Canadian National Railway (CNR.TO) (NYSE:CNI) is the larger of the two Canadian railroad companies. The railroad company has a vast network and serves three coasts of North America with over 20,000 miles of tracks. The company is strategically well placed to move oil from Alberta, the Bakken fields and to/from the refineries in the Gulf coast. A holding of Bill Gates' Cascade Investments, this stock has made Mr. Gates and his investment firm very rich over the years.
Note: All numbers used below are in CAD$ unless otherwise specified.
Corporate Profile (from Yahoo Finance)
Canadian National Railway Company, together with its subsidiaries, engages in rail and related transportation business in North America. It transports various goods, including petroleum and chemicals, grain and fertilizers, coal, metals and minerals, forest products, intermodal, and automotive products. The company operates a network of approximately 20,100 route miles of track that spans Canada and mid-America, connecting three coasts: the Atlantic, the Pacific, and the Gulf of Mexico. It serves the ports of Vancouver, Prince Rupert (British Columbia), Montreal, Halifax, New Orleans, and Mobile (Alabama), as well as the metropolitan areas of Toronto, Buffalo, Chicago, Detroit, Duluth (Minnesota)/Superior (Wisconsin), Green Bay (Wisconsin), Minneapolis/St. Paul, Memphis and Jackson (Mississippi), with connections to all points in North America. The company was founded in 1922 and is headquartered in Montreal, Canada.
The Case for Railroads
Railroads are the pulse of the economy. Whether transporting crude, lumber, merchandise, agricultural or industrial products, railroads are what keeps the economy moving. While the transportation for entities such as coal (which used to be the largest users of railroad service a few years ago) have fallen due to the fall in crude prices and rise of green energy alternatives, the transportation need for crude has risen significantly. North America is going through an energy revolution with the rise of crude production in Alberta, the Bakken fields in North Dakota and the Eagle Shale. While pipelines are the largest competitors for crude transportation, the immediate lack of infrastructure spells good news for the railroads.
- Wide moat industry - Railroads are a wide moat industry. The players are well established, and it's very hard for an upstart to disrupt the incumbents.
- Infrastructure already exists - While industries such as pipelines have a large lead time to start operating, in addition to being investment heavy, railroads already exist with the track system in place. Moreover, building new terminals are relatively inexpensive (ranging from US$30M-$50M per terminal).
- Fast transport - cycle days range from 13.5-17 days from Alberta to the Gulf coast. A unit train travels at an average speed of 28 km/hr. In fact, similar cycle days are achieved from Alberta to any place in North America.
- Transportation by rail is one of the most energy-efficient ways of moving goods. A ton of freight can be moved 400-500 miles on a single gallon of diesel.
- Scalability and flexibility - Unit trains provide economies of scale but require larger volumes to be shipped. Unit trains of up to 120 rail cars are not uncommon.
- The majority of the oil refineries are concentrated in the Gulf coast, which means that the extracted oil has to be shipped to the Gulf coast first for refining and then shipped again to the rest of the country.
- Challenges from Pipelines: While the crude-by-rail has caught on due to immediate need, the pipeline industry's development provides a risk to the railroad industry's revenue.
- Expensive: Pipelines also provide a cheaper alternative to railroads to move crude. On an average, shipping crude from Alberta to the Gulf coast costs $10-$15 per barrel on railroads, while pipelines cost about $5-$8 per barrel.
- Potential for accidents: Moving crude by rail can result in potential accidents. While pipelines can leak, they are seldom fatal. The same cannot be said for railroad accidents, where deaths can result and bring negative publicity to the industry.
- Weather affected: Bad weather affects railroads unlike others. The trains may need to be shut down under severe conditions or need to be operated under reduced weight (due to regulations), which makes them even more expensive to operate.
- Regulatory issues - The Canadian government has mandated rail companies to meet a minimum weekly grain volumes. If unmet, rail companies face a fine of up to $100K per week. CN is calling for the government to lower the minimum requirements. Details here.
Dividend Stock Analysis
Expected: A growing revenue, earnings per share and free cash flow year-over-year looking at a 10-year trend.
Actual: Top-line growth has continued to increase year over year for the past 10 years, with the exception of the year 2009, where the company saw the effects of the recession. Earnings per share (NYSEARCA:EPS) and Free Cash Flow (NYSE:FCF) remain stable and have maintained the uptrend over the years.
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 EPS and FCF payout ratios to indicate that the dividends can be raised comfortably in the future.
Actual: CNR.TO/CNI pays $1.00 in dividends annually, and at the time of this writing, yields a modest 1.30%.
The Canadian National Railway is a Dividend Contender, having raised dividends for 17 years in a row. The 1/3/5/10-year dividend growth rates (DGR) are 10.7/16.6/13.9/17.4%.
The EPS payout ratio is currently at 27% and FCF payout ratio is 46%. There is still plenty of room for dividend increases over the coming years.
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.
Actual: The number of outstanding shares has steadily decreased over the past 10 years. The management has had a smaller pace of reduction in the past year after the company announced a share repurchase plan of 15M shares in Oct 2013 (ends Oct 23, 2014) -- representing a 4.1% of the common shares before last years split.
Book Value and Book Value Growth
Expected: Growing book value per share. Sometimes stock repurchases are authorized by the board to reward management at the expense of book value. Read more about it here.
Actual: For value and dividend growth investors, the book value trend looks good. The book value per share has continued to rise over the years at a healthy pace. While there was a hiccup in 2011, where the book value growth turned negative, the numbers have turned around since. The current trend is continuing to point downward from a high of 21% in 2013 to 4.4% in the last 12 months (NYSE:TTM).
Return on Equity
Expected: A good healthy return on equity of over 20%.
Actual: Return on Equity has been well over 20% over the past 3-4 years. The current ttm ROE is 22.73%.
To determine the valuation, I use the Graham Number, Price-to-Earnings, Yield, Price-to-Sales, Dividend Discount (Gordon Growth model) and Discounted Cash Flow. For details on the methodology, click here.
Benjamin Graham, popularly known as the father of value investing, conceived a simple way of calculating the maximum price one should pay for a company's share based on the earnings and book value. With a book value per share of 16.3 and ttm EPS of $3.37, we arrive at a Graham Number of $35.16. Based on current price levels, the stock is overvalued by 118%.
By comparing the P/E ratio over the past five years, we can see the progression of the stock and the demand in the market. The current P/E of CN is 22.83. While this may appear very high, it is closely following the trend set over the last few years, and is currently close to the mean P/E for CN. The P/E is still very high based on historical standards.
Comparing the current yield against the low, high and mean yield values of the past five years provides us with a perspective of how the stock is currently valued. With the lofty prices come low yields. The yield has continued to be driven down, thanks for the rise in stock price over the years. The current yield of 1.30% is close to the mean yield for the year. The yield is very low based on historical standards.
Sales are the lifeline of businesses. The Price-to-Sales ratio is an indicator of the value placed on each dollar of a company's sales or revenue. The Price-to-Sales ratio has continued to rise over the couple of years, and the current P/S is close to the highest ratio ever seen on the stock. The P/S is very high based on historical standards.
Dividend Discount (Gordon Growth Model)
The Gordon Growth Model is a quick way to calculate the fair value of a company using the current dividend, the expected dividend growth rate, and our required rate of return or discount rate. There are couple of different ways of calculating this number.
Model-1: Stock Value (NYSE:P) = D / (r-G)
Model-2: Stock Value = (D*(1+G))/ (r-G)
D = Expected dividend per share one year from now
r = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)
Using a very modest expected rate of return (NYSE:R) of 8%, and a dividend growth rate of 5.88% (lowest dividend raise in the past 10 years), we get stock value of $47.22 for Model-1 and $50.00 for Model-2. The current stock price is overvalued by 62% and 53%, respectively.
Discounted Cash Flow
The consensus from analysts is that earnings will continue to grow at 13.07% per year over the next five years. We can go with a more modest assumption that the company can grow at two-thirds of that, or 8.63%, for the next 5 years and continue to grow at 5.00% per year thereafter. Running the three-stage DCF analysis with a 10% discount rate (expected rate of return), we get a fair price of $82.69.
The case for railroads is a strong one. The rise in crude production in North America has been great news not only for the energy sector, but also for the service and industrial sectors and railroads are at the forefront. This wide-moat industry is resilient and has been called a harbinger of the economic cycle. While the pipelines face environmental backlash and regulatory roadblocks, railroads have been benefiting well from the churning energy sector. Canadian National Railway is well-positioned to take advantage of a lot of the development fields considering they serve three coasts -- Pacific, Atlantic and Gulf, running over 20,000 miles of tracks. The company has been a dividend contender, raising dividends for 17 consecutive years, but the high valuation has lifted the stock price to stratospheric levels. The stock is overvalued by most metrics and a lower entry point is recommended.
Full Disclosure: None. My full list of holdings is available here.
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.