Forward, Fast

Surrounded by snow drifts two feet deep, locomotive 9136 rests at the head of a procession of identical engines at a sprawling rail yard in Winnipeg. The cherry-red locomotive is a Model SD90MAC, a 4,300-horsepower workhorse that spent the past decade and a half hauling heavy freight and intermodal trains. Now it sits idle, along with dozens of others—an unusual sight at a yard that rarely sees so many idle locomotives. The last time they lingered here was during the recession in 2009, but the fleet was pressed back into service the following spring when the economy picked up. This time is different. It’s unlikely these engines will see action again—at least not with Canadian Pacific.

CP overhauled four locomotives in the past two years—it clearly intended to use them for years to come. But that was before grizzled railroad veteran Hunter Harrison came to power following a brutal putsch by U.S. hedge fund Pershing Square last year. Pitching himself to shareholders, Harrison vowed he’d turn the least efficient of North America’s Class 1 railroads into the leanest and meanest in a few short years. SD90s are often accused of being unreliable and inefficient, and anything matching that description at CP today is toast. Late last year, the company tendered virtually its entire fleet of SD90s (58 of them) for sale. It offered eight for scrap in January.

Harrison hasn’t yet reached the end of his first year as CEO at Canada’s No. 2 railway, which reported net income of $484 million last year, but his radical transformation of CP is well underway—and by most reckonings, it’s running ahead of schedule. When he assumed the position last June, he promised to slash costs while raising service levels, and he’s moved quickly on both fronts: fewer train crews go to work each day, thousands of workers have already been turfed, and CP’s remaining fleet is pulling heavier loads. Only a few months into his tenure, analysts at Raymond James credited Harrison with “already effecting significant operational improvements.” In February, he hired president and chief operating officer Keith Creel, a protege with whom he’d worked previously, clearing up questions about his eventual successor. Investors can barely contain their enthusiasm for the changes afoot at the company. They’ve bid up CP’s stock above $120 a share; most sell-side analysts have Neutral or Sell ratings on the stock, but that primarily reflects concerns about whether Harrison can deliver results justifying the stock’s already rich valuations. Few question his approach.

As Harrison is fond of saying, CP is no place for anyone who doesn’t like change. A consummate storyteller, he portrays this transformation as unfolding against a harmonious backdrop of co-operation between CP’s management, employees and customers. Yet there will inevitably be winners and losers; Pershing Square clearly intends to be in the former camp. But what’s good for investors isn’t always good for customers or employees—any more than it is for rusting locomotives. If history is any indication, Harrison will pay their complaints little heed.

Few shed tears for CP’s previous board and management team. Those measuring a railroad’s efficiency often consult the operating ratio, which measures operating costs as a percentage of revenue (lower is better). Under CEO Fred Green, CP’s stood above 80% —the worst in the business. Harrison vowed to reduce it to the mid-sixties by 2016, by which time he plans to retire. To accomplish that, he’d have to overhaul the company.

He’d done it before—at CP’s biggest competitor, Canadian National Railway. Harrison came to CN, a former Crown corporation that had been recently privatized, in 1998 when it bought Illinois Central. As president of the once moribund American railway line, he’d transformed it into a super-efficient powerhouse; CN, grasping his genius, appointed him chief operating officer, later elevating him to CEO in 2003. In doing so, it committed itself to Harrison’s “precision railroading” philosophy. Although the term’s meaning is ambiguous, traditionally many railroads preferred to delay train departures until they were hauling as much cargo as possible. The problem with this approach is that it meant crews and locomotives stood idly, waiting for trains to fill, and customers had little certainty about arrival times. Harrison addressed that by putting CN’s trains on more rigid schedules, a strategy that allowed the company to squeeze more value out of its assets. CN’s operating ratio fell like a stone. By the time he retired in 2009, virtually all competing railroads were imitating at least portions of his approach.

Yanked away from his two retirement passions—golf and horse breeding—by Pershing CEO Bill Ackman, the 68-year-old veteran is applying the same tested template at CP. The difference this time: he’s giving himself a much tighter timeline. “He’s condensed all these things that he believed were successful at CN,” says Doug Finnson, vice-president of the Teamsters Canada Rail Conference, “and he’s implementing them over a very short period of time.”

He’s begun by shutting down anything that seems inefficient. He has closed four of CP’s “hump yards,” for example, which use gravity to sort inbound cars into collection tracks based on where they’re heading. Such yards were conceived during the 1950s to handle a thousand or more cars a day, but changing traffic patterns left CP’s underused. He’s also closed or combined several intermodal terminals (hubs designed for the transfer of shipping containers).

Since moving from Montreal in 1996, CP has been headquartered in downtown Calgary. Under Harrison, it’s now building a new headquarters to the southeast at its Ogden Yard, a move expected to save at least $15 million a year. But it’s not just about savings—it’s about reminding managers they don’t work for an oil company or investment bank. Harrison wants them to see graffitied freight cars when they look out the window. He’s also ordered hundreds of them back to school to learn how to run locomotives and work in rail yards.

Early evidence suggests his strategy is working. CP’s trains spent less time languishing in terminals last year, and average velocity rose 15%. Increased efficiency means CP can do more with less, allowing it to remove hundreds of locomotives from service. (Goodbye, SD90s.) It’s also returning thousands of leased freight cars. Observing all this, analysts at J. P. Morgan posed a pertinent question: “Why on Earth weren’t these opportunities pursued before?”

The up-front costs, though, are sobering. Consider Harrison himself. Simply by announcing his candidacy for CP’s top job, he put himself at odds with his former employer. CN promptly cut off his pension and other benefits and sued, alleging (among other things) that Harrison had breached contractual obligations. Pershing Square, which had promised to indemnify him against lawsuits and compensate him for any lost benefits, deftly handed the tab to CP following its proxy battle victory. In 2012, half a year of Harrison’s time cost CP $49 million. (The two companies buried their litigation hatchets earlier this year, and CP recovered US$9 million.)

There were other charges relating to labour restructuring and severance agreements for departing managers. As a result, CP’s already lacklustre operating ratio actually increased, to 83.3%. (CP diverted attention from that by emphasizing a modified operating ratio that ignored “significant” items such as “management transition costs.” By that measure, modest improvement is already evident.)

By his own reckoning, Harrison has eliminated 3,000 of the 19,500 positions (including part-timers and contractors) existing when he took over; at a New York investor conference, he mused he may turf thousands more than initially projected. Although much of this is to be accomplished through attrition, one might expect the bloodletting to compromise morale. But when talking to shareholders, Harrison’s message is that what’s good for CP is also good for its customers. For example, the company reports it slashed its customer service department in Winnipeg by 75%, from 800 workers, in favour of a new approach where the people delivering the service are also responsible for keeping the customer happy. And apart from the odd malcontent, he says, there’s almost no push-back from workers. Indeed, in late 2012 he signed five-year agreements with United Steelworkers and three other unions. “I’ve never been in a company where people were more ready and willing to change,” he wrote in his annual letter to shareholders. “They are tired of being in last place.”

“That’s bullshit.” Over at Teamsters, which represents CP’s locomotive engineers, traffic controllers and conductors, Doug Finnson invokes that phrase frequently when discussing Hunter Harrison’s latest pronouncements. But the one that really gets Finnson riled is CP’s claim that relations with unions are improving. He regards the overbearing Harrison as a martinet—not an uncommon view among rail workers. Relations were already troubled when he arrived on the scene: last May, Teamsters went on strike, costing CP significant revenue. Parliament ordered them back to work after nine days and forced them to arbitration.

During the arbitration process, CP began cancelling local rules at many of its terminals, including ones governing how locomotive engineers are called to work, in favour of new companywide rules. Teamsters opposed the changes before the Canada Industrial Relations Board. In two decisions, the CIRB found CP had violated collective agreements. In March, the board took the unusual step of filing its latest decision with the Federal Court for judicial enforcement because it expected CP to ignore its orders. “The employer has made it virtually impossible for the labour-relations system to work as it should,” the board observed.

Unions weren’t able to stop Harrison’s reforms at CN; they barely slowed him down. But his approach won’t improve what is already a climate of mutual suspicion. CP casts locomotive and rail-yard courses for managers as a way of spreading passion for railroading throughout the company. Finnson calls it Union Busting 101—preparing management to run trains in the event of a strike. “He’s doing the same thing he tried at CN,” Finnson claims. “He trained people to become conductors and locomotive engineers.…When conductors went on strike, they used managers to do their jobs.”

Finnson says the union fears CP will become a more dangerous place to work. Harrison has emphasized the importance of safety virtually his entire career, but some question his approach. According to a 2007 federal safety review of the railway industry, during the early 2000s the number of railway accidents in Canada—particularly main track derailments—sharply increased. The review panel praised CP for making “great strides” to developing a “healthy safety culture.” Harrison’s CN, by contrast, got lambasted for adopting a rigid rules-based system under which employees were more often suspended or fired for mistakes. This, according to the panel, created a “culture of fear and discipline” that compromised safety rather than improved it. Finnson reports that Harrison is replicating that approach at CP. The company recently saw derailments in Minnesota and northern Ontario, both of which resulted in oil spills, but it’s too early to draw conclusions about the causes of either accident.

For customers, the implications of Harrison’s strategy seem more ambiguous. “CN does a better job of getting there when they say they will,” offers Ian May, chair of the Western Canadian Shippers’ Coalition. “In terms of their standards and the way they operate, they’re much better.” As for CP’s service pre-Harrison, “it was bad. The grain guys were particularly vexed. I would expect him to clean that stuff up. But you’ve gotta realize, the bar is pretty stinkin’ low.”

Harrison argues improvements will follow from making the railway more efficient. That already seems evident in more competitive markets such as intermodal service between the Port of Vancouver and major centres like Chicago and Toronto. CP reports it has knocked a full day off its Vancouver–Chicago service. Analysts at Raymond James considered that “testament to the compatibility of reducing costs and raising service.” Cormark Securities recently predicted that competition between the two national railroads will rise, which implies further service improvements.

Shippers’ advocacy groups are hardly convinced, though. “When Hunter Harrison was at CN, the results were pretty mixed,” says Bob Ballantyne, chairman of the Coalition of Rail Shippers. May concurs. Although CN’s service remained largely unchanged after Harrison’s retirement, the company adopted a gentler approach to customer relations. “One of the problems with Hunter was, he was pretty gruff,” May says. “It was hard to get anything but a ‘screw you’ out of CN if you were complaining.”

By way of illustrating how efficiency and service sometimes clash, May recalls a branch line in Alberta, on which CN served four companies with a 120-car train. One of the customers doubled its business, and wanted 80 cars instead of its usual 40. But a 160-unit train was too long, and CN balked at adding another train. “The response by the railway, initially, was to not give them the service they wanted,” May recalls. “And when pressured, they took away cars from the other customers on that line. But nobody ended up getting what they needed.” Customer service, he says, became thoroughly subordinated to driving profitability for shareholders. “That’s really what’s at the core of what’s wrong with Mr. Harrison’s model.”

Some customers fear CP’s service is now suffering. “Some of our members have expressed concern over how much service, attitude and communications have deteriorated at CP over the last several months,” says Susan Murray, spokesperson for the Forest Products Association of Canada. But customers probably have less leverage than the unions. Their best hope was the Fair Rail Freight Service Act bill, the result of years of complaints and lobbying about rail service in Canada. Unveiled in December, it would give shippers new rights to service contracts with railways, and a new system to resolve disputes. But May calls the legislation underwhelming, saying it benefits railways more than shippers.

Harrison’s template, then, faces few credible external obstacles. And with several of CP’s business lines (notably oil shipments by rail) enjoying robust growth, the wind seems to be at his back. Some, like Finnson, question how much progress Harrison has made, suggesting that he may be taking credit for initiatives predating his arrival. For example, Finnson claims the planned move to Ogden Yard had been talked about for at least three years. But while Finnson intended that at a criticism, it could equally be regarded as further proof CP was far too bureaucratic under its previous management. Under the previous CEO, the company could conceive of sensible measures to save money. Under Harrison they get implemented—and quickly.