Published October 3rd, 2016
This is a guest contribution from The Financial Canadian.
“These companies will never go away,”
– T. Rowe Price equity analyst Andrew Davis on the railway sector
Railways are great companies to own.
They have one of the widest economic moats due to the high barriers to entry that exist in this industry. The tracks for Canada’s great railways were laid centuries ago, when land could be bought for pennies per acre and regulation was nonexistent. Just thinking about all the work that would be required to start a new railway company today gives me a headache.
Railroads are also a good investment because they are considered a proxy for the overall economy, and historically, the economy has gone nowhere but up. Some investors may counter this argument by saying that railroads are an outdated industry. While the railroad sector has existed for centuries, current railroads are optimized for maximum production – and regardless of future innovations, there will always be a need for the movements of good from one place to another.
So railways possess the economic moat that investors like Warren Buffett have come to recommend, and they have good future prospects based on the assumption of future economic growth. You can see Buffett’ top 20 stocks here.
That begs the question – which railway is the most attractive investment currently?
In Canada, there are two main players. These are Canadian National Railway (CN) and Canadian Pacific Railway (CP). Both are Class I railroads, of which only 7 exist in North America. Their size and operational scope serve to increase their already massive economic moat.
Looking into the fundamentals of these companies shows us that there is a clear choice for an investment right now. Let’s find out which one it is.
Company Overview – Canadian National Railway
Source: CN 2015 Annual Report
- Stock Price: $85.76
- Market Cap: $66.47B
- P/E Ratio: 18.90
- P/B Ratio: 4.42
- Dividend Yield: 1.75%
- Payout Ratio: 30.35%
From their website:
“A rich history and a bright future. We are more than just a railroad. We are a transportation company that offers integrated transportation services: rail, intermodal, trucking, freight forwarding, warehousing and distribution. We continue to deliver the goods year in and year out. We are an engaged corporate citizen, committed to the safety of our employees, customers and the public.
CN is invested in building shareholder value and stronger communities, focused on environmental stewardship and developing an exceptional environment in the workplace.”
With the slogan “North America’s Railroad”, CN Rail is Canada’s largest railroad. They are headquarted in Montreal, Quebec, were incorporated in 1919 and have been transporting goods across Canada ever since.
This company is led by CEO Luc Jobin, who assumed the role in July 2016. While new to the CEO role, he was the company’s Executive Vice-President and Chief Financial Officer since 2009. This is a positive for me as I am personally biased towards CEOs who were previously CFOs or COOs of the same company – I feel as though they have a greater sense of the company’s finances and operations.
Jobin is surrounded by a talented management team with a healthy mix of new talent and old heads. With Jobin, Mike Cory (Executive Vice-President and Chief Operating Officer), and Ghislain Houle (Executive Vice-President and Chief Financial Officer) assuming their roles in July 2016, the company seems to have a solid management team in place for the foreseeable future. Both the COO and CFO are new to their roles but veterans to the company, joining in 1981 and 1997, respectively.
Company Overview – Canadian Pacific Railway
Source: CP 2015 Annual Report
- Stock Price: $200.19
- Market Cap: $29.61B
- P/E Ratio: 20.49
- P/B Ratio: 6.22
- Dividend Yield: 1.00%
- Payout Ratio: 15.83%
Although CP’s website doesn’t seem to offer a succinct company overview like CN’s does, I’m sure you get the idea- – CP is a large Canadian railway company with operations that run nearly coast-to-coast. They are also much older than their rival. CP Rail was incorporated in 1881.
CP is led by CEO E. Hunter Harrison, who has been in the position since 2012. Previously he was the President and CEO of CN, where he also served as Executive Vice-President and Chief Operating Officer. CP’s management team (including Harrison) is set to undergo some serious changes in the near future (more on that later).
CP is a much smaller company than CN, although they have existed for longer. CP’s market cap of $29.61B is more than doubled by CN’s $66.47B. As you can see, CN Rail’s track system is also much larger than rival CP’s (again in line with their differences in market capitalization):
How to Analyze Railway Stocks
Before I dive into the fundamentals of each of these companies, I’m going to write a word on analyzing railroad stocks.
In a sense, railways operate in a very straightforward line of business. They get paid to move cargo from Point A to Point B along railway tracks. In some ways analyzing railway stocks is no different than any other companies – look for earnings growth, revenue growth, strong return on equity (ROE), and dividend growth.
There are also some particular metrics that are unique to the railway industry. The most important is Operating Ratio, calculated as operating expenses divided by revenue. Operating expenses are those required to do business, but not directly involved in the production of goods. Savvy investors will recognize that operating expenses are the opposite of operating margin (which is operating income divided by revenues).
Capital expenditures (or CAPEX – them money required to maintain fixed assets) are also a major concern for railways (though I won’t discuss it in my analysis). It requires massive amounts of capital to maintain the tracks that these companies use to do business. Given that CN had 108,411 carloads and CP had 52,246 carloads in the last reported week alone, these maintenance costs definitely add up.
Source: CN Website
Source: CP Website
This section was included because I’m going to be using the Operating Ratio to compare these two companies. Now, let’s begin to look at the investment theses of CN and CP.
Investment Thesis – Canadian National Railway
In 2015, Canadian National Railway had a fantastic year. Their operating ratio of 58.2% was lower than in 2014 (61.9%) or 2013 (63.4%). The company’s adjusted diluted earnings per share were up 18% year-over-year to $4.44. This was translated to a dividend increase of 25%, from $1.00 in 2014 to $1.25 in 2015. CN has also been generous with share repurchases, committing $1.75B in 2015, $1.505B in 2014, and $1.4B in 2013.
Year-to-date, CN’s impressive results continue. Let’s take a look at their second quarter. Adjusted diluted earnings per share of $1.11 were actually down from last year, but this was due to a challenging operating environment and not excessive expenses – their operating ratio was a record low of 54.5%.
Investment Thesis – Canadian Pacific Railway
For various reasons, I am not as optimistic about CP as I am about CN.
First of all, there has been a lot of management changes among the senior executives of CP. Earlier this summer CP announced that Keith Creel (currently President and Chief Operating Officer) will succeed Hunter Harrison as CEO effective July 1, 2017. Harrison, who is currently 71 years old, has agreed to stay with CP for three years on a consulting basis. Both men were previously executives at CN. While there has also been management changes recently at CN, the executives placed into new roles have longer track records with the company – Creel has only been with CP since 2013.
Secondly, CP’s financial results:
As you can see, CP has a higher operating ratio than CN. More concerning, though, is the refusal to raise dividends in the presence of encouraging EPS growth. Assuming that the stock price increases in line with earnings (meaning a constant P/E ratio), then this would have reduced the company’s dividend yield over time.
The Bottom Line
I’m going to compare these companies in three ways – valuation, dividend metrics, and intangibles. Long-time readers will know that this aligns with my investment philosophy, as I am part value investor, part dividend growth investor.
In terms of valuation, CN is the obvious winner here. They have a lower Price-to-Earnings Ratio (18.90 compared to 20.49) and a lower Price-to-Book Ratio (4.42 compared to 6.22). Since CP is a smaller company by a fair margin, it is possible that the market is pricing in a growth premium. I believe this is incorrect, and I do not view CP as a high-growth railroad.
I thought that dividend metrics is pretty much a toss-up, depending on whether you are seeking dividend income now or dividend growth in the future. For investors seeking income now, CN is the obvious choice due to their higher dividend yield. I thought CP would be a better alternative if you’re seeking dividend growth – they have a lower yield now, but also a much lower payout ratio meaning they can raise the dividend in the future without undue risk.
Both companies have a history of satisfying dividend growth over time. Take a look at this dividend chart for CN Rail:
Source: CN Website
CN Rail’s dividend growth from 2000 through 2015 represents a CAGR of 17.1%.
CP Rail does not provide a nice graph like CN’s on their website, but their dividend growth from 2002 through 2015 (note the slightly different comparison period) represents a CAGR of 8.1%. So CN wins on both current yield and history of growth, meaning they win the dividend category along with the valuation category.
For intangibles, CN definitely takes the crown due to the stability and competence of their management team, along with the operational diversity that comes from their increased size.
Since CN wins out in each of the three major categories that I’m observing, I have to say that they are the more compelling investment at the moment.