s efficiency is much more in line with the top performers in the industry,” Rosen says.
The rules change deals with the way certain pension assets and costs are treated.

“Companies will no longer be allowed to increase their operating income through estimates of expected future returns on corporate pension assets,” Rosen explains in a note to clients. Pension costs will be treated differently, as well, effectively boosting expenses.

And since the operating ratio measures operating expenses as a percentage of revenue, it rises when costs go up.
The impact of the rules change is negligible on U.S. railroads because their pension obligations are much smaller due to the Railroad Retirement system.

The Canadian railways are taking the change in stride and see it as a non-event. They’ve also been transparent: The fine print of their 2017 quarterly earnings reports have noted what the operating ratio would have been under the new rules.

“The change … is purely a reclassification of pension expenses which has no impact on CN’s net income or earnings per share,” spokesman Patrick Waldron says. “It will impact the operating income (operating revenues less operating expenses) and the operating ratio. 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.”

CP saw a dramatic improvement in its operating ratio from 2012 to 2016 as then-CEO E. Hunter Harrison transformed the railway. CP’s operating ratio went from 77 percent to 58.6 percent, an 18.4-point improvement.

Although the improvement shrinks to 16.8 points if the new rules are applied retroactively, that still leads the industry over that period, CP spokesman Andy Cummings points out.

“Importantly, there will be no change to net income or earnings per share going forward due to this new standard,” Cummings says. “CP is proud of its industry-leading operating performance improvements and is committed to growing revenue in a cost-effective manner that generates significant shareholder value.”
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