Canadian National Railway (NYSE:CNI) reported its second quarter results on July 21; earnings per share declined 6% from last year to $0.94 [US] and net income was down 11%. Even so, CNI shares are up 4% since last week and up 12% since the beginning of the year, while the Dow is down about 12%. Why is CNI so steadfast in this recession; aren't railroads sensitive to the economy? One reason could be the just-announced buyback of 25 million shares. But I believe there are many other important factors that make this stock a compelling long-term value play.
First, while oil prices may be down from their record highs, I believe higher energy prices, in general, are here to stay. This may make rail a better shipping alternative than trucking - although it is slower, it is less costly. And, rightly or wrongly, many see it as "more green." Higher oil prices have also boosted interest in oil sands projects in the northern part of the Canada, which will require rail support from CNI. Today, the oil sands produce about a million barrels a day, but this number is expected to triple over the next 10 years. Besides the oil sands, Canada's potash mines, coal mines and corn distribution centers are located on CN lines.
Second, CNI is a leader in the North American rail industry, with 20,400 route miles spanning from Halifax in the east to Prince Rupert and Vancouver in the west and southward from Toronto to New Orleans. According to the company "CN is the only railroad which crosses the continent east-west and north-south, serving ports on the Atlantic, Pacific and Gulf coasts while linking customers to all three NAFTA nations."
Third, CNI has a history of aggressive growth through acquisitions. It bought Illinois Central in 1999, Wisconsin Central in 2001, Great Lakes Transportation in 2004, and entered a partnership agreement with BC Rail the same year. Currently, Canadian National has plans to acquire most of the railroad assets and equipment of Elgin, Joliet and Eastern Railway for $300 million, improving access around Chicago.
Now, let's look at the financials. CNI has a market cap of $25 billion and total assets of $23.9 billion. It went public in 1995 at $3.33 per share and is currently trading at $52.87, an increase of 1,487%. The company has increased its dividend at an annual compound rate of 14% since it was listed; the current yield is 1.8%. Dividends last year were about 40% of free cash flow and 19% of net income. CNI shares are currently 10% below their high and trade at a P/E of 12, while the industry average is closer to 18. As of the second quarter 2008, long-term debt was 26% of total assets, in line with the industry, and return on equity was 21%, far above that of its competitors Union Pacific (NYSE:UNP) and Canadian Pacific (NYSE:CP).
2007 was a more difficult year for the company than previous years; operating expenses were up 9% on increased fuel costs. Even so, net income was up 3.4% and the company generated $1.05 billion in free cash flow. Management expects mid single-digit net income growth for 2008.
I have estimated the value of CNI shares using a discounted cash flow, at a weighted average cost of capital (wacc) of both 9% and 10%, and the analyst consensus EPS for the next 12 months (July through June) of $3.68. Growth was estimated at 8% for the next 3 years, and 3% thereafter. At a 10% wacc, the value is $53.39 and at 9%, it is $61.17. At the current price of $52.47 the shares appear slightly undervalued, and these numbers do not include any income from the Elgin acquisition, which requires regulatory approval.
There is, however, one future unknown that will have a significant impact on CNI's bottom line: the US/Canadian dollar exchange rate. A lot of the recent decline in the company's net (about 5%) was caused by the weaker US dollar. About 20% of CNI revenue is from the States and with the US and Canadian dollars near parity, when these revenues is converted back to Canadian dollars, the company loses. For most of the last 20 years, the Canadian dollar has ranged from $0.65 to $0.90. Parity is something that was only seen before during the US recessions of the late 50's and the early 70's. If the exchange rates return to their historic norms, there is an upside for CNI shares that may not be fully reflected in the current price.
What about the risks? Yes, the rail industry is sensitive to economic downturns, and CNI's volume of forest products and automotive shipments has decreased with the US recession. And if fuel becomes significantly cheaper, trucking may reclaim some market share. But I think the long-term trends favor rail and CNI.
Disclosure: The author does not own shares of CNI. Investors should do their own research before buying any company.