2 Railways On Diverging Tracks

May. 7.12 | About: Canadian National (CNI)

In evaluating potential investments, I often give consideration to how the company will perform during a recession. As economic output falls, consumers grow skeptical about future prospects and limit their spending. This can be harmful in industries that rely on discretionary spending, sectors such as technology and entertainment. This has less of an effect on consumer staples, and in particular the companies that bring those products to market.

For instance-- food is a consumer staple, a consumer may choose to restrict the amount of times they eat out in a month, however the amount of food consumed remains static and still needs to be brought to the consumers. Consumers have little power in reducing their electricity consumption; coal still needs to be provided to power plants. A consumer may be less likely to upgrade their vehicle in recessionary times. Regardless, their gasoline consumption remains little changed, and the oil that is refined to gasoline still needs to be brought to market.

It is this line of considerations that lead me to invest in Canadian railways. Canadian railways are largely immune from recessions, as the demand for their services comes primarily from providers of consumer staples. Canadian railways earn revenue from transporting prairie crops and fertilizers to export terminals, oil to refineries, metals and minerals to smelters, forest products to paper producers, and coal to power plants. These sectors remain largely unaffected by changes in the business cycle.

Rails are the most efficient means to transport goods to market. In 2010, it was estimated that one gallon of fuel could move 1 ton of freight 484 miles. That is approximately 4 times more efficient than trucking. This has obvious benefits not only for rail companies, but the companies that require their freight to be moved.

Canadian Railways

For investors in the Canadian marketplace, we are lucky in that the railroad network is a duopoly. Canadian rail service is provided by the Canadian National Railway Company (NYSE:CNI) and the smaller Canadian Pacific Railway Ltd. (NYSE:CP). While duopolies are often not challenged enough to provide a competitive service to purchasers of their services, for investors this means guaranteed business. Many elevators in the prairie provinces are serviced by only one rail line, therefore in order to get their grains to market, they have to purchase services from the railway. Future competition is not likely given the barriers to entry, railway construction requires enormous capital costs.

CP and CNI come from very different backgrounds. CP was built under the vision of Canada's first prime minister, Sir John A. McDonald, who wanted to connect the two coasts of the country. CP's construction between 1881 and 1885 achieved this feat. CP was largely responsible for populating the West of the country, as well as bringing Western resources back to Eastern Canada to be used in the manufacturing industry. Although very closely connected to government in its early days, CP has always been owned by non-governmental interests.

CNI was created 40 years later in 1919. The company was initially structured as a crown corporation, owned 100% by the federal government of Canada. During this time the Canadian government purchased several bankrupt railroads, under fears that key transportation links would be lost if these railways were to go under. CNI operated as a crown corporation until 1995, at which point it was privatized through an initial public offering on the Toronto Stock Exchange.

The different corporate structures greatly influenced how these companies were run. CP was geared towards providing returns to its shareholders, therefore it would not build or run unprofitable routes, likewise its spending patterns were greatly influenced by the business cycle. CNI was geared towards whatever mandate best suited the citizens of Canada, for instance if a non-profitable route was deemed essential to the country, it would be operated at a loss. Crown corporations often have mandates geared around employment, safety and other measures that are not primary concerns to for-profit entities. This is not to say that CP did not employ thousands of men or maintain its tracks adequately, this is to say that CP was not able to maintain its tracks to the same standards held by CNI.

The differing mandates of the two companies played to the advantage of CNI. CNI built tracks to previously unprofitable areas; however if these tracks were to become profitable in the future, CNI would have the tracks in place, whereas CP would not. Partly due to this, CNI has significantly more track at 32,831 km vs. 22,500 km for CP. Both tracks stretch as far West as the Pacific Ocean, however CNI goes further North to the NorthWest Territories vs. Edmonton for CP, further east to Halifax on the Atlantic Ocean vs. Montreal, and further south to the Gulf coast vs. Kansas city. Furthermore, it is a widely held belief that CNI's tracks are in better condition because in its years as a crown corporation the lines were maintained to a level that was not justifiable to a for-profit corporation.

Financial Comparison

The 2011 annual reports for CNI and CP would indicate that CNI is a much better run railway. Efficiency in rail is most often measured by the operating ratio; operating expenses/revenues. The lower the ratio, the better. For CNI, this ratio is 63.5%, improved from 63.6% in 2010 and 67.3% in 2009. For CP, this ratio is 81.3%, declined from 77.6% in 2010 and 81.1% in 2009. For every dollar of revenue earned, CNI is spending $0.635 in operating expenses vs. $0.813 for CP, as well CNI is improving its operating efficiency whereas CP's operating efficiency is declining.

Both companies have benefited greatly from the commodities boom that is propelling Western Canada. Western grains are brought to market almost exclusively from CP and CNI. Greatly increased potash production needs to be railed to the West Coast in order to be brought to markets in Asia. Increased oil production, especially from new unconventional fields such as the Bakken, are being increasingly transported by rail, as pipelines not only take years to construct but are also facing environmental hurdles prior to construction. Revenues over the past three years are indicative of this growth, as displayed below in millions of dollars.

CNI

CP

2011

9,028

5,177

2010

8,297

4,981

2009

7,367

4,402

Average growth

10.70%

8.45%

Click to enlarge

CP has greater leverage than CNI. CNI has a debt/equity ratio of 0.62 vs. 1.03 for CP (debt includes only interest bearing liabilities). This is also evident in the interest coverage ratio, which his 9.22% for CNI vs. 26.55% for CP. Although CP's level of debt is hardly a cause for concern, this information is indicative that CNI has greater flexibility in funding future operations / projects.

CNI was able to generate $2.976 billion in operating cash flows during 2011, which easily covered capital expenditures of $1.625 billion. Excess cash flow was used to pay dividends and buy back shares (which generally leads to an increased share price). CP was able to generate $0.512 billion in operating cash flows which did not cover capital expenditures of $1.104 billion.

The amount of capital expenditures is comparable on a per kilometer basis. CNI has 32,831 kilometers of track, whereas CP has 22,500 kilometers of track. Therefore, CNI is actually spending more on capex/km at $49,495 than CP at $49,066. CNI is putting more money into its tracks per kilometer, fully funding these expenditures from operations while having enough excess cash flow to buy back shares and pay a dividend. CP is putting in less money per kilometer of tracks, requiring debt to fund this before paying dividends, and buying back no shares.

The net results of my financial analysis is well in favour of CNI. CNI has greater revenue growth, less leverage, a lower operating ratio and a larger capital program that is fully funded from operations.

Valuation

CP has experienced a significant increase in its share price not due to market factors, but rather due to activist intervention. Bill Ackman runs a hedge fund named Pershing Square, who believes that CP has been underperforming rival CNI due to board of director and management shortcomings. Pershing Square has built up a 14.2% stake in the railroad over the past two years, bringing up the share price with its purchases.

Regardless of whether Pershing Square is correct in its assessment, its activity has pushed the PE ratio of CP up to 19.17. Compare this to CNI's PE ratio of 14.61, and CP would have to increase earnings by 31% in order to be valued comparably to CNI. Although CP has more room to improve its operating ratio, I feel the valuation differential is greater than is justified by the share price difference. A 31% increase could only be realized under very optimistic scenarios.

Recommendation

I am bullish on the railway sector. Railways are an efficient form of bulk good transportation, and this is sporting 10% annual growth in revenues. While I don't think an investor can go wrong by investing in CP, I feel that CNI is the safer play with a better network and a more reasonable valuation. CNI is a fairly valued company, with significant ability to grow its earnings and dividends over time, which can only result in an increased share price.

Disclosure: I am long CNI.