RBC Dominion Securities Inc. Walter Spracklin, CFA Erin Lytollis, CFA (Associate) (Analyst) (416) 842-7862 (416) 842-7877 [email protected] [email protected]

December 2, 2014 RBC Compass 2015 North American Railroad Shipper Survey Survey taps into the views of the Class 1 railroads' top customers. We are pleased to present the findings of our 2015 Shipper Survey. Key findings focus on shippers’ expectations for 2015 regarding: the direction of rail rates; volume growth; and service performance. This year, we also EQUITY RESEARCH EQUITY solicited shippers' views on recent changes to Canadian rail regulation as Investment Opinion well as anticipated market shifts between CNR and CP. Highlights are as Survey results support premium valuation for follows: rail stocks. The main investment implication of • Pricing gains to accelerate in 2015. Survey results reflect an unexpected our survey is that findings on rail rates and acceleration of pricing expectations as the share of participants volume growth reinforce our long-term thesis forecasting rate increases of +4% to +6% next year more than doubled that rail shares will be awarded higher multiples to 53% (from 25% last year). These results imply upside to our 2015 as free cash flow, and in turn, shareholder core price assumptions of +3% to +4%. Accordingly, we consider survey returns strengthen. Our position is predicated findings on price to have positive implications for rail shares. on positive macro trends (higher volumes) • Shippers' volume outlook is strengthening. Shippers’ volume and strong business fundamentals (real rate expectations once again converged on flat to modest growth (+1% increases, efficiency gains, stable capex) driving a to +5%); however, we note a positive shift in respondents’ volume step-function increase in rail cash flow generation forecasts as the share of participants anticipating modest growth that supports capital distribution at levels similar increased to 51% (from 40% last year). In our view, these results to the infrastructure sector. As dividends and signify greater business confidence due to favourable macro trends share repurchases grow, we expect rail stocks notwithstanding recent commodity price volatility. As a result, we see to be awarded with premium multiples akin upside to our 2015 volume assumptions of +1.4% to +5.1% for the Class to infrastructure stocks as the market realizes 1 railroads despite potential volume headwinds in energy markets from the upside in shareholder returns from the rail the recent decline in WTI. industry's free cash flow potential. • Sentiment on service has deteriorated. Negative reviews (“Fair” or “Poor”) surged to 77% of all service ratings this year (from 32% last year) on account of severe network disruption caused by volume congestion and extreme weather, in our view. We consider the decline in customer satisfaction to be a temporary sentiment shift caused by unforeseen factors that were largely out of carriers’ control. As such, we do not expect respondents’ unfavourable view of rail service to negatively affect railroad shares given shippers’ strong price and volume forecasts for 2015. • CP closes the gap on market share shift. Last year, our survey indicated that CNR was winning market share as 83% of respondents that switched rail providers indicated it was in CNR's favour. This year, however, volume shifts were roughly even. Of the 11 respondents that transferred freight between the Canadian rails in 2014, six favoured CNR and five favoured CP. Looking to 2015, an equal share of respondents (4%) indicated that they will shift volumes from CP to CNR and vice versa. Our discussions with shippers suggest that execution (not price) guides shippers' selection of rail freight providers; therefore, we believe that speed and consistency of service will shape CNR and CP's long-term position in the Canadian freight market.

Priced as of prior trading day's market close, EST (unless otherwise noted). All values in CAD unless otherwise noted. For Required Non-U.S. Analyst and Conflicts Disclosures, see page 29. RBC Compass

Table of contents Survey conclusions and key takeaways ...... 3 Survey approach ...... 3 Key takeaways ...... 4 Investment implications ...... 5 Strengthening pricing prospects suggest upside to our forecasts ...... 6 Positive outlook for truck rates ...... 8 Positive volume forecasts support our outlook ...... 10 Congestion and network disruption impair shipper sentiment on rail service ...... 11 Spotlight on Canadian rail service ...... 12 CP closes the gap on market share shift ...... 15 US rail service disappoints...... 17 Shippers fixate on execution in their evaluation of rail service ...... 20 Shippers are pursuing innovative supply chain transformation strategies ...... 21 Shippers offer diverse perspectives on Canadian freight rail legislation ...... 23 Multiple proposals put forth for CTA reform ...... 25 Survey mechanics ...... 26 Survey approach ...... 26 Respondent profile ...... 26 Market share ...... 27

December 2, 2014 2 RBC Compass

Survey conclusions and key takeaways Survey approach 2015 Shipper Survey. We are pleased to present the findings of our 2015 Shipper Survey. This year, we connected with 51 customers of the six large Class 1 railroads through telephone interviews supported by online questionnaires. As in previous years, the survey focused on rail customers’ views on recent trends and expectations for 2015 related to:

1) The direction of rail rates (i.e., core pricing excluding fuel surcharges);

2) Anticipated levels of business activity (i.e., volume growth);

3) The potential to transfer freight between modes (truck and rail);

4) The level of service provided by the Class 1 railroads; and

5) The impact of the current regulatory environment.

New in this survey: Shippers weigh in on supply chain transformation initiatives and changes to Canadian rail regulation. Given our objective of gauging current rail trends, we have updated our question list to gain insight into how shippers are transforming their supply chains to combat congestion and capacity constraints across the North American transportation network. Further, we have revised our questions on the Canadian regulatory environment to obtain shippers’ perspective on recent legislative amendments and the ongoing review of the Canada Transportation Act (CTA).

Hot topics: Respondents shed light on Canadian rail market share. Last year, we introduced a set of questions to evaluate the change in Canadian rail service following the leadership transitions at Canadian National Railway (CNR) and Canadian Pacific Railway (CP): we noted a negative bias in reviews of CP’s service and a positive bias in assessments of CNR’s service. We also asked shippers if they had transferred freight between the Canadian Class 1 railroads last year: CNR emerged as the clear winner. In 2014, the topic of market share gains and losses in the Canadian rail market remains a focus of investor interest as the robust targets introduced at CP’s 2014 Investor Day underscore a strategy shift from cost cutting to revenue growth. In this context, we have maintained the question set that provides insight on: 1) which carrier is winning share of the Canadian rail market; and 2) what factors are driving shippers to change rail providers. In our view, survey findings on these topics have important investment implications as they provide insight into Canadian carriers’ long term revenue potential.

Survey methodology. The approach and methodology employed in conducting a survey are often as important as the results themselves. We direct readers to the Survey Mechanics section at the end of this report for a detailed description of our process. A notable highlight is our efforts to align the sectors represented by survey respondents with the composition of rail revenue. We also prefer to survey larger shippers and 28% of participants spend over $200MM per year on freight services. Exhibit 17 outlines the breakdown of respondents by sector and separately by transportation budget.

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Key takeaways In this section, we elaborate on the main takeaways of our survey summarized on the front page of this report. Most importantly, we also outline the expected implications of survey findings on Class 1 railroad shares.

1) Pricing gains to accelerate. Survey findings reflect a strong upward shift in pricing expectations as the share of respondents forecasting rate increases of +4%-+6% more than doubled to 53% (from 25% last year). In our view, positive pricing momentum reflects improving macro fundamentals and tightening transportation capacity. With a strong majority of respondents (85%) anticipating higher rail rates next year and few participants (1%) calling for rates to decline, we are confident that rail pricing will remain on a positive growth trajectory in 2015.

 Impact: Positive for railroad shares. From an investment perspective, survey insights on rail rates are important for two reasons: 1) they reaffirm our thesis on the resilience of rail pricing power through the cycle; and 2) they highlight potential upside to our 2015 core price assumptions for the Class 1 railroads of +3.0% to +4.0%. Moreover, we are encouraged that severe network disruption has not precluded carriers from obtaining higher rates in contract negotiations this year and we see incremental upside in rail pricing as service recovers to historical levels.

2) Volume pipeline continues to build. Shippers’ volume expectations once again converged on flat to modest growth (+1% to +5%); however, we note a positive shift in respondents’ forecasts as the share of participants anticipating modest growth increased to 51% (from 40% last year). Based on our discussions with shippers, we believe these findings signal greater business confidence due to favourable macro trends notwithstanding recent oil price volatility.

 Impact: Positive for railroad shares. Survey findings on volume reinforce our growth outlook for the Class 1 railroads as we are assuming volume increases of +1.4% to +5.1% across the group in 2015. The positive shift in shippers’ volume expectations points to strengthening demand and we see potential upside to the consensus outlook as shippers’ forecasts historically have reflected a healthy dose of conservatism. That said, the recent collapse in oil prices could temper volume growth in energy markets depending on the severity and duration of the decline in WTI. Despite this potential headwind, we remain optimistic that freight volume growth will meet (or exceed) shippers’ expectations in 2015.

3) Shipper sentiment sours on North American rail service. Survey findings indicate that shippers’ view of rail service has deteriorated in 2014 as negative ratings (“Fair” or “Poor”) surged to 77% of all responses, up from 32% last year. In our opinion, widespread customer dissatisfaction is largely the product of volume congestion and severe weather that impaired network fluidity across North America. We are not surprised that negative ratings comprise the majority of reviews on all carriers’ service levels this year.

 Impact: Negative for railroad shares. Service trends are important in the rail sector as they back-stop railroads’ argument (to shippers and regulators) for higher rates. While the negative service trend is significant, we view the decline in customer satisfaction as a temporary sentiment shift driven by unforeseen factors that were out of carriers’ control (largely weather-related). Given that we view service issues as temporary, we do not expect respondents’ unfavourable view of rail service to negatively affect rail shares given shippers’ strong price and volume outlook. Nevertheless, the rails should be (and are) very focused on re-establishing service levels. December 2, 2014 4 RBC Compass

Investment implications Findings reinforce our positive long-term view on the rail industry. The main investment implication of our survey is that primary findings support our positive long-term view on the rail industry. Our thesis is predicated on: 1) sustained pricing gains throughout the cycle; 2) service improvements that reinforce pricing power; 3) operating progress that supports enhanced productivity; and 4) above-trend volume growth fuelled by expansion into new markets and the continued conversion of truck freight to rail.

Industry fundamentals (and survey results) support premium valuation for rail stocks toward infrastructure multiples. In our opinion, the rail industry is transitioning from an operating leverage story to a free cash flow story as we believe that positive macro trends (higher volumes) and strong business fundamentals (real rate increases, efficiency gains, stable capex) will drive a step-function increase in cash flow generation in the near term. As a result, we see capital distribution by rail companies approaching levels similar to the infrastructure sector and we expect rail shares to be awarded premium multiples akin to infrastructure stocks over time. Survey results reinforce our long-term thesis as findings point to stronger volumes and higher pricing in 2015 that should drive earnings and free cash flow growth next year. We refer readers to our Compass report published on June 14 for more details on our rail investment thesis (Get on this train! Powerful sector trends reinforce case for sustained premiums).

Valuation dichotomy persists between the Canadian and Eastern US rails. The valuation gap between the Canadian and Eastern US rails remained wide in 2014 with CNR and CP trading on average ~4.5 points above CSX and NSC on 12-month forward consensus P/E. In our view, the Canadian carriers’ premium multiples reflect positive company fundamentals – CP’s efficiency and revenue growth opportunity and CNR’s volume pipeline and execution excellence. Conversely, we believe the Eastern US rails’ depressed valuations reflect sector headwinds – namely persistent weakness in global coal markets. While our investment thesis on CSX and NSC is constructive longer term, we do not expect the valuation discount to lift until the coal market shows signs of recovery. In this context, we believe that the valuation gap between the Canadian and Eastern US rails will persist in 2015.

Recommendations Canadian National Railway (Outperform, $92 price target). In our opinion, CNR’s success in balancing service and execution excellence has resulted in record volumes across the network this year fuelled by new customer acquisitions and organic growth. In addition, the company continues to lead the industry on execution, outperforming the peer group on key operating metrics in 2014. We expect the shares to benefit from multiple expansions as the market gains an appreciation for potential returns afforded by CNR's best-in-class execution capabilities and strong volume pipeline.

Union Pacific (Outperform, US$135 price target). Our positive thesis on UNP reflects the company’s high-growth, low-risk profile with limited coal exposure, a healthy balance sheet, unparalleled access to Mexico, and unique growth opportunities in chemicals and intermodal. We expect these favourable fundamentals to support strong risk-adjusted returns over the long term and sustain UNP’s historical premium valuation to the group. At current levels, we view UNP shares as a compelling investment opportunity with double-digit upside to our fundamental price target.

December 2, 2014 5 RBC Compass

Strengthening pricing prospects suggest upside to our forecasts Rail pricing thesis is intact. The resilience of Class 1 rail pricing power through the economic cycle is a pillar of our favourable long term investment thesis on the freight rail industry. Survey findings continue to support our position as a slight majority (53% of respondents) expect rail rates to increase +4% to +6% in 2015 (Exhibit 1). These findings reflect an upward shift in pricing expectations as popular opinion called for +1% to +3% pricing growth in our two most recent annual surveys of railroad customers. As a result, we have a high level of confidence in our view that rail rates will not only rise, but the rate of growth will accelerate in 2015. Key survey findings on shippers’ pricing expectations are outlined below:

 Pricing gains to strengthen. A strong majority of respondents (85%) expect rail rates to increase in 2015, while 5% anticipate flat pricing and only 2% expect rates to decline. Another group (8%) did not disclose their freight rate expectations for next year.  Most shippers expect freight rate increases to exceed inflation. The largest group of respondents (53%) expects rail pricing to increase +4% to +6% in 2015, exceeding most carriers’ estimation of rail inflation (~3%). The second most prevalent outlook, representing 27% of survey participants, calls for +1% to +3% growth in rail rates.  Pricing outlook improves relative to prior-year expectations. Shippers’ pricing expectations have shifted towards higher rate increases in 2015 relative to the outlook for 2014 as the share of respondents anticipating +4% to +6% rate increases next year more than doubled to 53%, while the group forecasting flat to modest pricing growth almost halved to 32% of survey participants. In our view, positive momentum in rail pricing reflects improving macro fundamentals and tightening capacity across the transportation network.  Shippers’ expectations suggest there is upside to our forecasts. In our view, survey findings broadly align with our outlook for 2015 as our core price assumptions for the Class 1 railroads (+3.0% to +4.0%) fall within the range of ~80% of survey responses. That said, we see potential for actual pricing gains to exceed our forecasts as a slight majority (58%) are anticipating rate increases in excess of +4%.

Exhibit 1: Strong upward shift in shippers’ pricing expectations

What are your company’s expectations for rail rate increases in 2015? (excluding fuel surcharges) 60% 53% Meaningful decline in the proportion of 50% 42% Slight majority expect respondents anticipating flat to 39% 40% modest growth in rail rates rail rates to rise +4%-6%

27% 26% 30% 25%

20% 14% 13%12% 12% 8% 10% 5% 6% 5% 3% 2% 2% Percentage of Respondents 0% 1% 1% 1% 0% 1% 1% 0% No Answer <-10% -10 - 0% 0% 1-3% 4-6% 7-10% >10% 2013 2014 2015

Source: RBC Capital Markets research

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Pricing pressure to subside in 2015; Positive long-term outlook maintained. From 2008 to 2012, the Class 1 railroads achieved core price increases across their total book of business despite facing significant economic and sector-specific headwinds (Exhibit 2). While the magnitude of pricing gains fluctuated according to demand during this time, pricing remained positive and outpaced inflation in most periods. Last year, the pricing dynamic changed for several carriers as deteriorating coal fundamentals compounded subdued activity levels across the broader economy. As a result, the Eastern US rails made price concessions to help US coal producers remain competitive and these actions have weighed on core pricing growth. In 2014, core pricing gains have moderated further and we attribute these declines to persistent coal weakness and the muted macro environment in which current rates were negotiated last year. With rail volumes surpassing historical highs in many commodity groups year to date, we are confident that shippers’ pricing expectations for 2015 will materialize and freight rate growth will accelerate next year.

Exhibit 2: Survey results suggest that core pricing gains have reached a trough in 2014

Quarterly Core Price Increases (ex. Fuel) CNR CP CSX NSC UNP Q1/08 4.0% 5.5% 6.8% N/A 5.0-6.0% Q2/08 4.5% 7.5% 6.4% N/A 5.0-6.0% Q3/08 4.0-5.0% 6.0% 6.2% N/A 5.0-6.0% Q4/08 5.0% 5.0% 6.5% 6.5% 5.0-6.0% Q1/09 4.0-5.0% 4.0-5.0% 6.5% 8.5% 6.0% Q2/09 4.0-5.0% 4.0% 6.6% 8.3% 6.0% Q3/09 4.0% 4.0% 6.3% 7.1% 5.0% Q4/09 4.0% 0-2.0%* 5.3% 4.0% 5.0% Q1/10 ~3.0% ~0% 5.0% 3.0% 3.0% Q2/10 3.0% 2.0% 6.5% N/A 4.5% Q3/10 3.0% 2.0% 6.6% N/A 5.0% Q4/10 3.0% 2.0% 6.2% N/A 5.0% Q1/11 4.0% N/A 7.0% N/A 4.5% Q2/11 4.0% 2.5% 7.2% N/A 4.5% Q3/11 3.8% 2.0-3.0% 7.1% N/A 4.5% Q4/11 4.0% 5.0%* 6.9% N/A 5.0% Q1/12 4.0% 5.0%+* 5.9% N/A 5.0% Q2/12 4.0% 5.0%* 1.7% N/A 4.5% Q3/12 3.5% 3.0%* 1.5% N/A 5.0% Q4/12 4.0% 3.0-4.0%* 1.6% N/A 4.0% Q1/13 3.5% 3.0-4.0%* 0.3% N/A 4.0% Q2/13 3.4% 3.0-4.0%* 2.3% N/A 4.0% Q3/13 3.0% 3.0-4.0%* 1.0% N/A 3.5% Q4/13 <3.0% >3.0%-4.0% 1.6% N/A 3.5% Q1/14 3.0% 3.0-4.0%* 0.5% N/A 2.0% Q2/14 <3.0% 3.5% -0.6% N/A 2.5% Q3/14 3.2% 4.0% 0.2% N/A 2.5% *Company did not provide a breakdown between price and mix.

Source: Company reports, RBC Capital Markets research

December 2, 2014 7 RBC Compass

Positive outlook for truck rates Strong upward shift in shippers’ truck pricing expectations. Findings suggest that pricing in the truck industry is on the cusp of an inflection point as a year-over-year comparison of Selected shipper survey results reveals a definitive upward shift in shippers’ outlook for truck rates. An commentary: overwhelming majority of respondents (80%) expects truck pricing to increase by up to +6% “Truck pricing is still competitive, next year, whereas the consensus view last year (85% of responses) pointed to flat pricing or but it’s getting to the point where modest rate increases of up to +3% for 2014. This encouraging trend is reinforced by a trucks can start commanding positive shift in extreme pricing expectations as survey participants are unanimous that truck higher rates.” rates will not decline next year (vs. 4% last year) and 10% expect pricing to increase by more “Truck rates depend on the time than +7% (vs. 0% last year). While the overall trend is positive, our discussions with shippers of year and the lane.” revealed several factors that will likely cause the pace and magnitude of pricing growth to vary by geography, sector, and lane. We highlight the key themes of our conversations with “The truckers haven’t banded survey respondents on the truck pricing environment below: together to get rate increases – there’s always someone hungry for volume and they’re willing to  Capacity constraints are finally creating pricing opportunities. A recurring theme of our offer a lower rate to get our discussions with survey respondents is the widely held view that labour constraints will business.” be a catalyst for higher truck rates when freight demand exceeds industry capacity. This position reflects sound economic theory, yet despite an improving macro environment in recent years, truck pricing expectations have remained subdued since the recession until this year. What has changed? According to respondents, two new factors are exacerbating labour constraints in the trucking sector in 2014: 1) accelerating freight demand; and 2) rail congestion. We agree with this perspective and note that the key takeaways from recent conversations with private motor carriers across Canada also support this view. We refer readers to our Compass report published on July 8 for detailed insights on our survey of private Canadian trucking companies (Potential inflection point emerging in Canadian trucking sector).  Pricing prospects differ by sector and by lane. Another group of respondents extended the theory that industry capacity will determine the direction of truck rates to a micro level. These shippers believe that pricing gains will be focused in markets and geographies with the most acute capacity constraints. According to this group, the highest freight rate increases are likely to occur in markets that require specialized equipment or skilled labour; in geographies with limited labour supply (i.e., remote regions) or restrictive regulations (i.e., US hours of service); and in long-haul lanes that require drivers to be on the road for extended periods of time. In our view, the range of pricing expectations depicted in Exhibit 3 confirms that truck rates are influenced by a variety of factors and future pricing gains will not be uniform. Moreover, this perspective is supported by commentary from the trucking companies in our coverage space as we have noted that executives’ pricing outlooks differ by business line and geography.  Pricing strategies can successfully lower freight rates. The non-consensus view calls for muted (yet positive) growth in truck rates next year on account of various pricing strategies that shippers expect to limit trucking costs. Tendering continues to be the most common method of capping truck rates; however, some shippers are now including service metrics as part of Request for Proposals (RFPs). In our view, service is an increasingly important criterion in the carrier selection process and we expect price competition to continue to subside in the trucking industry. Another group of shippers is opportunistically using the spot market whenever rates are attractive. We believe this approach can yield short-term profits; however, we do not believe that the spot market can sustain long-term returns due to its inherent volatility.

December 2, 2014 8 RBC Compass

Exhibit 3: Pricing prospects pick up for motor carriers

What is your company’s expectation for truck rate increases (excluding fuel surcharges) in 2015? (excludes non- responses)

60% 48% 50% 43% Truck rate expectations 37% 40% 37% 35%37% accelerate Shippers do not expect 30% truck pricing to decline 20% 14% 12% 10% 11% 7% 10% 4% 3% Percentage of Respondents 0% 0% 0% 0% 2% 0% 0% 0% 0% <-10% -10 - 0% 0% 1-3% 4-6% 7-10% >10% 2013 2014 2015

Source: RBC Capital Markets research

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Positive volume forecasts support our outlook Survey consensus on volume aligns with our forecasts. Consistent with findings from prior surveys, the largest subset of shippers (78%) anticipate flat to modest freight volume growth (+1% to +5%) in the coming year (Exhibit 4). While the consensus outlook is unchanged year- over-year, we note a positive shift in shippers’ volume expectations as the proportion of respondents anticipating modest growth has increased to 51% (from 40%) and the group calling for flat volumes is stable at 27% of survey participants. These results are broadly consistent with our assumptions as we are modelling +1.4% to +5.1% volume growth for the Class 1 railroads in 2015.

Business confidence is building. The demand outlook is strengthening as the share of respondents forecasting positive volume growth has edged up to 69% (from 66% last year) and the group anticipating volume declines has shrunk to 4% of survey participants (from 6% last year). Based on our discussions with shippers, we believe these results signify greater business confidence due to favourable macro fundamentals notwithstanding recent commodity price volatility. We see potential upside to our growth forecasts for the Class 1 railroads as shippers’ forecasts typically reflect a degree of conservatism, in our opinion. Moreover, we believe that market share gains from truck and the continued development of new markets should offset any volume pressure caused by macro volatility.

Exhibit 4: Shippers’ volume outlook strengthens for 2015

What are your company’s volume expectations for 2015?

60% 51% 50% Survey consensus points to modest freight 39% 40% 18% of respondents 40% volume growth in 2015 36% are forecasting robust 28% volume growth next 30% 27% year

20% 14%15% 11%12% 10% 6% Percentage of Respondents 4% 3% 2% 2% 3% 2% 2% 2% 0% 1% 0% <-10% -5 to -10% -1 to -5% 0% 1-5% 6-10% 10%+ 2013 2014 2015

Source: RBC Capital Markets research

December 2, 2014 10 RBC Compass

Congestion and network disruption impair shipper sentiment on rail service Why measure service? Service is not an easily measured concept, nor is it a quantifiable driver of bottom-line results. As a result, service is often overlooked in financial analysis; however, it is particularly meaningful in the rail industry for two reasons: 1) it justifies higher pricing; and 2) it keeps the regulators in check. In our view, the railroads continue to address service issues head-on and the results of this survey highlight to what degree their efforts have been successful.

Shipper sentiment sours on North American freight rail service. Survey findings indicate that shippers’ view of rail service has deteriorated significantly in 2014 as negative ratings (“Fair” or “Poor”) increased to 77% of all responses (from 32% last year), while “Excellent” reviews fell from 10% to 3% of all ratings (Exhibit 5). In our opinion, service missteps in 2014 are largely the product of volume congestion and weather-related network disruption that has caused all carriers’ operating performance to deteriorate significantly this year (Exhibit 6). That said, shippers’ assessments of each carrier’s service offering revealed other unique themes that we discuss in this section of the report.

CNR sets the standard for rail service in North America. Weekly operating statistics confirm that CNR is not immune to the operating challenges that have plagued the North American rail network this year. However, its service offering received the most praise from shippers by a significant margin. To this end, we note that CNR was awarded positive ratings by 35% of respondents, whereas its closest competitor (Union Pacific (UNP)) received “Good” or “Excellent” reviews from only 23% of shippers. We attribute shippers’ more favourable view of CNR’s service offering to the company’s outperformance on key operating metrics year-to- date compared to significant deterioration in performance data posted by peers. As a result, survey findings reinforce our view of CNR as the industry leader on execution.

Eastern railroads edge out Western carriers on service. Reviews of the US Class 1 railroads’ service offering collapsed this year as 50% of respondents (or more) shifted their rating for each carrier from “Good” or “Excellent” to “Fair” or “Poor”. The Eastern carriers continue to provide slightly superior service as positive ratings comprised 16% of CSX Corporation (CSX) and Norfolk Southern’s (NSC) service reviews and only 13% of Burlington Northern Santa Fe (BNSF) and UNP’s ratings. That said, the increase in unfavourable ratings was similar for both geographies. Notably, the negative shift in shippers’ perception of US rail service was driven by CSX and BNSF’s performance as the proportion of “Fair” or “Poor” ratings increased to 90% and 96%, respectively, from 19% and 32% last year.

December 2, 2014 11 RBC Compass

Exhibit 5: Shippers’ view of North American freight rail service has deteriorated in 2014

How would you describe the level of rail service you are receiving?

60% 54% Majority view rail service 48% Positive service 50% as "Fair" or "Poor" 43% ratings drop off 40% 34% dramatically

30% 22% 22% 21% 18% 20% 10% 10% 10% 6% 4% 3% 1% 3% Percentage of Respondents 0% No Comment Poor Fair Good Excellent 2013 2014 2015

Source: RBC Capital Markets research

Exhibit 6: All carriers deliver weak operating performance compared to 2013

Average Train Velocity (Y/Y Change) Average Terminal Dwell (Y/Y Change) Q1/14 Q2/14 Q3/14 QTD YTD Q1/14 Q2/14 Q3/14 QTD YTD CNR (5%) (4%) (6%) (4%) (4%) CNR +12% +3% +11% +10% +9% CP1 (12%) (3%) (1%) +2% (3%) CP1 +59% +28% +13% +9% +27% BNSF (16%) (12%) (10%) (8%) (12%) BNSF +26% +17% +18% +13% +17% CSX (11%) (16%) (13%) (13%) (13%) CSX +20% +18% +21% +20% +19% NSC (7%) (9%) (13%) (15%) (11%) NSC +14% +10% +22% +30% +20% UNP (7%) (7%) (10%) (10%) (8%) UNP +12% +12% +13% +13% +13% CP definition is not consistent with the AAR's definition adopted by all other Class 1 railroads

Source: Association of American Railroads as of Week 47, 2014, RBC Capital Markets research Spotlight on Canadian rail service With CNR facing an increasingly strong rival in CP, the competitive landscape in Canada continues to be a focus of our discussions with investors. In this context, we are once again taking a closer look at shippers’ perception of CNR and CP’s service offering given the influence of service levels on rail market share, revenue growth, and ultimately, shareholder returns.

CNR: Service offering receives the most positive ratings Service reviews are mixed. Consistent with prior surveys, shippers continue to view CNR’s service offering most favourably of all Class 1 railroads; however, the proportion of “Fair” and “Poor” ratings doubled to 63% of responses this year (Exhibit 7). We attribute the negative shift in shipper sentiment on CNR’s service offering to persistent operating challenges throughout 2014. That said, we believe shippers’ relatively favourable view of CNR’s service reflects the company’s outperformance on key operating metrics year to date with train velocity down -4% Y/Y (vs. U.S. rails at -8% Y/Y to -13% Y/Y) and dwell up +9% Y/Y (vs. U.S. rails at +13% Y/Y to +20% Y/Y).

Commentary is negative. While the distribution of ratings reflects a mixed view of CNR’s service offering, respondent commentary largely focused on service shortcomings – namely capacity constraints, rail car shortages, and transit time issues. Some shippers acknowledged the impact of extreme weather on network fluidity in H1/14; however, many expressed frustration with ongoing disruption and non-performance. This commentary is supported by trends in CNR’s operating data as train velocity and terminal dwell remain well below prior year levels in Q4/14.

December 2, 2014 12 RBC Compass

Network congestion partly reflects strong demand for CNR’s product. In our view, CNR’s operating challenges in 2014 are (in part) a consequence of the company’s track record of execution excellence as we believe that CNR’s strong service offering has fueled market share gains that are driving record volumes across the network this year. Put simply, it is our position that extreme weather exacerbated network congestion caused by strong demand increasing the length and severity of service issues. Importantly, CNR continues to address capacity concerns with targeted capital investments and we are optimistic that the company’s infrastructure is better prepared to efficiently manage future volume growth and severe weather events.

Selected shipper commentary:

“Service has been terrible, but CNR has been the best of the group.”

“We have no real issues with CNR.”

“CNR’s service has been very, very challenging this year.”

Exhibit 7: CNR continues to receive the most positive ratings despite operating issues

How would you describe CNR’s service offering?

60% A material proportion of 51% 50% respondents continue to view 47% CNR's service offering favourably 40% 33% 30% 28% 30% 28% 21% 22% 20% 15% 11% 7% 10% 3% Percentage of Respondents 2% 2% 0% 0% No Poor Fair Good Excellent Comment 2013 2014 2015

Source: RBC Capital Markets research

CP: Congestion issues mask operating improvements; “Soft” elements of service continue to be an issue Service ratings span the spectrum. Shipper sentiment on CP’s service offering remains mixed; however, the proportion of negative responses (“Fair” and “Poor”) jumped to 79% from 48% last year (Exhibit 8). This negative shift in service ratings is consistent with CP’s operating trends as the company’s proprietary velocity and dwell measures have weakened by 3% Y/Y and 27% Y/Y, respectively, in 2014.

Commentary reflects a wide range of customer experiences. Our discussions with respondents revealed divergent perspectives on CP’s service offering with some shippers declaring strong support for the company’s ongoing transformation, and others expressing a high level of frustration with deteriorating service levels. Positive commentary almost exclusively reflected operating improvements as several shippers cited shorter transit times and better on-time performance. That said, some criticism did identify operating issues in a variety of sectors, as well as unsatisfactory customer service experiences. In our view, the negative trend in CP’s service ratings is fueled by fluidity issues throughout 2014 as survey

December 2, 2014 13 RBC Compass

commentary suggests that the company’s stand-alone operations have improved materially. That said, shippers’ disappointment with the customer service experience suggests that CP continues to struggle with the “soft” elements of service.

Strategic transformation to reveal the strength of CP’s service offering. CP unveiled new financial guidance at its 2014 Investor Day that confirmed a widely anticipated shift in the company’s strategic focus from cost cutting to revenue growth. New long-term targets reflect a robust revenue pipeline (10%+ CAGR) and strong productivity potential (58%-63% O/R) over the next four years. We consider the O/R target to be very achievable; however, our top-line estimates are more conservative as we see risk to some assumptions in management guidance on account of inherent demand volatility in bulk markets (coal, potash, fertilizer); tough near-term comparisons in grain; and overall economic uncertainty over the forecast horizon. Moreover, our estimates do not reflect major market share gains as CP faces strong rail competition in Canada. That said, we see market share as the main vehicle that can accelerate revenue growth to targeted levels and offset any future volatility caused by macro or sector-specific factors. Given that shippers focus almost exclusively on execution metrics in their assessment of service, we expect Canadian rail market share gains to be shaped by CNR and CP’s operating performance. Accordingly, we believe that market share shifts will be instructive on CP’s level of service, and ultimately, the feasibility of the company’s long term revenue targets. We address current market share trends in the Canadian rail sector in the following section of this report.

Selected shipper commentary:

“We are very happy as a CP shipper. It would seem that they are doing what they promised and making the necessary changes to the railway.”

“CP has cut resources way too thin to deal with winter, in our opinion.”

“CP has done a lot of work in speeding up their trains – they have taken one day out of the supply chain to Western Canada.”

“CP’s attitude and customer service hasn’t improved, just cycle time and fluidity has improved.”

Exhibit 8: Negative bias in mixed view of CP’s service offering

How would you describe CP’s service offering?

60% "Fair" and "Poor" 50% service ratings 42% 45%43% increase 40% 37% 33% 30% 23% 20% 17%15% 16% 15% 8% 10% 5% 3% Percentage of Respondents 0% 0% 0% No Poor Fair Good Excellent Comment 2013 2014 2015

Source: RBC Capital Markets research

December 2, 2014 14 RBC Compass

CP closes the gap on market share shift CP’s strategic transformation makes Canadian rail market share increasingly relevant. Last year, we introduced a series of questions to gauge rail market share shifts in Canada to assess the impact of the significant operating and personnel changes at CNR and CP. Survey findings indicated that CNR was a clear winner as 10 of 12 respondents that transferred freight between the Canadian carriers in 2013 shifted volumes onto CNR’s network. The topic of market share gains and losses between the Canadian railroads remains a focus of discussion with investors as the introduction of robust targets at CP’s 2014 Investor Day underscores a strategy shift from cost cutting to revenue growth. As a result, we have maintained the question set that provides insight into: 1) which carrier is winning share of the Canadian rail market; and 2) what factors are driving shippers to change rail providers. These findings are important from an investment perspective as they provide a view into CNR and CP’s long term revenue pipeline, which helps to evaluate each carrier’s earnings growth opportunity when taken into consideration with their operating potential. Accordingly, we believe these results provide insight into potential growth of shareholder returns from Canadian railroad stocks.

Shippers’ mix of Canadian rail providers to remain broadly unchanged. Consistent with last year’s survey findings, 69% of shippers that move freight to, from, or within Canada (45 out of 51 survey participants) did not shift any of their cargo between the Canadian carriers in 2014 (Exhibit 9).

 Captive shippers account for the majority of respondents with a static carrier mix. Shippers whose operations are served by a single railroad represent a slight majority of shippers (52%) that are maintaining their carrier mix.  Long-term contracts and “other” constraints prevent shippers from transferring freight. The next-largest group (27%) pointed to a variety of “other” reasons for continuing to use the same carriers in the same lanes with several shippers pointing to long-term contracts as a key constraint.  Satisfied shippers are in the minority. Satisfied shippers form the smallest group of respondents (21%) that did not transfer freight between the Canadian railroads this year.

We note a distinct shift in shippers’ reasons for maintaining their mix of Canadian rail providers as respondents that “have to” use their current carrier (i.e., shippers that are captive or face “other” constraints) increased to 79% of survey participants (from 50% last year), while the group that “wants to” move their freight with their existing provider (i.e., satisfied shippers) has declined to 21% of respondents (from 32% last year).

Canadian rail market share shifts are a wash for CNR and CP. Survey results suggest that Canadian rail market share was stable in 2014 as freight transfers between the two carriers were almost equally split between CNR (six of 11 respondents) and CP (five of 11 respondents). Looking ahead to 2015, an equal number of survey respondents expect to transfer freight from CNR to CP and vice versa; therefore, survey findings suggest that Canadian rail market share will remain unchanged in the near future.

Service levels dictate shippers’ rail carrier selection. Of the 11 shippers that transferred freight between CNR and CP this year, 10 cited “Service” as a primary driver of their decision to change carriers. Notably, freight rates did not play a prominent role in these decisions as only four respondents highlighted “Price” as a key reason for transferring their freight. These results represent a significant departure from last year’s survey findings as “Price” and “Service” were equally important to shippers that shifted their business between CNR and CP in 2013. In our view, prolonged network congestion has strongly influenced shippers’ December 2, 2014 15 RBC Compass

perspective as the importance of timely and consistent execution was a central theme of our discussions with respondents this year.

Significant proportion of respondents have “uncertain” outlook for 2015, suggesting it is any railroad’s game. Looking ahead, we see opportunity for either CNR or CP to increase their share of the Canadian freight market as 18% of respondents that move freight through Canada are “Uncertain” about their mix of rail transportation providers for next year. Our discussions with shippers suggest that execution will guide the selection of rail carriers; therefore, we believe that speed and consistency of service will shape CNR and CP’s long- term position in the Canadian freight market. Importantly, we believe that market share growth opportunities extend beyond sectors with flexible supply chains (i.e., intermodal) as five industries were represented by survey participants that switched a portion of their business between CNR and CP this year. Finally, we expect cost to remain a secondary determinant of rail market share as we believe that improvements in rail service will yield positive economic consequences for shippers in the form of lower carrying costs and ancillary charges. In this context, we believe that many shippers would be willing to pay a premium for fast, reliable rail service.

Exhibit 9: Canadian rail market share is stable in 2014

Has your company transferred any portion of freight between the Canadian railroads in 2014? Does your company plan to transfer any portion of freight between the Canadian railroads in 2015?

100% Survey results suggest that CNR 80% 71% 69% 73% continues to benefit from freight 60% transfers between the Canadian rails

40% 21% 18% 20% 11% 13% 4% 4% 4% 4% 7%

Percentage of Respondents 0% CN to CP CP to CN No change Uncertain 2013 2014 2015E

What are the primary reasons behind your company’s decision to Which scenario best describes the reason your company did not change and/or does transfer freight between the Canadian carriers? not plan to change its mix of Canadian rail freight providers in 2014 and/or 2015?

100% 60% 91% 52% Service drives Captive shippers form largest 50% 80% decisions to group that are maintaining their change carriers 40% carrier mix 60% 27% 30% 36% 21% 40% 20% v

18% 10%

20% Percentage of Respondents

Percentage of Respondents 0% 0% Served by Service is Other Price Service Other single carrier satisfactory

Source: RBC Capital Markets research

December 2, 2014 16 RBC Compass

US rail service disappoints BNSF: Shippers’ ratings point to a deterioration in service Shipper sentiment on BNSF’s service offering turned negative this year as positive ratings dwindled to 4% of survey responses (from 60% last year) and “Poor” ratings soared to 57% of responses (from 16% last year) (Exhibit 10). The severity of BNSF’s service missteps is corroborated by the STB’s recent inquiry into the company’s grain service and the deterioration in its operating metrics this year (train velocity –12% Y/Y, terminal dwell +17% Y/Y). In our view, there are three factors that have caused severe shortcomings in BNSF’s service offering this year: 1) an unprecedented surge in demand across the Northern Corridor (crude, grain, intermodal); 2) operating complexity caused by a large capital program in the Northern Corridor; and 3) inclement weather through most of H1/14.

Exhibit 10: BNSF receives the largest proportion of “Poor” ratings of all Class 1 railroads

How would you describe BNSF’s service offering?

80% Shippers' view of BNSF's service 57% 60% offering 52% deteriorates 43% 39% 40% 23% 16% 17%16% 20% 13% 8% 8% 3% 4%

Percentage of Respondents 0% 0% 0% No Poor Fair Good Excellent Comment 2013 2014 2015

Source: RBC Capital Markets research

CSX: Operating challenges are reflected in service ratings CSX received the lowest service ratings of the US Class 1 railroads in our coverage space with “Fair” or “Poor” ratings comprising 90% of responses (Exhibit 11). These results contrast sharply with last year’s survey findings as CSX received the highest proportion (77%) of “Good” or “Excellent” ratings of all US carriers. This sentiment shift is consistent with the company’s performance trends as CSX delivered the strongest velocity and dwell time improvements of all Class 1 rails in 2013 and has posted the largest deterioration in these metrics year to date. Accordingly, we believe that CSX’s operating momentum (or lack thereof) is reflected in shippers’ reviews of the company’s service offering.

December 2, 2014 17 RBC Compass

Exhibit 11: CSX experiences largest negative shift in service ratings

How would you describe CSX’s service offering?

80% Positive ratings drop off 67% significantly; Consensus 55% 55% 60% views CSX's service as "Fair" 40% 35%

19% 16% 20% 14% 10% 6%5% 5% 10% Percentage of Respondents 3% 0% 0% 0% No Poor Fair Good Excellent Comment 2013 2014 2015

Source: RBC Capital Markets research

NSC: Shipper sentiment on service turns negative Similar to CSX, NSC saw “Fair” and “Poor” service ratings replace the “Good” and “Excellent” reviews that the company received last year (Exhibit 12). The magnitude of the negative shift in service ratings was less pronounced at NSC compared to its direct peer, which we believe reflects NSC’s absolute outperformance on key operating metrics year to date.

Exhibit 12: Consensus view points to “Fair” service offering

How would you describe NSC’s service offering?

75% Negative shift in service 59%59% 60% ratings; Slight majority view NSC's service as 48% 45% "Fair"

26% 30% 22% 19%18% 19% 14% 15% 3% 5% 4% 5% Percentage of Respondents 0% 0% 0% No Poor Fair Good Excellent Comment 2013 2014 2015

Source: RBC Capital Markets research

UNP: Strongest service offering in the US UNP has excelled on service among the large US railroads this year with positive ratings comprising 23% of total responses (Exhibit 13). Although shipper sentiment has weakened materially year over year, we attribute UNP’s relative outperformance to lower operating volatility as the company’s decline in average train velocity and increase in average terminal dwell is more moderate than the closest US peer by ~320bps and ~480bps, respectively.

December 2, 2014 18 RBC Compass

Exhibit 13: Meaningful proportion of shippers continue to view UNP’s service positively

How would you describe UNP’s service offering?

80% UNP receives most 68% positive ratings of all U.S. 55% 60% carriers; however, sentiment has weakened 37% 40% 30% 23% 23%23% 20% 18% 7% 5% 5% 5%

Percentage of Respondents 3% 0% 0% 0% No Poor Fair Good Excellent Comment 2013 2014 2015

Source: RBC Capital Markets research

December 2, 2014 19 RBC Compass

Shippers fixate on execution in their evaluation of rail service Service is a focus of our survey; therefore, a critical insight from our study is the criteria that shippers use to assess rail service. We allow respondents to provide more than one measure in their response to this question to account for the complexity of shippers’ transportation needs. Exhibit 14 illustrates the proportion of shippers that identified each metric as important to their business and how often the railroads fail to deliver on these metrics.

Cycle time was the most important (and lacking) service criterion. Shippers have converged Selected shipper on cycle time as the most critical element of rail service as 65% of respondents identified this commentary: metric as “most important”. It is noteworthy that survey findings reveal a definitive rank of “We lost hundreds of carloads of service criteria this year as respondents placed equal importance on all execution metrics business in the winter because of last year. In our view, acute congestion across the North American rail network coupled with slow cycle times. The rails are now barely at long-term historical soaring freight demand in several sectors has underscored the link between cycle time and average cycle times.” capacity as slower asset turns have caused labour and equipment shortages across the industry. Our position is supported by survey results as popular opinion indicates that cycle “Some railroads have performed time is the most frequent cause of service failures. Notably, the proportion of respondents better than others – sometimes it depends on where they operate. that cited cycle time as the most common service issue doubled this year to 45% of all Chicago was a parking lot.” responses, which we believe illustrates the severity of service issues in 2014.

“Service consistency is much Car supply and consistency carry significant weight in shippers’ assessment of service. Car worse this year – there’s a lack of supply and consistency were highlighted by almost half of survey participants as key power, a lack of crews, poorly trained crews, and an emphasis elements of rail service representing a slightly higher proportion of respondents compared to on meeting the Canadian last year. These two metrics also ranked second to cycle time in terms of how often they government grain mandate at the cause service issues with the proportion of responses increasing to 35% from less than 30% expense of other shippers.” last year. We consider all execution metrics to be inextricably linked; therefore, we are not surprised to see all measures cited more frequently as causes of service failures this year given the challenging operating environment that has prevailed across North America.

Overall, we believe changes in the operating environment have shifted the pressure points across the rail network, causing shippers’ perception of rail service issues to diverge from last year’s survey results. In our opinion, shippers’ core service requirements remain fixed through time: consistent execution on every element of freight rail transportation.

Exhibit 14: Cycle time tops shippers’ list of service requirements and missteps

What do you consider to be the most important service metric(s) for railroads? Which service metrics do you think railroads tend to perform most poorly on?

75% 65% Cycle time is the most important service metric and the most frequent 60% cause of rail service issues 45% 45% 47% 45% 35% 35% 31% 30% 24% 25% 25%

15% 10%

Percentage of Respondents 2% 0% On-time Cycle time Consistency Car Supply Communication Other Most important service metric Areas where railroads are deficient

Source: RBC Capital Markets research

December 2, 2014 20 RBC Compass

Shippers are pursuing innovative supply chain transformation strategies Shippers are employing a wide range of tactics to improve their supply chains. We introduced a new question to our survey this year to obtain a comprehensive view of shippers’ efforts to improve their supply chains. The new question extends our prior query on shippers’ modal shift intentions to include other methods of supply chain transformation as many of these strategies (tendering, re-routing, etc.) have significant financial and operating implications for the freight rail industry. Survey findings reveal that approximately two-thirds of respondents are fine-tuning their supply chain through various strategic initiatives. Moreover, modal shifts remain the most popular method of supply chain transformation as almost two-thirds of all shippers looking to optimize their transportation network (20 of 33 respondents) are shifting freight from rail to truck, or vice versa (Exhibit 15). That said, an equal number of survey participants are also pursuing other transformation strategies and several shippers are executing multiple supply chain initiatives. We highlight the range of shippers’ ongoing efforts to cut cost and improve fluidity throughout their supply chain in this section of the report.

Modal shifts: Shippers change modes for better service. Similar to prior year results, the groups of shippers looking to transfer freight from rail to truck and from truck to rail are equal in size. “Service” is driving decisions to implement both modal shifts as all but three shippers executing this strategy cited “Service” as a primary reason for changing their transportation mix. This insight is noteworthy as last year’s survey findings show that “Price” prevailed over “Service” in shippers’ decisions to transfer freight between rail and truck. In our view, service has emerged as a primary decision driver due to the significant impact of volume congestion and extreme weather on network fluidity in 2014. As a result, “Price” has become a secondary – yet still significant – determinant of transportation mix with 14 of 20 shippers citing “Price” as a key catalyst for modal shifts. With significant rate increases on the horizon for both truck and rail customers, and volume constraints reaching critical levels in key corridors, we believe that price and capacity will become more dominant in shippers’ transportation decisions. In this context, we expect shippers to be opportunistic with their mode and carrier selections with the objective of balancing supply chain fluidity and transportation costs.

 Volume data suggests highway conversions are accelerating. Although survey findings indicate that an equal number of respondents intend to transfer their freight from truck to rail and vice versa, volume statistics suggest that highway conversions are accelerating as intermodal traffic is up +5.3% Y/Y year to date, exceeding carload growth of +3.9%Y/Y. We remain confident that sector fundamentals support the continued conversion of truck freight to rail over time as railroads are investing in their intermodal networks in order to compete with trucks on service. For example, UNP is targeting a larger share of US-Mexico cross-border freight with the installation of double-track along its Sunset corridor; the introduction of new premium services from Monterrey, Mexico to US freight hubs; and the opening of a $400MM intermodal facility in Santa Teresa, New Mexico. Moreover, truck capacity constraints could accelerate highway conversions as driver availability is a growing concern for this industry, particularly in the United States. In our opinion, the upward shift in shippers’ truck pricing expectations supports the view that the driver shortage is approaching an inflection point wherein demand is beginning to outpace supply and shippers are increasingly willing to pay a premium to secure limited truck capacity. In this context, we see an opportunity for rail to take market share from truck if motor carrier capacity cannot meet future demand and the rails are successful in their efforts to develop a truck-competitive service offering. Re-routing imports and exports: Service fuels decision to switch ports of call. Several shippers are re-routing their cargo through different ports and all of these respondents cited

December 2, 2014 21 RBC Compass

“Service” as a main driver of this decision. It is important to note that these situations are unique, reflecting specific issues and/or opportunities at various points in the supply chain. For example, port bottlenecks are prompting some shippers to move their product through less-congested terminals, while other respondents are changing ports of call to access a different Class 1 rail network. Overall, we believe that shippers’ decision to change ports is neutral for the rail industry because most freight will move by rail at some point as it travels inbound to end markets or outbound for export. That said, shippers’ willingness to change ports of call to access another rail carrier underscores the importance of fast, reliable service.

Tendering: Price and service drive carrier selection. We were surprised to learn that shippers are tendering their freight through formal RFP processes in order to lower transportation costs and improve the performance of their supply chain. This insight is noteworthy because tendering is characteristically a cost reduction strategy; therefore, it is interesting to see “Service” emerge as a key consideration in this process. Furthermore, this strategy is being used to award rail business in certain lanes, which is a departure from the traditional use of tendering in truck markets. Based on our discussions with respondents, we believe survey findings reflect increasingly sophisticated RFPs as shippers recognize the importance of balancing service criteria and cost considerations in creating an efficient, reliable supply chain. Our view is supported by the high level of importance that shippers place on execution metrics in their evaluation of rail service.

Exhibit 15: Service drives supply chain transformations

Are you currently implementing any of the following strategies to improve your What is the primary motivation for any supply chain changes you supply chain? are currently undertaking?

16 30 Equal indications of opposing 28 Service is the modal shifts suggests that rail main driver of and truck market share will 12 25 12 supply chain 10 10 remain static in the near-term 20 transformations 20 8 5 15 4 4

10

Number of Respondents Number of Respondents 0 5 3 Rail to truck Truck to rail Re-route Tender Other shift shift imports / freight 0 exports Price Service Other

Source: RBC Capital Markets research

December 2, 2014 22 RBC Compass

Shippers offer diverse perspectives on Canadian freight rail legislation Why do shippers’ views on rail regulation matter? In recent years, CNR and CP have faced increasing government oversight in the form of service reviews, minimum volume mandates, and legislative amendments. In our opinion, these regulatory actions are driven by the government’s desire to balance stakeholder interests and promote economic development. While the impact of government action on freight rail operations is beyond the scope of this report, we believe it is important to take shippers’ temperature on the regulatory environment for two reasons: 1) lawmakers give consideration to this group’s perspective in drafting rail policy; and 2) regulation can materially influence railroads’ operating flexibility Selected shipper and financial profitability. In this context, our prior surveys have assessed shippers’ views on commentary: the impact of the Rail Freight Service Review, the facilitator process, and the Fair Rail Freight Service Act. This year, we gauged shipper sentiment on both the purpose and utility of recent “The interswitching limit legislative amendments (i.e., Fair Rail for Grain Farmers Act, interswitching limit extension) – extension is a red herring the response was mixed. We also asked respondents if there are any outcomes that they because if you’ve got a switch that can handle 20 cars, it would like to result from the statutory review of the Canada Transportation Act (CTA) – we doesn’t matter if you want to received a myriad of replies. Given the diversity of respondents’ perspectives on regulatory switch a whole train there, you issues, there is no clear read-through from our survey on how shipper opinion will impact rail can’t do it.” legislation. That said, we believe it is instructive to highlight the range of shipper

“The grain mandate has perspectives on freight rail regulation in Canada to provide insight on possible outcomes. impacted track availability because CN and CP have to run The 2014 context: Federal government steps in to move Western Canadian grain. Arctic long grain trains across temperatures stalled rail operations across North America in Q1/14, causing freight backlogs Western Canada to meet to build across all sectors of the economy. In Western Canada, network congestion was volume minimums, which means they can’t run as many exacerbated by a record grain crop driving stockpiles to critical levels that incited the federal [other] trains.” to impose a weekly minimum volume of 1,000,000 metric tonnes on CNR and CP (combined) on March 7 for a period of four weeks. Three weeks later, the government reinforced its commitment to expediting the grain supply chain with the introduction of the Fair Rail for Grain Farmers Act on March 26, which proposed to extend the weekly grain volume requirements to August 3 and expand interswitching limits for all commodities in Prairie provinces to 160km (from 30km). We refer investors to our Compass note published on April 3 for a detailed history of interswitching regulations in Canada (Why rail investors should pay close attention to interswitching proposals). The Fair Rail for Grain Farmers Act was ratified on May 30, yet on August 1, the grain volume minimum was extended yet again to November 29 through an Order in Council. A final corollary of grain supply chain issues in 2014 was the acceleration of the review of Canada’s transportation legislation. On June 25, the Minister of Transport launched the statutory review of the CTA one year ahead of schedule citing the grain backlog as a key reason for pushing the review ahead. While the review is comprehensive, covering all modes of transportation and all types of traffic, we expect the steering committee to dedicate a considerable amount of time to evaluating grain supply chain issues in great detail. In this context, we consider shipper sentiment on grain legislation to be extremely relevant as we believe that volume mandates and extensive interswitching threaten network fluidity.

Shippers have mixed views of rail regulation in Canada. Our discussions with shippers revealed a broad range of perspectives on recent legislative amendments by the Canadian government; however, the popular opinion was negative, representing 40% of responses (Exhibit 16). These shippers cited many reasons for their unfavourable view of new regulations ranging from a preference for free market operations to disappointment in the substance of the legislation. The next largest group of respondents (30%) are undecided about the government’s actions – these shippers are either unfamiliar with the new regulations or have not been affected by them. A sizeable faction (15%) supports the new legislation. Notably, this group does not exclusively represent the agriculture sector – many

December 2, 2014 23 RBC Compass

other shippers appreciate that rail service issues have received public attention as a result of the grain volume mandate. Lastly, 15% of respondents have a mixed opinion on recent regulatory action as these shippers see both positive and negative elements within the new legislation. We believe it is instructive to highlight the scope of respondents’ opinions in order to provide context for the results depicted in Exhibit 16. Common themes of our conversations with shippers on Canadian rail legislation are outlined below:

 Grain volume mandate disadvantages other sectors. A popular criticism of the grain volume mandate is that it gives preferential treatment to the grain sector at the expense of other rail customers. Many shippers attributed deteriorating service levels to the diversion of rail resources to the grain supply chain and other respondents noted that long, heavy grain trains in key corridors are slowing the transit of their freight. Given the level of shipper frustration with this legislation, we expect the grain volume mandate to be hotly contested by both the Canadian railroads and members of the shipping community in the ongoing review of the CTA.  New legislation misses the mark. An interesting perspective shared by another group of respondents is that recent regulatory amendments do not address the root cause of rail service issues. For example, several shippers indicated that the extension of interswitching limits is futile given constraints on switch capacity and train capacity throughout Western Canada. Further, many respondents highlighted frustration with poor switch performance, which suggests that this group is unlikely to capitalize on additional switching opportunities. This commentary is supported by survey findings as only 28% of shippers that are based in Canada (or move freight through Canada) are able to take advantage of extended interswitching limits, and less than half of this group plans to do so (Exhibit 16). The majority of respondents (75%) are not able to (or do not plan to) take advantage of these regulations, which reinforces the view that recent legislation has not served the interests of most shippers.  Commercial negotiations are preferred over government intervention. Another subset of respondents oppose legislation altogether as they believe that regulation caters to the lowest common denominator and only serves to jump-start rail operations in the short term. These shippers support commercial negotiations as they believe that free market operations provide incentive for supply chain collaboration and are the only means of stimulating investment and stakeholder cooperation over the long term.  Grain volume mandate enforces compliance and puts service issues in the spotlight. Proponents of amendments to freight rail legislation cited two main reasons for supporting recent government action: 1) the grain volume mandate enforces compliance; and 2) the Fair Rail for Grain Farmers Act puts service issues in the spotlight. Notably, this perspective is not unique to grain shippers as the interswitching legislation applies to shippers of all commodities in Prairie provinces. In our view, these respondents’ favourable view of recent regulatory revisions reflects their support of legislation that helps to equalize a perceived imbalance of market power in the freight rail industry.

December 2, 2014 24 RBC Compass

Exhibit 16: Clear negative bias in shippers’ views of Canadian rail legislation

How does your company view recent regulatory amendments and Is your company able to and does your company plan to take advantage of provisions related to freight rail transportation across Canada? the extended interswitching limit in Western Canada?

50% 100% Popular opinion disapproves Most shippers cannot 40% or is undecided about recent (or do not plan to) use 80% 75% 40% rail legislation extended switching limits in Western 65% 30% 30% 60% Canada

40% 20% 15% 15% 28% 20% 13% 13%

10% Percentageof Respondents

Percentage of Respondents 8% 0% 0% Yes No Uncertain Positively Negatively Mixed Undecided Able to use new interswitching rules Opinion Plan to use new interswitching rules

Source: RBC Capital Markets research Multiple proposals put forth for CTA reform Shippers seek transparency, accountability, and market power. Survey respondents Selected shipper provided a long wish list of outcomes from the ongoing review of the Canada Transportation commentary: Act; these requests centred on three key themes: transparency, accountability, and market “The Canadian government power. We summarize how shippers would like these concepts to be written into the new needs to rebalance power legislation below: between the shippers and the railways.”  Shippers seek balanced market power. More competition and balanced market power “Enhancements to rail were frequently cited as the top item on shippers’ wish list for outcomes from the CTA transportation must focus on review. While these conversations did not yield a comprehensive action plan for creating less legislation and more competition in the freight rail industry, respondents pointed to non-performance accountability for all players in the rail supply chain. Freight penalties, service level agreements, and other new remedies as potential measures that must be handled with could increase shippers’ market power. commercial agreements and  Shippers would like service levels to be enforced. While shippers gained the right to a programs that elevate the level service agreement with the passage of the Fair Rail Freight Service Act in June 2013, last of accountability.” year’s survey findings indicated a high level of frustration with perceived ambiguity and a lack of effective enforcement tools in this law. Accordingly, we were not surprised to learn that shippers would like the new CTA legislation to hold CNR and CP accountable for the service that they provide to shippers. Specifically, many respondents would like to impose financial penalties on railroads for non-performance in the same way that shippers are charged demurrage for extended use of rail cars. Overall, this group of shippers is looking for the new CTA legislation to include provisions that will incentivize CNR and CP to meet a minimum level of service.  Shippers desire more visibility on rail operations. A final desired outcome from the CTA review is greater transparency on rail operations. Shippers would like carriers to provide more data on the status of their freight in order to optimize their own operations and manage the expectations of their customers. In our view, this need could be met with increased communication between the Canadian railroads and their customers.

December 2, 2014 25 RBC Compass

Survey mechanics Survey approach This report represents the findings of both live telephone and online surveys with major North American railroad shippers. Key attributes of the survey are as follows:

 Seventeen of the 51 survey participants completed the online questionnaire and we had follow-up discussions with three of these respondents.  The survey was conducted from September to November 2014.  Confidentiality and non-attribution are important features of this survey in order to ensure participation and disclosure are maximized.

Respondent profile The 2015 North American Railroad Shipper Survey highlights the views of 51 shippers representing a diverse cross-section of eight different industries with combined annual spend of more than $12B on freight transportation (Exhibit 17). Importantly, larger shippers (i.e., those with annual transportation budgets of $200MM+) continue to have strong representation in our survey at 28% of respondents. We believe it is critical to solicit survey responses across the entire spectrum of shippers in order to obtain a balanced perspective on current rail issues.

Exhibit 17: Respondent profile

Breakdown of respondents by sector How much do you spend on freight transportation services annually? Metal / $50- Aggregates Agriculture $200MM 16% 16% 38%

Intermodal Automotive <$50MM (Int'l) 2% 20% 4% Coal 8%

Intermodal (Dom) 19% Chemicals / N/A Energy 14% $200- 20% $500MM Forestry $500MM+ 14% 16% 14%

Source: RBC Capital Markets research

December 2, 2014 26 RBC Compass

Survey focuses on rail shippers. This survey is targeted toward railroad customers; therefore, most respondents (57%) transport more than half of their freight by rail. Nonetheless, a number of survey participants ship the majority of their freight by truck and almost all respondents use a combination of rail and truck carriers.

Exhibit 18: Distribution of respondents’ freight by mode

How much of your freight is transported via rail? How much of your freight is transported via truck?

25% 25% 20% 20% 20% 18% 16% 16% 14% 15% 12% 15% 12% 12% 10% 10% 10% 10% 8% 10% 8% 6% 6% 4% 4% 4%

5% 2% 5% 2% 2% Percentage of Respondents Percentage of Respondents 0% 0% 0% 0% 1-10% 11- 21- 31- 41- 51- 61- 71- 81- 91- 0% 1-10% 11- 21- 31- 41- 51- 61- 71- 81- 91- 20% 30% 40% 50% 60% 70% 80% 90% 100% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Source: RBC Capital Markets research

Market share We included the six large Class 1 railroads in our survey again this year to provide the best possible picture of the entire North American rail industry. As many of our shipper contacts are based in Canada, CNR and CP were used by the majority of shippers at 90% and 75%, respectively, while the proportion of respondents that use the US Class 1 rails ranged from 39% to 45%.

Exhibit 19: Market share breakdown by rail

Which rail companies do you deal with? Which rail company do you use the most?

100% 75% 90% 59% 80% 75% 60%

60% 45% 45% 43% 43% 39% 31% 40% 30%

20% 15%

8% 6% Percentage of Respondents

Percentage of Respondents 4% 4% 0% 0% CN CP BNSF CSX NSC UNP CN CP BNSF CSX NSC UNP

Source: RBC Capital Markets research

December 2, 2014 27

RBC Compass

Appendix I: Rail Comparables

RBC CM Research Mkt Net Target 12-Mth Price Cap EV Debt EPS P/E EBITDA ($MM) EV/EBITDA Symbol Rating5 Multiple Target ($/sh) ($MM) ($MM) /EV 2014E 2015E 2016E 2014E 2015E 2016E 2014E 2015E 2016E 2014E 2015E 2016E Yield

Canadian Rails 1,3 Canadian National Railway CNR O 19.5x 92.00 85.00 69,250 76,915 10% 3.65 4.22 4.74 23.3x 20.1x 17.9x 5,545 6,186 6,798 13.9x 12.4x 11.3x 1.2% Canadian Pacific Railway CP SP 18.5x 222.00 236.00 40,568 45,137 10% 8.51 10.72 12.01 27.7x 22.0x 19.7x 2,886 3,342 3,552 15.6x 13.5x 12.7x 0.6%

U.S. Rails (Class 1) 2,3,4 CSX Corp. CSX SP 15.0x 36.00 37.91 37,872 46,435 18% 1.90 2.16 2.42 20.0x 17.5x 15.7x 4,746 5,176 5,550 9.8x 9.0x 8.4x 1.7% Kansas City Southern KSU O 20.0x 132.00 125.30 13,828 16,038 14% 4.78 5.13 5.74 26.2x 24.4x 21.8x 1,098 1,174 1,278 14.6x 13.7x 12.5x 0.9% Norfolk Southern NSC SP 15.0x 123.00 117.20 36,273 43,762 17% 6.46 7.40 8.20 18.1x 15.8x 14.3x 4,727 5,213 5,622 9.3x 8.4x 7.8x 1.9% Union Pacific UNP O 18.5x 135.00 123.31 110,140 119,758 8% 5.60 6.41 7.28 22.0x 19.3x 16.9x 10,599 11,563 12,525 11.3x 10.4x 9.6x 1.6% Average (U.S. rails exc. KSU) 20.1x 17.5x 15.6x 10.1x 9.2x 8.6x 1.8% Average (Canadian & U.S. rails exc. KSU) 22.2x 19.0x 16.9x 12.0x 10.7x 9.9x 1.4%

U.S. Rails (Class 2) 2,4 Genesee & Wyoming GWR O 18.0x 110.00 100.89 5,436 7,059 23% 4.18 4.75 5.45 24.1x 21.2x 18.5x 581 638 699 12.1x 11.1x 10.1x 0.0%

1 CAD 2 USD 3 CNR, CP, CSX, NSC, UNP covered by RBC Dominion Securities Inc. Analyst Walter Spracklin (416)842-7877 4 KSU and GWR covered by RBC Capital Markets, LLC Analyst John Barnes (804)-782-4020 5 Investment ratings: Top Pick (TP), Outperform (O), Sector Perform (SP), Underperform (U)

Source: Company reports, ThomsonONE, RBC Capital Markets estimates; Priced as of market close on November 27, 2014

December 2, 2014 28 RBC Compass

Required disclosures Non-U.S. analyst disclosure Walter Spracklin;Erin Lytollis (i) are not registered/qualified as research analysts with the NYSE and/or FINRA and (ii) may not be associated persons of the RBC Capital Markets, LLC and therefore may not be subject to FINRA Rule 2711 and NYSE Rule 472 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. Conflicts disclosures This product constitutes a compendium report (covers six or more subject companies). As such, RBC Capital Markets chooses to provide specific disclosures for the subject companies by reference. To access current disclosures for the subject companies, clients should refer to https://www.rbccm.com/GLDisclosure/PublicWeb/DisclosureLookup.aspx?entityId=1 or send a request to RBC CM Research Publishing, P.O. Box 50, 200 Bay Street, Royal Bank Plaza, 29th Floor, South Tower, Toronto, Ontario M5J 2W7. Please note that current conflicts disclosures may differ from those as of the publication date on, and as set forth in, this report. The analyst(s) responsible for preparing this research report received compensation that is based upon various factors, including total revenues of the member companies of RBC Capital Markets and its affiliates, a portion of which are or have been generated by investment banking activities of the member companies of RBC Capital Markets and its affiliates. Distribution of ratings For the purpose of ratings distributions, regulatory rules require member firms to assign ratings to one of three rating categories - Buy, Hold/Neutral, or Sell - regardless of a firm's own rating categories. Although RBC Capital Markets' ratings of Top Pick(TP)/ Outperform (O), Sector Perform (SP), and Underperform (U) most closely correspond to Buy, Hold/Neutral and Sell, respectively, the meanings are not the same because our ratings are determined on a relative basis (as described below).

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