Trends in operating revenues and expenditures among groups of carriers in each major mode show increased operating margins. The ability to meet long-term capital costs, including debt interest and an imputed cost of equity, varies across the industry, but most companies are improving profitability.

Introduction

This chapter discusses indicators of the financial performance of the companies that make up transport industries. It addresses the issue of financial viability, using the results of the financial surveys of industry participants undertaken routinely by Statistics Canada, together with annual reports of some of the larger companies. For this report, the analysis is limited to companies engaged as carriers - it does not examine the expanding number of companies providing infrastructure or related services, rather than carrying freight or passengers. These include the newly commercialized airports, Nav Canada, the St. Lawrence Seaway and certain ports. The analysis will be extended to these entities in future editions, as information on their operations and finances becomes available. The indicators are primarily compiled across all (or most of) the carriers in each mode, without identifying the results for individual carriers, except in cases where identification is necessary.

Financial viability is not a straightforward concept that can be easily deduced from published financial accounts of the relevant enterprises. And, of course, since each of the transport industries or modes consists of a number of enterprises (a very large number in the case of trucking, and growing numbers in aviation, rail freight and intercity bus services), great disparities in size must be taken into consideration. Financial performance differs considerably among organizations, with the result that some succeed and even expand, while others fail and close down their operations.

It is arguably presumptuous for an outside analyst to make judgments about viability. Such assessments are made continually by financial markets and by individual creditors of each enterprise. Indeed, the continued survival of an enterprise is a demonstration of its viability.

However, the capital-intensive nature of many transport enterprises means that their short-term profitability, or their survival despite losses, might differ substantially from their longer term performance. The capital investments made on long-lasting equipment such as aircraft, railroad tracks, locomotives, rail cars, and even trucks and buses, though infrequent, are large, with major effects on financial accounts in some periods. The analysis set out here should be seen as a supplement to the annual accounts available from major transport enterprises or from industry-wide surveys of annual finances by Statistics Canada - an attempt to provide a simple indicator of whether current operations are likely to provide the means to cover their longer term costs, including those of capital investments.

The analysis requires that the current structure of capital financing by the enterprises be known, or be capable of estimation from the current accounts. To the extent that capital is financed by debt, there is little difficulty in identifying the cost from routine accounts, the interest charged on loans or bonds, or the guaranteed payments to owners of preferred stock. The complication arises in identifying a suitable cost of investments by holders of the rest of an enterprise's equity - the common stock. There is, of course, no guaranteed return on such stock - investors effectively loan money to the enterprise in the hope they will be able to gain through periodic dividends or an increase in the stock's price. Such equity thus has no money cost to the enterprise. Nevertheless, if the enterprise is to continue to attract equity investment for future capital spending and long-term success, it must provide a return that satisfies equity holders. The analysis attempts to estimate what that return needs to be.

Alternative means of estimating this required return on equity exist in the literature of economics and corporate finance, as well as in that of regulatory agencies. ^{note 1} Much of the difference among them lies in their treatment of the return for financial risk-taking and their assessment of the risks of each enterprise, which can be expected to differ widely within the transport industries. Such an assessment lies beyond the scope of this report. Instead, this analysis is based on a cost of equity arbitrarily set at two percentage points above the long-term average corporate bond rate.

These financial costs of capital employed are then added to the comparisons of current revenues and costs to assess whether recent revenues have been sufficient to cover all capital costs.

Air Carriers

Financial analysis of the air carrier industry is based on the performance of the two main airlines - Air Canada (AC) and Canadian Airlines International Limited (CAI) - and their affiliates, as well as a number of other carriers for which data are available. ^{note 2} Total operating revenue of these carriers amounted to $7.8 billion in 1995, representing 87 per cent of the record $9 billion revenue reported that year for the entire industry.

Total revenue of the selected carriers in 1995 was 17 per cent higher than that in 1989. Most of the increase occurred in the last two years, following a period of decline and stagnation in the early 1990s (see Figure 11-1). The faster growth in revenues from international passenger services (including transborder and other international routes) resulted in a shift in revenue shares in 1995: a 46 per cent share for the international segment, compared to 44 per cent for domestic services. Freight and other revenues accounted for the remaining ten per cent (see Figure 11-2).

Despite recent strong revenue growth, accumulated losses over past years have left the air industry in a weak financial position. As shown in Table 11-1, most carriers experienced operating losses in 1991/92, with operating costs for all the selected carriers about 4.6 per cent greater than total revenues. In general, the margin of revenues over operating costs has risen since 1994 in the air industry, though some carriers are still not showing a profit.

The industry's average margin of operating revenues over operating costs ("operating margin") was four per cent of revenues in 1995. Air Canada, including its affiliates, achieved six per cent. With the exception of CAI, which continued to report operating losses, the other carriers also saw improved operating profits.

The increasing reliance of airlines on leased equipment is reflected in the industry's operating cost structure as well as its investing activities. Between 1988 and 1995, aircraft lease payments more than doubled, surpassing depreciation rates (4.2 per cent) to account for 8.8 per cent of total operating expenses.

Over the past few years, air carriers have adopted a "sell and lease back" strategy to maintain their fleets. As a result, net capital investment was negative in some years, which reduced the carriers' capital assets. In 1993, for instance, total capital investment of the two major airlines and their affiliates amounted to $450 million, while at the same time sale and lease-back of assets registered about $810 million, a reduction of $360 million in property and equipment assets (see Figure 11-3).

Table 11-1 outlines the financial results of the selected carriers for the period 1989 to 1995.

In the early 1990s, the equity capital of the industry declined, as air car-riers experienced losses resulting from reduced demand. Some faced liquidity problems, as earnings failed to cover interest payments, though most were able to cover variable costs (operating expenses excluding depreciation and leases). As a result, several carriers have undertaken major restructuring in recent years, including workforce and/or payroll reductions, as well as refinancing of debts and equity.

Overall, the industry is in the midst of recovery. While some carriers are still experiencing financial difficulties, most have seen increases in their operating margins and have shown net profits in the past two or three years.

With a capital structure consisting of only 25 per cent equity, 74 per cent debts and about one per cent deferred income taxes, the air industry relies heavily on debt capital. However, the cost of capital is reduced by low-interest perpetual debts for some of the large carriers.

As noted earlier in this chapter, the after-tax cost of equity rate has been set at two percentage points above the long-term average corporate bond rate to provide a framework for estimating the long-term capital costs of the selected carriers and assessing whether revenues have recently been sufficient to meet those costs.^{note 3}

As shown in Figure 11-4, the air industry as a whole has not earned revenues sufficient to cover long-term capital costs. Based on the industry's current capital structure, the analysis shows that it has to achieve an operating margin of eight per cent of revenues to do so, while the recent margin has averaged four per cent. However, if the CAI group is excluded from the calculation, the average margin has been seven per cent - close to the required level.

Rail Carriers

Freight railways in Canada generated a total of $6.8 billion operating revenues in 1995, of which 91 per cent was shared by the two Class I railways - Canadian National (CN) and Canadian Pacific (CP).

After experiencing four consecutive years of near-stagnant revenues, the rail freight sector experienced 11 per cent revenue growth in 1994 (see Figure 11-5). This strong performance was not sustained in 1995, but appears to have returned in 1996.

Total freight railway expenses in Canadian operations rose to $8.1 billion in 1995, because of some special charges incurred by CN and CP. Excluding these special charges, total expenses were about the same as in 1994 - approximately $6.2 billion. The average operating margin of regional railways was 16 per cent of revenue during the period, compared to nine per cent (excluding restructuring charges) for the Class I railways.

However, the two Class I freight railways are benefiting from the cost restructuring that took place over the past few years. The average operating margin rose to about 14 per cent of revenues in the first nine months of 1996.

On the passenger side, Via's operating revenues increased from $150 million in 1991 to $175 million in 1995, achieving most of the growth in 1994 (see Figure 11-6). With government subsidies to the carrier reduced by $100 million over the same period, cuts to operating expenses were necessary, as were staff reductions. In 1995, the government subsidy covered 56 per cent of Via operating expenses, down from 69 per cent in 1991.^{note 4} (Subsequent to these accounts, subsidies have fallen further, from $301 million in 1994/95 to $236 million in 1996/97.)

The analysis in the rail freight sector is based on the system results of CN and CP for the period 1991 to 1996. Because of CN privatization and CP organizational restructuring, consistent financial data on assets and liabilities can be found only in the latest official annual financial reports of these railways. Table 11-2 summarizes the combined financial condition of the two major freight railways from 1991 to 1996.

Both CN and CP systems include their US rail operations, which generate about 15 per cent and 30 per cent, respectively, of their total system revenues. On average, the two railways' US subsidiaries have slightly lower margins of revenues over operating costs than do their Canadian operations.

In 1995, the two railways incurred a total of $2.6 billion in restructuring costs, largely attributable to re- evaluations of assets ("write-downs").

Excluding these restructuring charges, the two railways attained a combined operating income of $800 million. Total cash earnings from operations amounted to $1.2 billion in both 1994 and 1995, representing about 16 per cent of total operating revenues.

The railways experienced continued profitability in 1996, with a combined operating income in the first nine months amounting to $1,141 million on their total systems.

The railway industry's capital expenditures were unusually low in the early 1990s, covering only depreciation. This was due in part to the completion of several major projects in the mid-1980s and in part to operational losses. With improved cash flows in recent years, both railways have increased capital spending on new equipment and structures (see Figure 11-7).

The industry's capital structure consists of 45 per cent debt, 50 per cent equity and five per cent deferred income taxes. The elimination of certain categories of debt and the disposal of assets unrelated to the core freight railway business after privatization have greatly simplified CN's new capital structure. Meanwhile CP's debt ratio increased in 1995 as a result of asset write-down and restructuring, as well as increases in long-term debts.

Capital Costs The railway industry is relatively more capital-intensive than the other transport industries, because its fixed assets include not only locomotives and freight cars but also railroad tracks. Consequently, it needs higher profit margins to meet its long-term capital costs.

Using the same model as for the other modes, the freight railway industry would need to achieve a 17 per cent operating margin (or an operating ratio of 83 per cent). Although operating margins have increased in the past three years, they generally remain slightly below that level (see Figure 11-8).

However, the simplified model assumes that the railways pay statutory rates of income taxes, whereas, in recent years, their effective tax rates have been lower, as a result of accumulated losses and recoveries of previous years' taxes. If the effective income tax rate of CP in 1996 were used, the railways would have covered their cost of capital in the past year.

Marine Carriers

The financial performance of the water transport industry, which is represented by Canadian-domiciled for-hire marine carriers, is relatively more volatile than that of other transportation modes. The performance of a few large carriers tends to dominate the overall results for the industry.

Industry revenues in 1994 totalled $1.8 billion, 13 per cent higher than in 1993. The slightly improved operating margin achieved - five per cent of revenues - was also the average margin for the six-year period between 1989 and 1994.

In recent years, the marine transport industry has experienced a decline in the value of its assets - especially its ships. As shown in Table 11-3, the value of total assets declined by 24 per cent between 1989 and 1994, to $712 million from $942 million. A shift to chartering rather than owning vessels contributed to the decline, as did reductions in capital expenditures.

The cost of capital is relatively lower for the marine transport industry than for other modes, as its capital structure includes a high proportion of deferred taxes and a low proportion of equity. Specifically, the capital structure consists of 52 per cent debt, 19 per cent deferred income taxes, and only 29 per cent equity funds. Deferred income taxes have arisen from the capital cost allowance (CCA) for Canadian-built vessels. Such deferred income taxes incur no carrying costs.

In the absence of data on interest expenses, the corporate long-term bond rates were applied to the industry debt capital to estimate its debt costs. The operating income of the industry, which barely covered the estimated debt costs in 1992, increased to three times the cost of interest in 1994.

In the six-year period analysed, the industry obtained revenues sufficient to meet long-term capital costs in three years: 1991, 1993 and 1994 (see Figure 11-9). This was in part due to deferred income taxes and a relatively high proportion of capital financed by debt rather than equity. Overall, an operating margin of four per cent was required to cover long-term capital costs.

The profitability of the for-hire trucking industry has improved since 1994, largely because of strong revenue growth: 17 per cent per annum (see Figure 11-10). In 1994, the industry's average operating margin rose to eight per cent of revenue, from an average of three per cent in the five preceding years. While revenue growth continued in 1995, net operating income increased only slightly, to $824 million. Table 11-4 highlights the financial results of the for-hire trucking industry for the period 1989 to 1995.

Although many individual trucking firms were adversely affected by the recession of the early 1990s, the industry as a whole fared better than did other transport modes, with higher operating margins and cash earnings. During the period between 1989 and 1994, the average annual earnings before depreciation reached $786 million. After providing for maintenance capital, or depreciation (averaging $447 million per annum), the annual earnings generated an average of about $340 million in net operating income over the six years.

With an industry capital structure consisting of 59 per cent equity, 35 per cent debt and six per cent deferred taxes, average debt ratios were relatively low compared to those of other modes. However, a wide range exists in those ratios among trucking firms, especially among large carriers.

The trucking industry is relatively less capital-intensive than are the other freight modes. As a result, the industry can meet long-term capital costs with a relatively low operating margin: about four per cent of revenues.

Although, over the period studied, the trucking industry did not achieve sufficient revenues to cover long-term capital costs until 1994, it was closer to doing so than were the other transport modes during the recession years. By 1994/95, the industry's average operating margin exceeded the required return by three to four percentage points (see Figure 11-11).

Total revenues of the inter-city bus industry amounted to $611 million in 1995. Scheduled bus services accounted for $368 million of this, while the remainder came from charter services. Over the period studied - 1989 to 1995 - total industry revenue increased by 15 per cent, largely because of strong growth in the charter bus services. The overall 42 per cent increase in revenue achieved by this sector was in sharp contrast to the stagnant revenues of scheduled services, and increased the charter share of total revenue for that period to 40 per cent from 32 per cent.

Although there has been little change in total revenue, the bus industry has reported increases in operating profits in the two most recent years, notably through cost reductions. The average operating margin rose to 11 per cent of revenue in 1995 from five per cent in 1993, and the industry's net operating income rose to $66 million in 1995 - a 37 per cent increase over 1994 (see Table 11-5).

Total net assets, including equipment and other property, grew by 26 per cent between 1989 and 1995, to $358 million from $284 million. Provision for maintenance capital expenditure (depreciation) was set at about $34 million in 1995, and the carriers increased equipment leasing.

With a capital structure consisting of 51 per cent debt and 49 per cent equity in the early 1990s, the extent of debt financing was more pronounced for charter carriers than for scheduled bus companies. However, the differences in capital structures narrowed in recent years, as charter carriers increased their equity ratios.

In the absence of data on interest expenses, the corporate long-term bond rates were again applied to the industry debt capital to estimate its debt costs.

The estimated capital costs of the industry have declined continuously since 1990, because of declining interest rates and increases in debt financing. Recent data suggests that the industry needs to achieve an operating profit margin of eight per cent to meet long-term capital costs. As Figure 11-12 shows, the target was met in both 1994 and 1995.