Canadian National Is The Most Efficient Railroad

Jun.22.14 | About: Canadian National (CNI)

Summary

Canadian National's operating ratio is the lowest among railroad peers.

The company has a good combination of strong free cash flow generation and manageable financial leverage.

Though Canadian National's dividend yield isn't that high, we think it boasts one of the stronger dividends in the railroad space.

As part of the Valuentum process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Canadian National's (NYSE:CNI) case, we think the firm is fairly valued at $53, a level below where the company is currently trading. Investors should know that price is always different than value. Price is what you pay, while value is what you get.

For some background to help with the terminology in this article, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below). Highly-rated firms have strong valuation support and solid pricing support, making for interesting new ideas for consideration.

If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Canadian National posts a Valuentum Buying Index score of 7, reflecting our 'fairly valued' discounted cash-flow assessment of the firm, its attractive relative valuation versus peers, and bullish technicals. For relative valuation purposes, we compare Canadian National to peers CSX Corp (NASDAQ:CSX), Norfolk Southern (NYSE:NSC), and Union Pacific (NYSE:UNP). In the spirit of transparency, we show how the performance of our Valuentum Buying Index has stacked up per underlying score as it relates to companies in the Best Ideas portfolio:

Image Source: Valuentum

Canadian National's Investment Considerations

Investment Highlights

• Canadian National is engaged in the rail and related transportation business. The firm's network of about 20,000 route miles of track spans Canada and mid-America, connecting three coasts: the Atlantic, the Pacific and the Gulf of Mexico. Its freight revenues are derived from seven commodity groups representing a diversified portfolio of goods.

• Canadian National's operating ratio--operating expenses divided by revenue--is the lowest among railroad peers. We think the firm boasts highly efficient operations.

• Canadian National has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 25.1% in coming years. Total debt-to-EBITDA was 1.6 last year, while debt-to-book capitalization stood at 37.7%.

• The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.

• Though Canadian National's dividend yield isn't that high, we think it boasts one of the stronger dividends in the railroad space.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Canadian National's 3-year historical return on invested capital (without goodwill) is 7.7%, which is below the estimate of its cost of capital of 10%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Canadian National's free cash flow margin has averaged about 14.4% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Canadian National, cash flow from operations increased about 14% from levels registered two years ago, while capital expenditures expanded about 16% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Canadian National's shares are worth between $42-$64 each. Shares are trading at the high end of this fair value range at ~$63 per share. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $53 per share represents a price-to-earnings (P/E) ratio of about 18.3 times last year's earnings and an implied EV/EBITDA multiple of about 11.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 6.4% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 6%. Our model reflects a 5-year projected average operating margin of 42.1%, which is above Canadian National's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 3.1% for the next 15 years and 3% in perpetuity. For Canadian National, we use a 10% weighted average cost of capital to discount future free cash flows.

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Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $53 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Canadian National. We think the firm is attractive below $42 per share (the green line), but quite expensive above $64 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Canadian National's fair value at this point in time to be about $53 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Canadian National's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $69 per share in Year 3 represents our existing fair value per share of $53 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: UNP is included in the Best Ideas portfolio.