Taxes, trade and Trump: Railways face uncertain year

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Railway executives are happy to forget the past 12 months. It was a year of diminishing cargo volumes, profit warnings and slumping profits, not to mention a failed takeover bid that roused the ire of U.S. lawmakers and exposed divisions within the industry.

But economic growth, rising consumer confidence and the prospects of a regulation-hating government in Washington have cast 2017 in a better light.

Taxes, trade and Trump: Those are the forces that will most affect the plight of railways in 2017, analysts and industry leaders say. But the unpredictability of president-elect Donald Trump has everybody guessing.

"There is far from complete clarity on whether Trump will carry out all of his campaign promises, but overall our assessment is that his potential policies will be mixed for Canadian railways," said Cameron Doerksen, an analyst at National Bank.

"More restrictive trade policies including the implementation of tariffs on softwood lumber, potential changes to NAFTA and tariffs on Chinese imports would clearly be negative for the railroads, particularly for [Canadian National Railway Co.], which has a large exposure to lumber as well as cross-border and international [containers]," Mr. Doerksen said. "However, lower U.S. corporate taxes would be positive for CN and [Canadian Pacific Railway Ltd.], potentially lowering their combined tax rates by five to six percentage points."

A Trump tax break could reduce CP's effective tax rate to 20 per cent from 26 per cent, said an executive from the railway, which last spring dropped its lengthy hostile takeover attempt of Virginia-based Norfolk Southern Co., after it became clear the U.S. government opposed the deal.

Analysts have raised profit and share-price targets for most of the large North American rail companies, pointing to rising freight tonnage and the likelihood of a cut to U.S. corporate taxes. And industry lobbyists have pounced on the chance to persuade the incoming Trump administration to stall or scrub a slate of rules due to be phased in.

The American Association of Railroads has asked the U.S. Surface Transportation Board to delay any new regulations until president-elect Trump has filled three of the five STB seats. The AAR is unhappy with planned rules that would cap certain freight rates as well as a requirement that opens portions of a railway's network to competitors.

"The policy landscape in Washington, D.C., dramatically shifted on Election Day and, as such, the freight rail industry believes the STB should suspend its misguided quest to re-regulate freight rail," Edward Hamberger, AAR president, said in a New York speech in November.

Big railways that operate in the United States, including CP and CN, are also facing deadlines to complete the installation of costly fail-safe train controls designed to improve safety by overriding human errors. Getting rid of that requirement is unlikely, said Citigroup analyst Christian Wetherbee, since it would require a legislative change.

Perhaps the biggest question mark about the Trump government is if it will rip up the North American free-trade agreement and erect barriers to cross-border trade. CP and CN have significant cross-border trade, and have much at stake, but Mr. Wetherbee said it is likely the three-country trade deal will get renegotiated, not discarded.

"Our base assumption is that NAFTA does not get blown up," Mr. Wetherbeee said in an interview from New York. "Ultimately there's probably some adjustment done. I don't know that that's necessarily a bad thing. Could it be more protectionist and lower trade? I'm a transport guy and that's not a good thing for volumes and the economy."

U.S. tax reform is the biggest wish for railways, Mr. Wetherbee said, noting it could boost profits by 20 to 30 per cent and boost free cash flow.

Reduced taxes, rising freight volume and efficiency gains should more than counter the slower price increases railways are able to impose, said Walter Spracklin, an equities analyst with Royal Bank of Canada, referring to his company's survey of rail customers.

"A strong majority of shippers expect rail prices to be higher again in 2017, [but] the rate of growth is expected to slow considerably to 1.6 per cent, which is down notably from the 2.5 per cent last year," Mr. Spracklin said in a research note.

Rail shippers trying to negotiate better freight rates will have several trends in their arsenal, Mr. Spracklin said: weak demand for trains; excess rail capacity; competitive trucking rates; and better rail prices for certain regions and commodities.