First published on 31 March 2006

The Long Haul

            Robert Ritchie and Fred Green

Calgary Alberta - The reception area at Canadian Pacific Railway's head office in Calgary is a bit like a museum diorama, a sampler of corporate history befitting the line that united the fledgling Dominion of Canada from sea to sea in the 1880s. Stuffed upholstered armchairs and a gloomy oriental rug evoke ancient boardrooms, while lustrous old waiting-room benches, rolltop cabinets, and a massive bronze train bell recall the steam age. Sombre portraits of CPR titans George Stephen and William Cornelius Van Horne stare each other down.
 
Down the hall to the left of Van Horne, however, the executive offices have a very different feel, one that's more Microsoft campus than Victorian establishment. The glass-walled offices of chief executive Robert Ritchie, chief financial officer Michael Waites, and president and chief operating officer Fred Green have functional wood workstations and are linked by a common room filled with comfy leather chairs and coffee tables, a place to meet casually and solve problems.
 
"You can't get wrapped up in history, but you don't want to forget it," Green concedes when asked about the contrast between tradition and reality.
 
The 49-year-old may have a well-trimmed goatee, but that's about all he has in common with railway legends like Van Horne. And Green has more reason than ever to appreciate the application of consultative modern management to a venerable corporation. In February, CPR's board picked him as the 61-year-old Ritchie's replacement. He takes over formally at the company's annual meeting in May.
 
The timing could hardly be better for both men. Ritchie leaves on a high and Green inherits an often underappreciated but now apparently healthy railway franchise.
 
The second-smallest of North America's seven Class 1 railways, CPR is coming off its best year ever, with 2005 revenues up more than 12% to $4.4 billion, operating income breaking through the $1-billion mark for the first time, and net income up 31.5% to $543 million. In percentage growth at least, CPR outstripped the much larger Canadian National Railway Co., the gold standard of the industry. The accomplishment is partly due to several years of Ritchie-led, and Green-executed, efforts to invest in track and rolling stock, cut costs, and build the technology-based systems necessary to make CPR a fully "scheduled railway" one where everything from car loadings to deliveries is designed to meet customer needs rather than fit an arbitrary railway timetable.
 
But the company also has benefited handsomely from the strong North American and global demand for its freight hauling services. Thanks particularly to the booming Chinese economy, CPR's shipments of grain from the Prairies, and metallurgical coal from Elk Valley in southeastern British Columbia, are booming, filling tracks leading into the port of Vancouver.
 
Going the other way, Asian shipments of finished goods in containers the line's intermodal traffic are flourishing. The company's global container business, which operates through the port of Montreal, is humming too. Even its business in the United States, channelled along the wholly owned Soo Line to Chicago and into the northeastern states along subsidiary Delaware and Hudson Railway, is solid.
 
"We talk a lot about China, but the reality is that we've built our business largely on the north-south movement of freight and it continues to chug along," says Green.
 
For the most part, financial analysts like what they see. "CPR is regarded as a good railway, not in the same category as CN, but it's well regarded as an operator," says Randy Cousins, a transportation analyst with BMO Nesbitt Burns in Toronto. Along with other railroaders, the analysts say that there's no end to the good times in sight. Rail shipments are predicted to continue to be strong at least this year and next. And thanks to its replenished rail network, one that appears ideally placed to serve the Asian (read Chinese) demand that has exploded in the last year and a half, the Street expects CPR to rack up double-digit earnings gains in 2006 and 2007.
 
The line that was the weak link among the Class 1s in the 1980s and early '90s has been revived as a nimble competitor, just in time to celebrate the 125th anniversary of the company's incorporation.
 
As Green says, "It's a mighty franchise and a wonderful time to be in the railroad business."
 
Investors are climbing aboard as well. CPR stock has traded recently in the $59 range, up 28% over the past year, compared with a 20% rise in the same period for the S&P/TSX Composite Index. It may not be doing as well as archrival CN in percentage terms (CN is up roughly 37% in the past year) but, if you believe the consensus analysts' forecast, CPR will continue to outperform other transportation stocks this year.
 
Even before the Asian boom kicked in, CPR was making gains with a three-pronged strategy that aimed to boost revenue from commodity freight haulage, raise productivity through system investment, and manage labour costs, the latter while keeping safety standards high and maintaining peace with the 36 union bargaining units the line deals with in Canada and the U.S.
 
Particularly since CPR was spun off as a separate company, as part of the breakup of Canadian Pacific Ltd. in 2001, the aim has been to build "the most fluid railway in North America," Green says. Translated into specific actions, that has meant the following:  CPR has invested heavily to replace its old direct-current (DC) diesel locomotives with higher-capacity alternating-current (AC) diesels. As railroaders explain it, AC locomotives are better able to "lift" freight cars and get them going.
 
At the same time, CPR has spent to modernize its freight car fleet with new coal cars, hoppers, and specialty cars to haul lumber and steel. Says Ritchie:  "When we moved our head office from Montreal to Calgary in 1996, our locomotive fleet was one of the worst in the industry. Now, arguably, it's one of the best, it's certainly one of the youngest."
 
Tracks and rail yards along the company's 22,500-kilometre network have also come in for their fair share of investment. Last year alone, CPR spent $900 million on improvements, $160 million of that going to expand capacity along the western corridor linking Moose Jaw to Vancouver.
 
CPR has developed an Integrated Operating Plan, somewhat akin to the scheduled railroading approach pioneered by CN. In return for spending more than $400 million on technology in the past five years, primarily in software and operating systems, the line has gained the ability to prepare detailed plans for customer shipments, optimize the use of rolling stock, reduce downtime in yards, and more effectively schedule train crews and repair staff.
 
Both Ritchie and Green have pushed "co-production" and interline agreements with other railways as a way to gain broader market access in Eastern Canada and the United States. (CPR has no track east of Montreal, nor south or west of Chicago.) CPR now has more than 20 co-production agreements (many of them with rival CN) to maximize common use of assets in a particular area.
 
The company's numerous interline agreements govern the way it transfers or accepts freight loads from other lines essential to a railway that hands off roughly 40% of its freight traffic.
 
Co-production agreements have also enabled CPR to revive underperforming assets such as the subsidiary Delaware and Hudson line in the northeastern United States. In one deal, D&H rationalized services in New York State with Norfolk Southern Corp. The pact also provided a connection to CN, which wanted to move forest products shipments more directly from Quebec to the U.S. South. The overall result:  more traffic and greater utilization of the D&H line. "We have successfully reinvigorated the property," Green says.
 
The result of all this added efficiency:  CPR has been able to cut its labour costs. Thanks to the success of the Integrated Operating Plan, for example, the railway laid off some 400 managers and supervisors last year. "In the course of one year, we have reduced by half the number of failed deliveries that would require us to have someone on the phone," says Green. "We have been able to collapse the size of our customer service group substantially."
 
Several hundred train crew and yard workers have been laid off as well, but the company has managed it without jarring relations with its unions.
 
Early this year, there were two contracts with the line's police association and a branch of the Teamsters at the ratification stage. None of CPR's other five Canadian unions will be in talks until the year-end. Relations with stateside unions are also stable.
 
All the investing and operational recalibrating, particularly the improvements made in the line's western corridor, has impressed analysts. "Once the utilization of these assets grows over the next few quarters, it's going to translate into a 1% to 2% improvement in CPR's operating ratio," says one. "They have some under-levered assets in a number of areas that should benefit as volume grows and they have a number of productivity initiatives and co-production agreements done over the last year with CN and others that should pay off over the next couple of years. We're going to see improvements in results and margins over the next two years."
 
CPR's operating ratio, the all-important proportion of total operating expenses to total revenues, has long been improving. Ten years ago, the line's OR stood at more than 85%; today it's a hair over 77% and falling. This comes nowhere near CN's industry-leading 63.8%, but Green is confident of meeting the analysts' expectations. "We've said that this year we will take off another couple of points, to 75%," he says. Green, though, is more interested in drawing attention to the "secular change" he sees in the industry.
 
Prior to mid-2004, he says, railroaders had suffered through decades of weak demand that forced them to cut costs and reduce capacity. Then the Asian boom hit, and commodity prices strengthened. Burgeoning customer demand ran smack into truncated rail capacity. "The industry has not really been able to earn its cost of capital consistently, and now we're at the point where the marketplace values the service that we offer," says Green. "That allows us pricing power."
 
Pricing power. It's a railroader's dream scenario because it suggests you really can charge as much as the traffic will bear. But there are limits. You have to gauge your price relative to the competition in the railways' case, the trucking industry. (Trucking is currently being squeezed much more than railways by rising fuel costs.) You also have to judge the impact on the shipper's competitiveness, charge too much and you'll undermine their revenues and profits. This is the delicate game that CPR and all the other lines have to play. The difference these days is that railroaders are holding the better cards.
 
Fred Green is not your classic railroader. Unlike CN's callused, drawling, chief executive, Hunter Harrison, who worked his way up from the switching yards in his native Memphis, Green is smooth-handed and low-voiced. He speaks carefully, qualifying all his responses, his thumbs and fingers forming thoughtful pyramids. The dark blue shirt, the silk tie, the navy suit and shiny black shoes, are standard senior management issue. Every greying hair is in place. Glasses are tucked away to reveal the clear blue eyes of a manager in his prime. If there was a CEO-grooming course in business school, he would be a star graduate. Looks are a bit deceiving, though. Green is still willing to go into the corners playing seniors' hockey, and he's up for several days of backcountry skiing when he can find the time. And he takes his share of criticism, especially when his two grown sons come to visit. "They're the social balance at the dinner table," he says. "They're very much interested in ensuring that the environment is protected and that society is fair to everybody. I'm the business guy."
 
Green was born in Newfoundland while his construction executive father worked on the Stephenville airport. The family later moved to Montreal, where Green grew up and took commerce at Concordia University. In 1978, the year he graduated, he married his high school sweetheart and began rounds of job interviews. No particular industry appealed to him, but he liked the apparent pride of the CPR recruiters. He joined the company as a marketing analyst and never looked back. Green quickly headed into marketing and sales in the line's intermodal operation, before graduating to operational management jobs, first in Western Canada and later in the Maritimes, where he ran a small subsidiary, Canada Atlantic Railway.
 
By the time it was sold off 10 years ago, Green was back out west as general manager of Prairie operations. In early 2004, he was named executive vice-president responsible for operations, marketing, and sales in North America, by October that year, he was chief operating officer. He took over from Ritchie as president last November, and early this year added the CEO-designate title as well.
 
Green is known in the industry as a smart and solid performer, but Ritchie naturally takes it one step further. "He's got great leadership skills, he knows what he wants, and he knows what the plant is capable of," he says. "He's very goal-oriented. He sets targets and he's very good at communicating them to the senior leaders."
 
Green will need these attributes and more to deal with the substantial challenges facing CPR. Despite its current health, the railway has long been seen as a gifted, but potentially vulnerable, smaller player in the Class 1 league (defined, for reasons known only to the U.S. Surface Transportation Board, as lines with operating revenues of more than US$289.4 million. "It might be in the middle of the pack in terms of operating ratio and earnings, and that's okay, but the hard fact is it's the smallest [Big Six] player in North America. How much longer can it survive as an independent entity, that's the question," says Joe Martin, director of Canadian business history at the Rotman School of Management at the University of Toronto.
 
CPR's likelihood of survival is partially pegged to the fact that it has very little of its own track in the U.S., being relegated to the Soo Line, which ends in Chicago, and the Delaware and Hudson, which serves but four northeastern states. CPR also isn't as strong in Eastern Canada as it is in the West. Says Cousins:  "CPR has a lot less volume in Eastern Canada than CN and railroading is a bulk sport in that the more you move, generally the more profitable you are." There are even questions about the strength of Western Canadian operations.
 
Blair Carey, a transportation analyst with Accountability Research, notes that coal, which makes up 17% of CPR's freight revenues, could be a problem for the line because the freight rate is partly based on the market price of the commodity. "They were in a big fight with Elk Valley about this for most of 2004," says Carey, "so they're highly sensitive to the price of that commodity in particular." Carey also suggests, and he isn't alone, that CPR is running near its production capacity around Vancouver. That, he says, is causing the line to charge even higher freight rates and generating ill will. Carey's big complaint about CPR, however, has nothing to do with operations. It's the company's unfunded pension liability (more than $600 million) and unfunded post-retirement benefits such as health and life insurance (more than $450 million). "They have the largest pension liability in relation to their total assets of any of the Class 1 railways," Carey says. "The chickens are going to come home to roost on this one, just like they did at General Motors."
 
In a recent report, Carey ranked the 132 companies in the S&P/TSX Composite Index that have defined benefit pension plans. CPR ranked in the middle of the pack, with a $6.8-billion plan that's 8.9% underfunded.
 
Bombardier Ltd., the worst of the blue chips in Carey's pension funding sweepstakes, had a $5.2-billion plan that was 36% underfunded.
 
CN, meanwhile, had a shortfall of only $84 million on its $13-billion plan.
 
Of course, the larger question with CPR is:  Will it still be around when the chickens arrive? Rail mergers have been on the back burner since 2000, when CN, under pressure from other railways and shipping organizations, abandoned plans for a US$12.6-billion marriage with Burlington Northern Santa Fe Corp.
 
But CPR's Ritchie rekindled the debate earlier this year in an interview with The Globe and Mail in which he said he'd heard rumours that CN was again on the prowl.
 
But if any company in the industry could actually get away with a merger, it's CPR, suggests BMO Nesbitt Burns's Cousins. That's because it's small enough that a matchup with another line wouldn't put shippers and U.S. regulators like the Surface Transportation Board on high trust-busting alert. Still, most people in the industry don't see a major deal any time soon, simply because the regulatory hurdles and the outcry from shipper-customers would be too loud.
 
Besides, says one analyst, mergers really aren't necessary right now:  "CEOs of Class 1s tell us they're continuing to see improvements in their own results from improving operations and pricing as well as more co-production agreements. They're getting the benefits that a merger could bring without necessarily having a merger."
 
That's essentially Green's position, with some important qualifiers. "It doesn't appear that the forces that would cause a merger to occur are imminent, but that doesn't mean one can't happen," he says. "Individuals and egos might want to do certain things. It's the responsibility of any management team to be ready to go, and you can be assured that we have done our homework to best understand how to participate should something like that unfold."
 
In the meantime, Green will expand CPR's network of co-production agreements to, among other things, assure the U.S. market coverage that some outsiders think is lacking. He's also confident that the Asian-inspired good times will continue for the foreseeable future, and that the company's Vancouver rail operations will be more than able to handle the loads.
 
In addition to CPR's investment in the area, the port of Vancouver has expanded, guaranteeing the railway's ability to increase shipments and revenues for several more years, he says.
 
As for the unfunded pension liability, Green professes to be more worried about putting too much money in. "If long bond interest rates climbed one point, we would eliminate $550 million of our pension deficit," he says. "We want to be awfully cautious not to overfund the pension plan because it's trapped, you're not allowed to take the money out."
 
The only thing that seems to rankle Green and Ritchie is the notion held by the analytical community that CPR is nothing more than a good mimic of CN. On this point, the retiring CEO is more pointed than his successor, noting that the much-vaunted CN was once a financial ward of the state and that CPR has no need to be a copycat. "A lot of analysts don't understand the industry," Ritchie says. "Imitate CN? Absolutely not. We do what is required to make this company excel."
 
And CPR is, after all, a railway with a certain tradition, a company where the past flows into the present like well-laid track. Asked what advice or words of wisdom he'll have for Green when the transfer of chief executive power formally takes place in May, Ritchie harks back to his early days in the company and the simple wisdom of the chairman at the time, the redoubtable N.R. (Buck) Crump. "He used to lecture people by saying that the thing you have to do is leave the railway in better shape than you found it." Ritchie accomplished that task, now it's Green's turn.
 
Freighted with History

• 1881 - CPR is incorporated and given land and cash grants whose generosity reflects John A. Macdonald's determination to settle the Prairies and complete a railway to British Columbia;
   
  
• 1885 - Donald Smith drives the Last Spike. Transcontinental service begins the following year;
   
  
• 1896 - CPR begins its long run as the main agent of massive immigration to the West;
   
  
• 1920 - CPR is active in hotels, ships, and mines. An airline follows in 1942;
   
  
• 1939-1945 - CPR's Angus Shops in Montreal build 1,420 tanks as part of the war effort;
   
  
• 1976-'79 - VIA Rail takes over rail passenger service from CPR and CN;
   
  
• 1990-'91 - CPR caps its century-long search for stateside lines by taking full ownership of the midwestern Soo Line Railroad and buying the northeastern Delaware and Hudson Railway;
   
  
• 1996 - Head office relocates to Calgary from Montreal;
   
  
• 2001 - CPR is spun off as Canadian Pacific Ltd. breaks itself up. Robert Ritchie is named CEO;
   
  
• 2006 - After the company's best year ever, Fred Green replaces Ritchie as CEO.