Canadian National Railway Company Stock Report

Canadian National Railway Company

 

Historic growth is strong and relatively steady.  Growth was strong in 2017 but has slowed considerably in late 2017 and earnings per share declined in Q1 2018. In 2017, CN booked a large accounting gain as its deferred tax liabilities were sharply reduced due to the Trump income tax cuts. Adjusted earnings removes that large gain. Notice that in the case of CN adjusted earnings are usually lower than GAAP earnings. This is rare, for most companies the adjustments increase earnings. This indicates that CN has not had too many unusual losses and that in any case management has been conservative and not found reasons to adjust earnings upward. Book value per share (the green line)continued to increase despite a large share buy-back program.

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 no shares
Based on financials from: Dec ’17 Y.E. + Q1 ’17
Last updated: 29-Apr-18
Share Price At Date of Last Update:  $                            100.65
Currency: $ Canadian
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): (lower) Buy at CAN $100.65
SUMMARY AND RATING:   The graph illustrates that this company has produced  very strong historic (adjusted and/or GAAP) earnings per share growth.  The company appears to grow earnings in a predictable manner. It has excellent economics. Revenues per share growth in the ten years shown has averaged 8.1% annually, Adjusted earnings per share annual average growth in the ten years shown has been 10.8%, Book value per share has  grown at a 8.1% annual average which is impressive given significant buybacks and also the dividend. Value ratios indicate a strong company which appears to be about fully valued at this time suggesting a rating of perhaps Weak Buy / Hold. The recent earnings and sales trend has weakened with a 13% earnings decline in Q1 2018 (driven by cost increases as revenue was up 2%) which came after a 3% decline in Q4 but very strong growth in the first nine months of 2017. Management has been strong and seems to be very aggressively focused on growth in shareholder value. A new interim CEO is in place after they decided that the CEO they promoted in 2017 was not the right choice. Does well on the Buffett tenets except tends to require much more capital replacement spending than Buffett would prefer (But Buffett likes the rail industry and paid a high valuation to acquire Burlington Northern).  Outlook for earnings growth is for about 9% average growth in the remaining three quarters of 2018. However, a new risk in 2018 is the outcome of the NAFTA negotiations given that about one third of its traffic crosses the border. The insider trading signal is about neutral to moderately positive. We strongly like the duopoly nature of the industry in Canada and the tracks that can’t be duplicated. Should do reasonably well long term.  Overall we rate CN a (lower) Buy. I plan to begin to re-establish a position in this company. I would also be prepared to add to that on any material dip.
DESCRIPTION OF BUSINESS: Railroad, operating coast to coast in Canada and includes the former Illinois Central Railway which extends the reach south to the Gulf of Mexico. The company hauls its own rail cars and also customer-owned cars. And it must frequently transfer cars to and from other rail roads. The total route-miles of track are about 20,000 as of early 2016 (and this has been stable for some years).  There are 24,812 employees as of Q1 2018. The employee count is up 10% in the past year. The employee count had been decreasing for years but in late 2017 it became apparent that the cuts had been too deep. About two thirds of the revenues and profits are from Canada and the rest from the U.S.  In 2017: 34% of revenue related to freight coming from or going overseas. 33% related to freight crossing to or from the U.S., 17% related to Canadian domestic traffic and 16% to U.S. domestic traffic. The company originates 85% of its traffic (with 15% originated by other rail roads). It originated s and terminates 65% of its traffic. In 2017 intermodal (consumer goods) accounted for 26% of its freight revenues. Petroleum and chemicals were 18% and grains and fertilizers were 18%, Forest producers wee 12%, metals and minerals were 12%, automotive (94% new vehicles and 6% parts) accounted or 7% and coal was the smallest category at 4% of revenue.
ECONOMICS OF THE BUSINESS: The economics are excellent as indicated by the 23% ROE. Rail is more efficient than trucking. There is very limited rail competition in most of the territory it serves. Often one competing rail service. It is a capital intensive business. However wages are also a large part of the expense. Partly due to the capital intensive nature of the business, profits over sales are large at 28%. But profits over assets are only about 9%. Debt and deferred income taxes and other liabilities provide leverage. A substantial proportion of the income taxes are typically continuously deferred (and substantial amounts become non-payable due to income tax rate reductions over the years including the recent Trump reductions.
RISKS: An important new risk in 2018 is the outcome of NAFTA negotiations since about one third of its traffic crosses the Canada / U.S. border. The company notes environmental and casualty liability risks. Also labour trouble is a possible risk but they have recently achieved long-term labour settlements. Rising pension costs. Some regulatory and environmental risks. See annual report for more risks.
INSIDER TRADING / INSIDER HOLDING: Checking insider trading from July 1, 2017 to April 28, 2017 there is a mix of buying and selling. Most of the directors bought shares on January 30 at $98 or the equivalent U.S. price but this was likely taking director compensation as shares rather than true buys with their own money.  But there were also additional buys at prices up to about $100. Several insiders sold substantial shares but these insiders hold millions worth of shares. Several more insiders sold on exercising options. Many insiders have very  significant wealth in options and so it is not necessarily a negative signal when they cash some in. But in this case the sales seem significant. Overall, the insider trading signal is neutral to moderately positive.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand (pass although there are some complexities and estimates in the accounting), has favorable long-term economics due to cost advantages or superior brand power (pass due to limited competition and lower cost structure than trucking), apparently able and trustworthy management (pass given focus on efficiency and profits and past success), a sensible price – below its intrinsic value (marginal pass ), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass with debt at 73% of book equity and with book equity being far lower than its market value), good recent profit history (pass) little chance of permanent loss of the investors capital (pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (fail given that free cash is lower than net income and the need to replace assets fairly regularly)
MOST RECENT EARNINGS AND SALES TREND:    Adjusted earnings per share growth over the past four quarters has been (starting with the most recent quarter and going back ) minus 13%, minus 3%, positive 4% and positive 20%. The revenue and earnings  per share trend can be distorted by volatile fuel prices and fuel price surcharges and by the changes in the Canadian dollar. Revenue per share growth in the past four quarters has been positive 2%, positive 5%, positive 10% and positive 21% (volatile fuel surcharges contributed to the figures). The fully year 2017 had 8% adjusted earnings per share growth and 11.5% revenue per share growth. The full year 2016 had 3% EPS growth and minus 1% revenue per share growth.  The full year 2015 had 18% EPS growth and 12% revenue per share growth.  The full year 2014 had 23% EPS growth and 18% revenue per share growth.  Overall the recent trend has been weak to negative after a strong period of growth in first three quarters of 2017.
INDUSTRY SPECIFIC STATISTICS: Car loadings in the past four quarters starting with the most recent (Q1 2018) were up 3%, up 7%, up 11% and up 14%. Revenue ton miles in the most recent four quarters were down 4%, up 1%, up 11% and up 18%.   For 2017 as a whole, car loadings were up 10% and revenue ton miles were up 11%.  For 2016 as a whole, car loadings were down 5% and revenue ton miles were down 5%.For 2015 as a whole, car loadings were down 2% and revenue ton miles, down 3%. These volume indicators are weak in the past two quarters after being very strong in the first three quarters of 2017. Freight categories by revenue that were strong in 2017 included metals & minerals up 25%, coal (a small category) up 23%, intermodal up 12%. The only decline was forest products down 1%. In Q1 2018, the important intermodal category was up 10% an the small coal category was up 10% but grains and fertilizer were down 11%, metals and minerals were down 7% and automotive was down 4% and petroleum & chemicals were down 3%.
Earnings Growth Scenario and Justifiable P/E: The trailing P/E was recently 20.8. This can be justified with EPS growth of about 7% annually and the P/E declining modestly to 18 over a ten year holding period as one scenario. Or 8% annual growth and a terminal P/E of 16 as another scenario. This assumes a required return of 7.0%.
VALUE RATIOS: Analysed at CAN $100.65 and U.S. $78.31. The price to book value ratio at 4.5 is ostensibly unattractive but mathematically simply reflects the very high ROE combined with the P/E. It also reflects the fact that the value of CN’s land and land rights, much of which was acquired decades ago are not reflected at anything close to current market value. Price to book would be substantially lower (more attractive) if deferred taxes were removed or fully discounted as a liability – since they may continue to be deferred for many years. The adjusted P/E (the only big adjustment was to remove the gain associated with the Trump income tax reductions) is 20.8 which seems about neutral to moderately unattractive for this high-quality company. The dividend yield remains modest at 1.8% and amounts to a pay-out ratio of 37% of earnings. Return On Equity is extremely strong at 23%. Revenues per share have grown at an average 8.7% in the past 5 fiscal years. Adjusted EPS growth over the last 5 fiscal years has averaged 12.2% and had been relatively steady.  As detailed below, we calculate the intrinsic value to be $89 to $110, assuming five-year growth of 7% to 9% and a P/E in five years of 17 and 19 respectively, and using a required rate of return of 7.0%.   This indicates an estimated Price to Value ratio of between 113% and 81% respectively. The Value Ratios in isolation,  indicate a  very strong company which is likely about fully valued or more indicating  a rating of Weak Buy / Hold.
SUPPORTING RESEARCH AND ANALYSIS  
Symbol and Exchange: CNR, Toronto ( and CNI, New York)
Currency: $ Canadian
Contact: janet.drysdale@cn.ca
Web-site: www.cn.ca
INCOME AND PRICE / EARNINGS RATIO ANALYSIS  
Latest four quarters annual sales $ millions: $13,029.0
Latest four quarters annual earnings $ millions: $5,341.0
P/E ratio based on latest four quarters earnings: 14.2
Latest four quarters annual earnings, adjusted, $ millions: $3,640.0
BASIS OR SOURCE OF ADJUSTED EARNINGS: One time gains and losses identified by management are removed for the adjusted earnings figure. Impacts of currency change are not adjusted for.
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 usually higher than the depreciation expense.  Pension expenses appear to have been under-stated. Free cash flow continues to lag earnings . The deferral of taxes on the other hand adds to earnings quality. Overall, the quality of earnings seems strong.
P/E ratio based on latest four quarters earnings, adjusted 20.8
Latest fiscal year annual earnings: $5,484.0
P/E ratio based on latest fiscal year earnings: 13.8
Fiscal earnings adjusted: $3,770.0
P/E ratio for fiscal earnings adjusted: 20.1
Latest four quarters profit as percent of sales 27.9%
Dividend Yield: 1.8%
Price / Sales Ratio 5.81
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio:                                         4.52
Balance Sheet: (Updated Q1 2018) CN’s balance sheet is very strong.  Assets are comprised as follows: Properties 90% (Predominantly track and roadway and also rolling stock), current assets 7% (predominantly accounts receivable and materials), a prepaid pension amount 3% and 1% intangibles. These assets are financed as follows: Common share owners equity 43%, debt 21%, deferred income taxes 18%, accounts payable 5%, and other deferred liabilities 3%. Debt is 72% of the book equity level which is relatively modest but has been increasing.  And, the book equity is artificially low because much of its land and rail rights of way were acquired decades ago at prices far below current value. There is  no goodwill on the books, which is surprising given it had made major acquisitions in the past but this is probably an artifact of U.S. GAAP accounting in which acquisitions are often treated as mergers. Its retained earnings are almost four times its common share equity excluding retained earnings (despite dividends and substantial share buy backs) which indicates a strong history of profitability. A very large deferred income tax liability is a softer liability in that this amount is likely to continue to grow for years (a liability that you don’t need to repay is not much like a current payable due).
Quality of Net Assets and Book Value Measurement: With little or no intangible assets, the assets appear to be very strong. The book value of the equity overall appears to be very conservatively stated. There is a large and growing deferred income tax liability which will likely not be paid for many years. 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.  Much of the market value of its land is not reflected on the balance sheet. However, with the shares trading at over five times book value, the company is valued for earnings and not the book value of its assets.
Number of Diluted common shares in millions:                                 744.2
Controlling Shareholder: None, partly due to a 15% ownership restriction imposed by government. Bill Gates owns over 15.9% of the company (13.6% personally and another 2.3% through his foundation) and has been a major owner for many years. Bill Gates’ ownership has now exceeded the 15% limit solely due to CN’s share buybacks and he is therefore allowed to vote only 15%.
Market Equity Capitalization (Value) $ millions: $74,903.7
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 42.8%
Interest-bearing debt as a percentage of common equity 72%
Current assets / current liabilities: 0.6
Liquidity and capital structure: The company has a very strong balance sheet and access to liquidity.
RETURN ON EQUITY AND ON MARKET VALUE  
Latest four quarters adjusted (if applicable) net income return on average equity: 23.1%
Latest fiscal year adjusted (if applicable) net income return on average equity: 23.9%
Adjusted (if applicable) latest four quarters return on market capitalization: 4.9%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
5 years compounded growth in sales/share 8.7%
Volatility of sales growth per share:  Moderately volatile
5 years compounded growth in earnings/share 18.8%
5 years compounded growth in adjusted earnings per share 12.2%
Volatility of earnings growth:  moderately volatile
Projected current year earnings $millions: $3,851.2
Management projected price to earnings ratio: 19.4
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Yes
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 15.0%
More conservative estimate of compounded growth in earnings per share over the forecast period: 6.5%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 9.0%
OUTLOOK FOR BUSINESS:  The company is projecting only about  4% earnings growth in 2018 however, given the 13% decline in Q1 this Implies an average growth of 9.3% in the remainder of 2018.  In the past we have found that they usually exceeds their guidance. As Q2, 2017 was strong, the company faces a tough comparable in Q2 2018.
LONG TERM PREDICTABILITY: This company seems relatively predictable. It would seem to be a very good bet that the company will still be around in ten and twenty years and more and will be hauling more freight than today as the economy grows over the years although it does not grow every year. It seems to us that CN is well positioned for the long term as North America continues to import goods from Asia. The  strong earnings per share growth that averaged 12% in the past five years was boosted by currency and possibly by lower fuel costs (net of surcharges) and by share buybacks. It seems very unlikely that earnings can grow that fast in the next five years. 7% might be a more reasonable target. Some of the achieved earnings growth has come from efficiencies including a lower head count although as of the end of 2017 it seemed apparent that two many positions had been eliminated.  It is not clear if the level of share buybacks can be maintained. It seems unlikely that the pace of efficiency improvement can be maintained.
Estimated present value per share: We calculate $89 if earnings per share grow for 5 years at an average compounded 6.5% and the shares can then be sold at a reduced P/E of 17. And $110 if earnings per share grow at a compounded 9% for 5 years and the shares can then be sold at a slightly lower P/E of 19. 9% annual growth may be quite optimistic. Both estimates use a 7.0% required rate of return. This is not  a share price prediction.
ADDITIONAL COMMENTS  
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) 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, although workforce is unionized), The industry as a whole is subject to trucking as substitute product but tends to be more efficient that trucks  (marginal pass), 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 for established incumbents.
COMPETITIVE ADVANTAGE: Strong management with a focus on simple fundamentals like labor efficiency and moving the trains faster and minimizing investments in assets.  Often acknowledged as the best managed and lowest operating cost per dollar of revenue railroad in North America. Appears to have some “pricing power” as evidenced by the ability impose fuel surcharges and higher rates  without affecting volumes. Presumably the tracks that they own are an advantage because their are likely few or no other rail service options available to many of their customers. (Although in some U.S. markets they compete with barges on the Mississippi river).They state that they have advantages in operation with a scheduled shipping approach that they believe allows them to price their service at some premium rather than pricing as a commodity service.
COMPETITIVE POSITION: This industry does not lend itself to a calculation of market share since transportation service is very location specific and market share data is not available.
RECENT EVENTS:  The CEO retired in June 2016 for health reasons and was replaced by an existing executive who has been with the company since 2009. However after operational stumbles in the winder of 2017/2018 he was replaced in March 2018 by an existing executive on an interim basis. Traffic grew sharply in the first nine months of 2017 but has since slowed considerably and revenue ton miles were down 4% in Q1 2018 although revenue was still up 2%. The dividend was increased by 10% for 2018 continuing a log string of annual increases.
ACCOUNTING AND DISCLOSURE ISSUES: Uses U.S. GAAP. Generally exceptionally good disclosure.  Excellent disclosure of freight moved (number of rail cars, ton-miles etc.) and revenue sources and results for different freight types.   There are some complexities involved in understanding the pension liability and environmental liabilities. Pension expenses appear to be somewhat understated in most recent years since cash contributions to the pension exceed the booked expense. Also depreciation is a large expense and by its nature must be estimated. The extent to which pricing is regulated is discussed but not really disclosed in a meaningful way. The positive or negative net impact of the fuel surcharge was not much discussed.
COMMON SHARE STRUCTURE USED: Normal common shares, 1 vote per share.
MANAGEMENT QUALITY: Historically, excellent management. It appears that these people definitely know how to run a railroad (however there were some operational stumbles in 2017). Their long-time focus on asset utilization such as moving the trains faster and limiting idle time seems very logical. Their focus on customer service is also logical.  The excellent level of disclosure in the annual report is a sign of a management that respects the shareholders. They have also bought back shares steadily over the years and at prices which have proven to be advantageous for the continuing shareholders although we have sometimes thought they were paying too much to buy back shares. The share count was reduced by 25% over the ten years ended 2017. The last four CEOs appear to have pursued the same steady methods that have worked in the past and that keep on working. The new interim CEO who most recently took over in March 2018 is unlikely to change the strategy.
Capital Allocation Skills: Management has shown strong capital allocation skills over the years by not over-paying for acquisitions and by buying back shares steadily at attractive prices. It does remain to be seen if the more recent share acquisitions will prove to have been done at an attractive price.
EXECUTIVE COMPENSATION:  Compensation is generous ranging from $3.8 million to $12.3 million for the named officers for 2017. Compensation does appear to decrease in the bad years which is good. Overall, given the size and profitability of this company, we are  not concerned about executive compensation at this time.
BOARD OF DIRECTORS: (updated April 2018)  12 members. A prestigious board with a number of former CEOs of prominent companies.  A typical outside board member has substantial shares (several $million worth to $33 million) and this insures that their interests are aligned with other shareholders however it appears that most of those shared were simply earned as compensation for being Board members and not purchased independently.  Longer term Board members have apparently made fortunes as Board members probably largely by wisely retraining their share. There appears to be none who were independent large shareholders before being directors. Overall, probably  a good Board. This Board showed its independence of management when it recently replaced the CEO.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, achieved earnings per share 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 and risk capacity 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 often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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