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Canadian National Railway Company (CNR, Toronto CNI, New York)
RESEARCH SUMMARY
Report Author(s):  InvestorsFriend Inc. Analyst(s) 
Author(s)' disclosure of share ownership:  Author(s) hold shares 
Based on financials from: Dec '05 Y.E. +Q3 2006
Last updated: 20-Oct-06
Share Price At Date of Last Update: $52.31
Currency: $ Canadian
Current Rating (Company Rating does not consider the circumstances of any individual investor and is therefore not a recommendation and is not Investment Advice): (higher) Buy rated at $52.31
DESCRIPTION OF BUSINESS: Railroad, operating coast to coast in Canada and includes Illinois Central Railway which extends the reach south to the Gulf of Mexico.
RATING:   The graph illustrates that this is a "great company" with strong (adjusted) earnings per share growth (although revenue per share growth was good but not great). ROE is very strong and overall the value ratios indicate a Buy or Strong Buy. The most recent earnings growth trend has been very strong. This management seems to be very aggressively focused on growth in shareholder value. Arguably passes all of the Buffet tenets. The core business is likely to grow only slowly but recent smart acquisitions may rescue the growth rate and the company projects "10% plus" growth for 2007. At some point a recession will slow the growth but so far growth is very strong.  Significant share buy backs add support to the price. Overall we rate it a (higher) Buy due to the strong management, the earnings history, the reasonable P/E and the probable hidden value in deferred taxes expensed, this is offset by the difficulty of maintaining growth particularly if a recession occurs. 
RISKS: The company notes environmental and casualty liability risks. Also labour trouble is a risk. Rising pension costs. See annual report for more risks.
INSIDER TRADING / INSIDER HOLDING: Checking the six months ending October 20, 2006, a number of insiders exercised options and sold all the shares acquired.  A couple of directors and other insiders bought shares. Many other insides own shares and were not selling. Notably director Charles Baillie purchased 12,000 shares plus 2200 shares for a Marilyn Baillie at $49 and $46.77, which seems like a vote of confidence. The CEO purchased 16,000 shares Overall, the insider trading / insider holding signal is positive.
WARREN BUFFETT's TENETS: Arguably passes all of Buffett's tenets (see Robert Hagstrom's book) - simple to understand (pass), good profit history (pass), reasonably favourable prospects due to strong management and low costs (pass), rational-candid-ethical management (pass), high ROE (pass), high profits on sales (pass), a reasonably low debt ratio (pass) and arguably selling at a reasonable discount to intrinsic value (pass). 
MOST RECENT EARNINGS AND SALES TREND:  Good cost control.  Earnings per share rose 28% in 2005 and 27% in Q1 2006, about 19% in Q2 and 27% in Q3 2006. Therefore, the more recent trend is very strong.
VALUE AND GROWTH RATIOS: Analysed at $52.31. Price to book value ratio at 2.99 seems unattractively high in isolation. Price to book would be lower (more attractive) at under 2 if deferred taxes were removed or discounted as a liability. The P/E (adjusted to remove a recent tax gain) is 15.9 which seems attractive. Dividend yield is small at 1.2%, but the dividend has recently increased 30%. Return On Equity is quite strong at 16.8% in 2005 and very strong at 19.2% in the past 12 months. Sales per share have grown at an unexciting compounded 7.6% in the past 5 years but this has recently accelerated strongly. EPS growth over 5 years has averaged a strong 13.9% and recent growth in earnings per share is even higher. As detailed below, we calculate the intrinsic value to be $54.94 to $66.67, assuming five-year growth of 9% to 12% and a P/E in five years of 15 to 16 respectively.   This indicates an estimated Price to Value ratio of between 95% and 78% respectively.  In order to return 15% annually growth would need to average 13.5%, which is optimistic but not out of the question. Overall these ratios, in isolation,  indicate a Buy or Strong Buy.
SUPPORTING RESEARCH AND ANALYSIS
Symbol and Exchange: CNR, Toronto ( and CNI, New York)
Currency: Canadian $
Category: Mature with moderate growth potential
Contact: mark.wallace@cn.ca
Web-site: www.cn.ca
INCOME AND PRICE / EARNINGS RATIO ANALYSIS
Latest four quarters annual sales $ millions: $7,660.0
Latest four quarters annual earnings $ millions: $2,018.0
P/E ratio based on latest four quarters earnings: 14.0
Latest four quarters annual earnings, adjusted, $ millions:  $1,768.0
BASIS OR SOURCE OF ADJUSTED EARNINGS: One time gains and losses are removed for the adjusted earnings figure.
Quality of Earnings Measurement and Persistence: The reported Earnings seem "real". But, the company notes that the depreciation charges are insufficient to replace the equipment after inflation. This seems to be the case given that capital expenditures are markedly higher than the depreciation expense. Offsetting this is the fact that deferred income taxes are expensed but not paid in cash and the present value of the eventual cash payment will likely be substantially less than the deferred income tax amount. However, cash taxes are expected to increase significantly in 2007. Pension expenses have been very much under-stated due to an unrealistic assumption of 8% return on plan assets in 2004 (9% prior to 2003). The company reported just $22 million pension expense while putting in $165 in 2004!. Still, overall, the quality of earnings is probably good, as proven by the substantial free cash flows. We calculate  free cash flow closely approximates the net income in 2005 adding back deferred taxes.
P/E ratio based on latest four quarters earnings, adjusted 15.9
Latest fiscal year annual earnings: $1,556.0
P/E ratio based on latest fiscal year earnings: 18.1
Fiscal earnings adjusted: $1,556.0
P/E ratio for fiscal earnings adjusted: 18.1
Latest four quarters profit as percent of sales 23.1%
Dividend Yield: 1.2%
Price / Sales Ratio 3.68
BALANCE SHEET ITEMS
Price to (diluted) book value ratio:                                        2.99
Quality of Net Assets and Book Value Measurement: With little or no intangible assets, the assets appear to be very strong. There is a large and growing deferred income tax liability which will likely not be paid for many years, if ever. (Witness the $250 million gain due to lower tax  rates recognised in Q2 2006). The present cash value of this liability is therefore likely much lower than the book liability and this tends to add to the true economic value of equity and create a stronger, higher quality balance sheet.
Number of Diluted common shares in millions:                                       530.2
Controlling Shareholder: none, partly due to a ridiculous 15% ownership restriction imposed by government
Market Capitalization $ millions: $27,734.8
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 41%
Interest-bearing debt as a percentage of common equity 57%
Current assets / current liabilities: 0.8
Liquidity and capital structure: Very Good 
RETURN ON EQUITY AND ON MARKET VALUE
Latest four quarters adjusted (if applicable) net income return on average equity: 19.2%
Latest fiscal year adjusted (if applicable) net income return on average equity: 16.8%
Adjusted (if applicable) latest four quarters return on market capitalization: 6.4%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE
5 years compounded growth in sales/share 7.6%
Volatility of sales growth per share:   stable with moderate growth and recently accelerating 
5 years compounded growth in earnings/share 12.4%
5 years compounded growth in adjusted earnings per share 13.9%
Volatility of earnings growth:  strong steady growth 
Projected current year earnings $millions: $1,802.7
Projected price to earnings ratio: 15.4
Over the last five years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? No, revenue growth per share is modest
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 13.5%
More conservative estimate of compounded growth in earnings per share over the forecast period: 9.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 12.0%
OUTLOOK FOR BUSINESS:  Appears set for continued growth but earnings would fall if the economy slumps. Increased pension costs could reduce earnings by 4% in 2006 and forward, from what they would otherwise be. The company projects 10 to 15% earnings per share growth but indicates 10% plus for 2007. With a possible recession looming in North America there is a risk of an earnings decline, however, there have been no signs of this to date.
Estimated present value per share: We calculate $54.94 if earnings per share grow for 5 years at an average compounded 9% and the shares can then be sold at a P/E of 15. And $66.67 if earnings per share grow at a compounded 12% for 5 years and the shares can then be sold at a P/E of 16 (approximately the current P/E). Both estimates use an 8% required rate of return. This is not  a share price prediction. 
ADDITIONAL COMMENTS
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry rather than any particular company.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition.  This industry has very strong barriers to entry in terms of rail rights of way (pass). Not subject to dependency on powerful customers (pass). No dependency on powerful suppliers (pass), The industry as a whole is subject to trucking as substitute product (fail), Probably limited  tendency to compete excessively on the basis of price due to competitive advantage over trucks in many cases but tempered by commodity nature of products and presence of fixed cost structure (marginal pass). Overall, appear to be a somewhat attractive industry
COMPETITIVE ADVANTAGE: Strong management with a focus on simple fundamentals like moving the trains faster and minimizing investments in assets. Acknowledged as the best managed railroad in North America. Appears to have some "pricing power" as evidenced by the ability impose fuel surcharges without affecting volumes.
RECENT EVENTS:  Recently completed two relatively smaller acquisitions.
ACCOUNTING AND DISCLOSURE ISSUES: Uses U.S. GAAP. Generally exceptionally good disclosure. However, we found it hard to understand what the total adjusted net income was for prior years when adjustments for all unusual items, such as income tax recovery are included. Excellent disclosure of freight moved and revenue sources and results for different freight types. However, disclosure could be improved by including a 5 year summary in the annual report and by including net income, adjusted net income and average number of basic and fully diluted shares in the 5 year summary. The large pension plan is expected to increase pension expenses by $60 million in 2006 and the pension deficit will likely rise somewhat.
COMMON SHARE STRUCTURE USED: Normal common shares, 1 vote per share.
MANAGEMENT QUALITY: Excellent management. It appears that these people definitely know how to run a railroad. Their focus on asset utilization such as moving the trains faster (limiting idle time) seems very logical. Appears to be a master at paying low cash income taxes - although cash taxes expected to rise materially in 2007. The excellent level of disclosure in the annual report is a sign of a management that respects the shareholders. 
EXECUTIVE COMPENSATION:
BOARD OF DIRECTORS: A prestigious board with a number of representatives from the investment community. A typical outside board member has substantial shares and this insures that their interests are aligned with other shareholders.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company's growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry. 
DISCLAIMER: All stock ratings presented are "generic" in nature and do not take into account the unique circumstances and risk tolerance of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. InvestorsFriend Inc. itself does not have a position in any of the indicated securities while the authors may have a position. 
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