Canadian National Dividend Stock Analysis 2016

| About: Canadian National (CNI)

Summary

Canadian National is the second largest railroad operator in North America commanding an impressive 20,000 miles of rail network.

CN is the only railroad that serves the three coasts - Pacific, Atlantic and Gulf coasts.

The company has the best operating margins in the industry with a ratio of 43.4%.

A Dividend Contender after raising dividends for 19 consecutive years, the company is a Bill Gates' Cascade Investments favorite holding.

Canadian National Railway Co (NYSE:CNI) is the second largest publicly traded railroad company in North America. The company commands an impressive 20,000 miles of rail network and the only railroad serving three coasts. The following system map image demonstrates the scale and reach of Canadian National.

Click to enlarge

(Image Source: Canadian National IR)

Canadian National is one of the best run companies in the industry. The company continues to churn out impressive numbers year after year. Qualitatively, CN also maintains an impressive strategic advantages such as the Chicago bypass, while other railroads have to face and deal with the delays. In addition, it is the only company that has the competitive advantage of serving three coasts of North America -- Pacific, Atlantic, and Gulf coasts.

The company recently underwent a change at the top. Long time leader Claude Mongeau had to relinquish the CEO position after a health battle and earlier this month Luc Jobin officially became the CEO after being an interim-CEO for a few months.

The Railroad Industry

Railroads are considered a wide moat industry, as it entails immense capital requirements and new entrants in the industry are almost unheard of. Railroads are the pulse of the economy. Whether transporting crude, lumber, merchandise, agricultural or industrial products, railroads are what keeps the economy moving. Railroads are often closely observed by economists and analysts to get a sense of how the overall economy is doing. It is also considered a leading indicator for any recessions or slowdowns.

Since the railroads play such a crucial part of the economy and provide excellent long term capital appreciation, while providing investors with increased dividends year after year, the industry has attracted some of the biggest high-profile billionaire investors in the US. Warren Buffett's Berkshire Hathaway ( BRK.A)( BRK.B) tookover Burlington Northern Santa Fe (BNSF) in 2009; Bill Gates' Cascade Investments LLC own a 11.8% stake in Canadian National Railway (CNI); and Bill Ackman's Pershing Square owns a 6.4% stake in Canadian Pacific ( CP).

The following table provides an overview of the railroad industry comparing Canadian National with its competitors Union Pacific Corp (NYSE:UNP), CSX Corp ( CSX), Norfolk Southern Corp ( NSC), Canadian Pacific Railway , and Kansas City Southern ( KSU).

Click to enlarge

(Image Source: Created by author. Data from Google Finance & FinViz)

Current Trends

Railways have played a crucial part in transporting everyday goods such as crude, lumber, merchandise, agricultural or industrial products. Over the past decade, the highest growth has come from crude oil transportation. The rapid expansion of oil drills across the continent meant that fast and easy transportation of crude oil, whether from Canadian oil sands, or shale regions was necessary and railroads filled this need in the market quickly. However, with the current downturn in oil prices over the past two years, shipment volumes fell as the drill count reduced across the continent. More recently, with the uptick in the oil prices, shipments have increased steadily bringing some respite to the railroads.

Coal shipments, on the other hand, are seeing secular declines. As the world moves towards cleaner fuels and green alternatives, coal is being shunned by the market. Traditionally, coal has been the largest user of railroad service and this reduction in shipment volume has hurt most railroad operators. Canadian National has been the lightest transporter of coal in the industry and as such, the company has avoided the fall in revenue faced by other competitors. In 2014, coal made only 6% of CN's total revenues. In 2015, that number declined to 5.1% of total revenue.

The chart below shows the overall rail traffic in the US - and as can be seen, its been dismal so far in 2016. The shipments are finally picking up again for petroleum products, and there has been indication that grain shipments could also increase. How the rest of the season progresses remains to be seen.

Click to enlarge

(Image Source: Association of American Railroads)

Dividend Stock Analysis

Note: All numbers below are in Canadian dollars (CAD$) unless otherwise noted.

Financials

Expected: A growing revenue, earnings per share and free cash flow year over year looking at a 10-year trend. A manageable amount of debt that can be serviced without affecting future operations.

Click to enlarge

(Source: Created by author. Data from Morningstar)

Actual: Canadian National remains one of the most well run companies in the industry. The company has continued to increase the revenue year after year except in 2009 (due to the recession). The earnings have followed the revenue. Currently, while the other competitors have to deal with the gap in coal shipments falling off a cliff, CN continues to avoid such a problem and analysts maintain a positive outlook on the company.

CN's debt/equity is 0.69 and the company's balance sheet shows a current ratio of 0.90. S&P gives the company a 'A' credit rating.

CN's yield of maturity is as shown below. A few debt repayments are upcoming starting later this year.

Click to enlarge

(Image Source: Morningstar)

Dividends and Payout Ratios

Expected: A growing dividend outpacing inflation rates, with a dividend rate not too high (which might signal an upcoming cut). Low/Manageable payout ratio to indicate that the dividends can be raised comfortably in the future.

Click to enlarge

(Source: Created by author. Data from Morningstar)

Actual: Canadian National is a Dividend Contender having raised its dividend for 19 consecutive years. The current dividend stands at 1.9%. The 1-, 3-, 5-, and 10-yr dividend CAGR (Compound Annual Growth Rates) are 8.9%, 9.5%, 13.5%, and 15.1% respectively.

Outstanding Shares

Expected: Either constant or decreasing number of outstanding shares. An increase in share count might signal that the company is diluting its ownership and running into financial trouble.

(click to enlarge)

Click to enlarge

(Source: Created by author. Data from Morningstar)

Actual: The number of shares have declined steadily over the years.

Book Value and Book Value Growth

Expected: Growing book value per share.

(click to enlarge)

Click to enlarge

(Source: Created by author. Data from Morningstar)

Actual: The book value has increased steadily over the years although a dip was noted in 2015. At the time of this writing in mid-2016, the book value seems to have stabilized and seems to have turned positive for the trailing twelve months.

Operating Margins

Expected: A healthy operating margin of over 30%.

Actual: The company has an operating margin of 43.4% -- the best in industry.

Valuation

To determine the valuation, I use the Graham Number, average yield, average price-to-earnings, average price-to-sales, and discounted cash flow. For details on the methodology, click here.

The Graham Number for CN with a book value per share of $18.93 and TTM EPS of $4.53 is $43.93.

CN's average yield over the past five years was 1.5% and past ten years was 1.54%. Based on the current annual payout of $1.50, that gives us a fair value of $100.00 and $97.40 over the 5- and 10-year period, respectively.

CN's 5-year average P/E is 18.18, and the 10-year average P/E is 15.59. Based on the analyst earnings estimate of $4.85, we get a fair value of $88.17 (based on 5-year average) and $75.61 (based on 10-year average).

The average 5-year P/S is 4.78 and average 10-year P/S is 4.04. Revenue estimates for next year stand at $15.98 per share, giving a fair value of $76.40 and $64.57 based on 5- and 10-year averages, respectively.

The consensus from analysts is that earnings will rise at 6% per year over the next five years. If we take a more conservative number at 5% running the three-stage DCF analysis with a 10% discount rate (expected rate of return), we get a fair price of $71.57.

The following charts from F.A.S.T. Graphs provide a perspective on the valuation of CN.

Click to enlarge

(Source: F.A.S.T. Graphs)

The chart above shows that CN is fairly to slightly overvalued. The Estimates section of F.A.S.T. Graphs predicts that at a P/E valuation of 15, the 1-year return would be 0.8%.

Click to enlarge

(Source: F.A.S.T. Graphs)

Conclusion

Railroads are the pulse of the economy, and CN operates an impressive 20,000 miles of rail network serving three coasts of North America. While crude shipments are on their way to a recovery thanks to the rise in oil prices, coal remains in a secular downtrend, although coal plays a very small role and CN escapes the issues faced by other competitors in the industry. CN operates at a great margin and has demonstrated to be the best in class. The stock appears fairly-to-slightly overvalued currently. If we give equal weight to all valuation metrics used above, we get a fair value of CAD$76.41 (for the Canadian TSX-listed shares).

Full Disclosure: Long CNI. My full list of holdings is available here.

Disclosure: I am/we are long CNI.

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