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Should the U.S. government move to disband the 24 year old North American Free Agreement (NAFTA) the affect on Canadian rail giants Canadian Pacific $CP and Canadian National Railways $CN the affect will be immediate.

North American Railway Map CNNorth American Rail Routes courtesy CN

The currency markets have been volatile all week with the Mexican Peso and Canadian Dollar moving sharply on news and counter news reports about NAFTA's demise. On the stock market Canadian Railway companies Canadian Pacific and Canadian National Railways shares have been jumpy.

Canada's railways companies have been recovering from a healthier global economy and higher demand to move crude oil as the price reaches levels not seen since 2014. Overhanging the sector is the potential dismantling of the North American Free Trade Agreement (NAFTA).

CP Rail $CP is scheduled to report earnings this Thursday and analysts expect an EPS of $2.59, up 14%, and revenue of $1.33 billion, up 9%. What investors what to hear is the companies' plan should NAFTA be torn down. That is compared to $1.55 billion or $10.29 per share in 2016. For 2018, they forecast $1.84 billion or $13 per share.

CN Rail $CN is expected to earn, analysts expect the railway to earn $3.83 billion or $5.05 per share in adjusted profits for the full year. That compared to $3.58 billion or $4.59 per share in fiscal 2016. That is expected to increase to $4.06 billion or $5.52 per share in fiscal 2018.

Looking at Brexit as an indication the earnings implications would be almost immediate. A conservative view would mirror the 10 per cent drop following the Brexit vote for the United Kingdom industrial and transportation sectors on the FTSE. Companies tied to North American trade being the most vulnerable on the Toronto exchange.

Fadi Chamoun of BMO Capital Markets wrote in a report that a repeal of NAFTA could create significant uncertainty and potentially weigh on the valuations of Canadian National Railway and Canadian Pacific Railway.

  • 30 per cent of the railways’ revenues are derived from cross-border trade
  • 60 to 70 per cent of that being Canadian exports to the U.S.

Bank of Montreal last year released a report on the NAFTA affect on the Canadian economy. The conclusion was a there would be around a one percentage point decrease in gross domestic product. They also see a five per cent depreciation in the value of the Canadian dollar,

While any depreciation of the $CADUSD would be welcomed by exporters there would be the initial political fatigue we saw in BREXIT. Following this anadian export competitiveness would improve and over time offset half the decline in GDP. The 1.7 per cent increase in tariffs from the NAFTA benefit being removed would be adjusted by the lower exchange rate.

BMO Chief Economist Douglas Porter has described the impact as a serious but manageable risk. It is expected that U.S. tax reforms will boost earnings for companies with large U.S. operations. It is estimated the decrease in the tax rate from 35 to 21 per cent will flow on with around two points off the effective tax rates of CN Rail and CP Rail, helping to raise earnings per share.

Even prior to the tax reform the outlook for rail volumes has improved as the North American grain harvest and automotive trends were not as weak as anticipated. The rise in crude prices has also boosted crude-by-rail demand.

Chamoun anticipates overall carloads will grow about two per cent this year after increasing about 4.5 per cent in 2017. That should translate into double-digit earnings growth for 2018.

The higher crude priceshave also led to Increased oil sands production projections over the next two years until new pipeline capacity comes on stream,  Walter Spracklin of RBC Capital Markets is forecasting production increases of 315,000 barrels per day in 2018 and 180,000 in 2019. Spracklin estimates that the two railways only handled 38 per cent of peak capacity last year transporting 35,000 to 40,000 carloads, compared to 110,000 carloads during the peak in 2014.

CP Rail has an opportunity to gain a larger share of the crude business with CN Rail's li imited capacity to handle crudes despite it's netowrk deeper into the tar sands.

The two railways outlooks will be keenly followed as will the outcome of NAFTA talks. Despite the platitudes of Candian Prime Minister Trudeau the effect is real.

Source: CN, CP, BMO, RBC

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