Canadian National Railway Dividend Stock Analysis 2015

| About: Canadian National (CNI)
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Summary

Canadian National Railway -- the second-largest railroad network; serves three coasts of N. America.

A favorite of Bill Gates' Cascade Investments -- it is one of the best-run companies and boasts best-in-class operating margins.

CN has raised dividends for 18 years since its IPO in 1995; 5-year CAGR of 15.2%.

Canadian National Railway Company (NYSE:CNI) is the second-largest railroad company in North America. The company operates 20,000 miles of network serving three coasts -- Atlantic, Pacific, and Gulf coast. CN's peers include Union Pacific Corp. (NYSE:UNP), CSX Corp (NYSE:CSX), Norfolk Southern (NYSE:NSC), Canadian Pacific (NYSE:CP), and Kansas City Southern (NYSE:KSU).

CN operates in one of the widest moat industries -- railroads. The company has a diversified traffic volume including intermodal, petroleum & chemicals, grain & fertilizers, forest products, metals & minerals, automotive, and coal.

(Source: CN Investor Presentation Sep 2015)

Corporate Profile (from Yahoo Finance)

Canadian National Railway Company, together with its subsidiaries, engages in rail and related transportation business in North America. It offers transportation services that include rail, intermodal container, and trucking services; and supply chain solutions, including warehousing and distribution, cargoflo, logistics parks, freight forwarding, customs brokerage service, industrial development, and marine services. The company transports various goods, such as automotive, coal, fertilizers, food and beverages, forest products, dimensional and heavy loads, shipping grains, metal and minerals, petroleum and chemicals, specialty crops, and intermodal products. It operates a network of approximately 20,000 route miles of track spans Canada and mid-America, from the Atlantic and Pacific oceans to the Gulf of Mexico. It serves the ports of Vancouver, Prince Rupert (British Columbia), Montreal, Halifax, New Orleans, and Mobile (Alabama); and 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. Canadian National Railway Company was founded in 1922 and is headquartered in Montreal, Canada.

The Railroad Industry

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 services a few years ago) has fallen due to the fall in crude prices and rise of green energy alternatives, the transportation need for crude saw significant rise in the recent past. However, the recent turn of events with falling energy prices has put a damper on crude transportation via railroads. The following charts from Association of American Railroads shows the drop in traffic from the peak in Sep/Oct 2014 for petroleum products coupled with the steady decline in coal transportation. It is interesting to note, coal traffic picked up quite a bit in August.

(Source: AAR - Monthly Rail Traffic Data)

The following table compares the railroad industry to show where CN fits in, compared to Union Pacific Corp., CSX Corp, Norfolk Southern, Canadian Pacific, and Kansas City Southern.

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

I present a more detailed railroad sector overview in this post.

Dividend Stock Analysis

Note: The numbers provided below are for the TSX-listed stock and are in Canadian Dollars CAD$.

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.

(Source: Created by author. Data from Morningstar)

(Source: Created by author. Data from Morningstar)

Actual: The railroad business has been profitable over the past decade and the financials show a nice steady rise year over year. CN has a debt/equity of 0.67 and a current ratio of 0.70.

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.

(Source: Created by author. Data from Morningstar)

Actual: CN currently yields 1.71% and is a Dividend Challenger having raised dividends for 18 consecutive years -- every year since its IPO in 1995. The 1-, 3-, 5-, and 10-yr dividend growth rates (DGR) are 9%, 11.3%, 15.2%, and 17.4%; and a Chowder number of 16.91. The company has a very manageable payout ratio of 27.60%.

The last dividend raise came in January 2015, when it raised its dividend by 25%! The company has indicated that it is moving towards a goal of 35% payout ratio.

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.

(Source: Created by author. Data from Morningstar)

Actual: The number of shares have steadily declined over the years. CN announced a $1.7B buyback program in Oct 2014 to be completed over 12 months. The buyback program will cancel 3.9% (up to 28M) of outstanding shares.

Book Value and Book Value Growth

Expected: Growing book value per share.

(Source: Created by author. Data from Morningstar)

Actual: The book value has steadily increased after a drop in 2012, but maintains a nice upward trajectory.

Operating Margins

Expected: A healthy operating margin of over 30%.

Actual: Operating margin for CN is the best in class in the railroad industry. The company beats out companies such as UNP with an operating margin of 39.60%.

Valuation

To determine the valuation, I use the Graham Number, Average Price-to-Earnings, Average Yield, Average Price-to-Sales, Dividend Discount (Gordon Growth Model) and Discounted Cash Flow. For details on the methodology, click here.

The Graham Number for CN with a book value per share of $17.48 and ttm EPS of $4.03 is $39.81. Based on the last closing price, the stock is currently 83.94% overvalued.

CN's 5-year average P/E is 13.04 and the 10-year average P/E is 14.28. Based on the analyst earnings estimate of $4.69, we get a fair value of $61.16 (based on 5-year average) and $66.97 (based on 10-year average).

CN's average yield over the past five years was 1.56% and past 10 years was 1.51%. Based on the current annual payout of $1.25, that gives us a fair value of $80.13 and $82.78 over the 5- and 10-year periods, respectively.

The average 5-year P/S is 3.06 and average 10-year P/S is 2.97. Revenue estimates for next year stand at $16.54 per share, giving a fair value of $50.61 and $49.12 based on 5- and 10-year averages, respectively.

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. Using an expected rate of return of 10% and a dividend growth rate of 8%, we get a fair value of $66.

The consensus from analysts is that earnings will rise at 11.8% per year over the next five years. If we take a more conservative number at 8% (considering all the headwinds facing the Canadian economy currently) and assume that CN is growing its earnings by 6% thereafter, running the three-stage DCF analysis with a 10% discount rate (expected rate of return), we get a fair price of $77.91.

The following charts from F.A.S.T. Graphs provides a perspective on the valuation of CN. For details of how to read the graph, click here.

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

The chart above shows that CN is slightly undervalued. The Estimates section of F.A.S.T. Graphs predicts that at a P/E valuation of 15, the 1-yr return would be -4.43%.

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

Conclusion

Railroads are the pulse of the economy, and CN commands an impressive 20K miles of rail network serving three coasts. The company is a dividend challenger having raised dividends for 18 consecutive years and has a 5-yr DGR of 15.2%. The company has the best in class operating margins beating out giants such as UNP, NSC and CSX. CN appears to be slightly overvalued at the current moment even though the stock is down 8.5% YTD; a better entry price is recommended for investors looking to initiate a position. If we give equal weight to all valuation metrics used above, we get a fair value of C$65.25.

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.