Dividend Growth Investors Should Keep An Eye On Canadian National

| About: Canadian National (CNI)

Summary

CNI is one of the most efficient railroad operators in North America and has proven to be a very durable business since its formation in the early 1900s.

The company scores strongly for Dividend Safety and Dividend Growth, and I believe double-digit dividend growth could continue even despite the slump in commodity markets.

CNI's stock has significantly underperformed the market over the last three years. Is now the time to buy this high quality dividend grower?

Canadian National Railway (NYSE:CNI) has increased its dividend every year since its initial public offering in 1995, averaging 17% annual growth over that time period.

Since they were deregulated in the 1980s, railroad operators have enjoyed a boom in productivity and fortified their position as an essential piece of North America's supply chain.

The slump in commodity prices has caused a number of railroad stocks to go on sale, and CN looks particularly interesting since it has less exposure to the weakest commodity - coal.

Despite commodity price volatility, CN raised its dividend by 20% earlier this year and expects to continue increasing its dividend at a faster rate than overall earnings growth.

Let's take a closer look to see if this high quality railroad operator is worthy of inclusion in our Top 20 Dividend Stocks portfolio.

Business Overview

CN was formed in the early 1900s through the combination of several financially-challenged railways and was later privatized in 1995.

Today, CN owns and operates approximately 20,000 miles of railroads across Canada and mid-America, connecting the Atlantic, the Pacific, and the Gulf of Mexico.

The company handles more than $250 billion worth of goods each year and carries over 300 million tons of cargo for exporters, importers, retailers, farmers, and manufacturers.

CN's freight revenue is primarily composed of seven commodity groups: intermodal (24%), oil and chemicals (21%), grain and fertilizer (17%), forest products (15%), metals and minerals (12%), automotive (6%), and coal (5%).

By geography, 33% of the company's revenues relate to transborder traffic, 31% overseas traffic, 18% U.S. domestic traffic, and 18% Canadian domestic traffic.

Business Analysis

The Canadian railroad industry was deregulated in 1987 under the National Transportation Act, resulting in the cancellation of transportation subsidies and deregulation of freight rates for most commodities. It also resulted in the privatization of CN in 1995 (CN was previously government-owned).

The Canada Transportation Act went into effect in 1996 and further transformed the Canadian rail industry to make it more competitive.

Unlike the National Transportation Act, which provided little room for rail operators to restructure their operations and become more productive, the Canada Transportation Act allowed railways to speed up their restructuring via employment reductions, investments in more efficient equipment, and elimination of low-traffic lines.

Since the act was passed, CN has seen its operating ratio fall from about 80% to less than 60% today, representing a remarkable improvement in productivity.

Today, freight rail service in Canada is essentially a duopoly between CN and Canadian Pacific Railway.

Given the company's geographic diversity, it's worth quickly reviewing the U.S. railroad industry, which was deregulated by the Staggers Rail Act of 1980.

Similar to the situation in Canada, U.S. railways have enjoyed substantial improvements in productivity to become more profitable and competitive with alternative modes of transportation.

The industry also consolidated to further boost productivity, and the three largest U.S. railroad operators account for more than 60% of total rail miles in the country today.

Warren Buffett is a fan of railroad operators and acquired Burlington Northern Santa Fe (BNSF) in 2010 for $34 billion, adding the company to Berkshire Hathaway's portfolio of high quality dividend stocks.

Railroads possess many of the characteristics Warren Buffett admires in a business. They own hard-to-replicate assets, provide essential services, have strong pricing power, and enjoy higher demand as the world's population grows.

CN has invested billions of dollars to build a railway network that is capable of reaching about 75% of the population in North America. The company reinvests close to 20% of sales into capital equipment, which dwarfs most companies' capital spending of 2-4% of revenue.

Few companies have the capital needed to build and maintain competitive railroads.

There are also only so many routes available in the market, making it harder for potential new entrants to enter the industry.

Incumbent railroad operators already have access to largest markets in North America and maintain the economies of scale needed to price their services at rates that potential new entrants cannot match.

Take Canada's grain market, for instance. According to The Economist, "Of the 340 inland grain terminals on the Prairies, only six are served by both railways [CN and CP] and another 22 are within 30km of both."

As a result of the industry's concentration, railway operators also enjoy consistent pricing power. CN's pricing policy is inflation plus and has delivered 3-4% annual pricing gains over the last 10 years.

In addition to pricing power, CN's investments in track infrastructure, technology, and other equipment have helped it maintain industry-leading productivity measures in a number of categories.

As seen below, the company has the lowest terminal dwell time and the highest train velocity of any major operator. These factors help it maintain an operating ratio below the industry's average.

Click to enlarge

Source: Canadian National Railway 2015 Annual Report

As long as the company continues to invest in productivity, it should remain a critical part of North America's supply chain for many years to come.

The railroad industry is very durable, and freight volumes tend to track population growth over the long term.

For example, between 2010 and 2035, the Federal Railroad Administration expects that the U.S. freight system will see a 22% increase in the total amount of tonnage it moves driven by continued growth in the country's population.

CN will likely remain a critical component of North America's supply chain thanks to its cost-effective railroad network, productivity investments, and strategically located assets.

Key Risks

The fiscal year 2015 was filled with records for CN -- revenues, operating income, net income, and earnings per share all reached new all-time highs in Canadian dollars. The company also attained a record operating ratio of 58.2%.

However, not all is well in the railroad business today. The slump in commodity prices is weighing on shipping volumes.

CN is experiencing the greatest weakness in coal, crude oil, and sand for fracking. It's no secret that railroads have benefited from the boom in commodity prices and shipments over the last decade.

No one knows when commodities will find a bottom, but it's hard to imagine most prices remaining lower than where they are today in five years.

In other words, outside of coal, I don't see commodity weakness threatening CN's long-term earnings power.

It's also important to keep in mind that coal only accounted for 5% of the company's freight revenue last year. While new power plant emission regulations and low gas prices have accelerated the decline in coal, CN simply doesn't have that much exposure to the commodity.

Oil is probably the bigger risk since the Alberta oil sands have a higher cost of production than other regions. There is also some uncertainty over the impact, if any, new pipeline capacity could have on railroad demand since it represents an alternative transportation method.

No one knows what commodity prices and shipments will look like over the next year, but CN will likely be just fine over the long run given the cost-effectiveness of rail and its duopoly status in Canada.

Despite the weaker volume environment today, the company continues generating solid performance. CN recorded a record first quarter operating ratio of 58.9% and continued to realize core pricing gains.

Aside from commodity price volatility, another risk to be aware of is competition from alternative methods of transportation such as trucks, barges, and pipelines.

This was a big issue prior to the deregulation of railroads in the 1980s. Since then, however, railroads have maintained a steady market share of around 40% of U.S. freight as measured in ton-miles (the length freight travels).

Bulk commodities such as grain, metal, and energy products usually need to be shipped hundreds or even more than a thousand miles.

Railroads can transport these heavy materials more cost-effectively than trucks because they are more fuel efficient. They can also access more areas of the country compared to barges since they are not restricted to waterways.

Despite the unpredictable nature of commodities over short time periods, it's hard to identify any risks that could really threaten CN's long-term future.

Dividend Analysis: Canadian National Railway

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Dividend Safety Score

Our Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

CN's Dividend Safety Score of 93 indicates that the company's current dividend payment is extremely safe. CN's strong score is driven by its low payout ratio, excellent cash flow generation, solid balance sheet, and time-tested commitment to its dividend.

CN's dividend safety begins with its dividend payout ratio. As seen below, the company has maintained an earnings payout ratio below 30% for the last decade.

Even if earnings were unexpectedly cut in half, the company's payout ratio would only increase to 60%.

In other words, CN's payout ratios provide a solid margin of safety and allow the company to continue paying and growing the dividend throughout a wide range of economic conditions.

Canadian National CNI Dividend

Source: Simply Safe Dividends

Canadian National CNI Dividend

Source: Simply Safe Dividends

A company's performance during the last recession also impacts its dividend safety. As seen below, CN's sales fell by 19% during fiscal year 2009, highlighting its sensitivity to the broader economy.

Despite the slump in demand, CN remained in strong enough financial health to increase its dividend. The company's stock also returned -20% in 2008, good enough to beat the S&P 500's return by about 17%.

Canadian National CNI Dividend

Source: Simply Safe Dividends

Free cash flow is another critical factor to evaluate when it comes to dividend safety. Without generating free cash flow, a company cannot sustainably pay dividends.

CN has generated positive and growing free cash flow over the last decade. While railroads are extremely capital intensive businesses, they generate predictable cash flow and have relatively low incremental costs when new shipment volume is added to an existing line.

Canadian National CNI Dividend

Source: Simply Safe Dividends

Studying a company's return on invested capital can provide clues about its economic moat, making this one of the most important financial ratios to analyze. The strongest business models will earn high and stable returns.

CN has earned solid returns despite being a capital intensive business. Its pricing power and commitment to productivity have helped it maintain industry-leading efficiency metrics, and I believe the business has a solid moat. These types of companies are usually in better shape to continue making dividend payments.

Canadian National CNI Dividend

Source: Simply Safe Dividends

Turning to the balance sheet, CN once again appears to be in good shape. The company maintains investment grade credit ratings and appears to be carrying a reasonable debt load. CN could retire its total book debt using its cash on hand and just 1.5 years' worth of earnings before interest and taxes (EBIT).

Click to enlarge

Overall, CN's dividend payment looks very secure. The company's low payout ratios, consistent free cash flow generation, and reasonably healthy balance sheet position the company well to survive through practically any economic downturn.

Dividend Growth Score

Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

CN has a Dividend Growth Score of 73, which suggests that the company's dividend growth potential is strong.

CN is a blue-chip dividend stock that has raised its dividend every year since 1996, recording a compound annual growth rate of approximately 17% over that time period.

From 2005 through 2015, CN increased its annual dividend per share from 25 cents to $1.25, representing a five-fold increase.

Simply put, the company's historical dividend growth has been outstanding. Management most recently raised the dividend by 20% and increased the company's target payout ratio to 35%.

Over the next several years, CN will likely keep growing its dividend faster than underlying earnings to approach its new payout target.

Continued double-digit dividend growth is certainly a possibility.

Valuation

CN's shares trade at a forward-looking P/E ratio of 16.7 and have a dividend yield of 2%, which is higher than their five-year average dividend yield of 1.6%.

The company has increased its earnings and free cash flow per share by 9.1% and 7.7% per year, respectively, over its last five fiscal years.

The boom in oil certainly helped growth. Over the long run, I expect the company's earnings growth rate to be at more of a mid-single digit rate, reflecting moderating price increases and continued volume growth in line with broader population growth.

Using these assumptions, CN appears to offer annual total return potential of approximately 7%-9% per year.

The stock appears reasonably priced today, although a protracted downturn in commodity prices could continue to pressure near-term earnings.

Conclusion

CN is a high quality business with a strong economic moat. While it's nice knowing the company doesn't have much exposure to coal, oil volumes could prove to be a challenge throughout the rest of the year.

I don't believe the slump in commodities will impact CN's long-term earnings potential, but I would admittedly become more interested in the stock if it pulled back another 10%-15%.

Regardless of the stock price, CN's dividend should continue to exhibit strong growth over the coming years. Investors seeking a blend of income growth and capital appreciation should keep CN on their watch lists.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.