Canadian National Railway Company Stock Report

Historic growth is strong and relatively steady but did slow in 2019.  This was followed by a noticeable decline in 2020 due to the pandemic. Growth was strong is 2021 and 2022 followed by a modest dip in earnings in 2023.

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) had continued to increase despite a very large share buy-back program. It has decreased in 2022 and 2023 due to a larger share buy-back program. Earnings and book value have benefited from the impact of the declining Canadian dollar over most of the past decade as this boosts the value of its U.S. earnings and assets.

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 ’23 Y.E.
Last updated: April 3, 2024
Share Price At Date of Last Update:  $                                176.75
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 CAD $177 or US $131.
Qualifies as a stock that could be bought with confidence to hold for 20 years? Yes
Has Wonderful Economics? Yes
Has Excellent and Trustworthy Management? Yes
Likely to grow earnings per share at an attractive rate over the next decade? Yes
Positive near-term earnings outlook? Yes
Valuation? Fair
SUMMARY AND RATING:   The graph illustrates that this company has produced  very strong historic (adjusted and/or GAAP) earnings per share growth. The dip in 2020 was caused by the pandemic. The recent dip in the book value per share is due to large share buy-backs and is of no concern. The company appears to grow earnings in a predictable manner in the long term. It has excellent economics. Revenues per share growth in the last ten years averaged 7.4%. Adjusted earnings per share annual average growth in last ten years has been 9.1%. In the past ten years, book value per share has  grown at a 7.1% annual average which is impressive given significant buybacks and also the dividend. Value ratios indicate a strong company which however may be about fully valued suggesting a rating of  Weak Buy or (lower) Buy. Management has been strong and seems to be very aggressively focused on growth in shareholder value. A recent strong focus on digitisation seems like a very wise strategy.  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 years ago). The insider trading signal is moderately positive. We strongly like the duopoly nature of the industry in Canada and the tracks that can’t be duplicated. The outlook for 2024 is strong with expected 10% EPS growth although it appears that Q1 will likely show only modest growth at best. This company can be expected to continue to  do reasonably well long term.  The valuation is not overly compelling but this is a very high quality company. Overall, we rate CN a (lower) Buy at $179. we are holding at this price and would like to buy if the price dips by about 10% or more.
MACRO ENVIROMENT: A possible North American recession is a head wind. Higher interest rates are a only a modest head wind in terms of interest costs since the great majority of their debt is locked in for many years – still they may issue new debt for new investment. It’s more so a headwind in terms of the P/E ratio that the market is likely to assign. A lower Canadian dollar is beneficial as it increases the profits of its U.S. operations when translated to Canadian dollars.
LONG TERM VALUE CREATION: CN has an extremely strong history of value creation since it was privatised in 1995.
DESCRIPTION OF BUSINESS: Updated with December 31, 2023 figures. CN is a 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 18,800 and this figure has declined modestly in recent years.  There are “nearly 25,000” employees – and this figure has also declined in recent years. In 2023 69% of revenues were from Canada and 31% from the US.  In 2023, intermodal (consumer goods) accounted for 24% of its freight revenues. Petroleum and chemicals were 20% (this category has been increasing its share) and grains and fertilizers were  also 20%%, Forest products were 12%, metals and minerals were 13%, automotive (94% new vehicles and 6% parts) accounted for 6% and coal was the smallest category also at 6% of revenue.
ECONOMICS OF THE BUSINESS: The economics are excellent as indicated by the relatively consistent average 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 a recent 30%. Profits over assets are smaller but still substantial at about 10%. Debt and deferred income taxes and other liabilities provide leverage. A substantial proportion of the income taxes are typically continuously deferred.
RISKS: The company notes environmental and casualty liability risks. Also labour trouble is a possible risk (there was an eight day strike in November 2019). Vancouver dock workers strike impacted operations in 2022. Protestors blocked its tracks in early 2020. Potential rising pension costs. Some regulatory and environmental risks. See annual report for more risks.
INSIDER TRADING / INSIDER HOLDING: Checking insider trading from April 1, 2023 to March 28, 2024. There was a mixture of buying and selling but focusing on the buying, the signal seems moderately positive. Most of the selling was after exercising options and in one case for charitable purposes.
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 92% of book equity and with book equity being far lower than its market value), good recent profit history (fail) 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 (marginal pass as they need to replace assets fairly regularly but land and rights of way never need to be replaced). Overall, the company does well on the Buffett tenets although the very recent profit history is somewhat weak.
MOST RECENT EARNINGS AND SALES TREND:    Adjusted earnings per share growth over the past four quarters starting with the most recent quarter, Q4 2023, and going back was: down 4%, down 21%, down 9%, and up 38%. The revenue and earnings  per share trend can be distorted by volatile fuel prices and fuel price surcharges versus fuel costs, and by the changes in the Canadian dollar. Revenue per share growth in the past four quarters has been up 3%, down 8%, down 3%, and up 22%.  The full year 2023 had adjusted earnings per share down 2% (versus a very strong 2022) and revenue per share up 3%. The full year 2022 had adjusted earnings per share up a huge 26% (versus the somewhat pandemic-impacted 2021) and revenue per share up 8%. The full year 2021 had adjusted earnings per share up 12% (versus the pandemic-impacted 2020) and revenue per share up 5%. Overall the recent trend had been extremely strong but has turned negative in the latest three quarters. Growth has been boosted by share buy backs. Historic data:  The full year 2020 had an 8.5% decline in adjusted earnings per share due the pandemic and to other disruptions early in the year and a 6% revenue per share decline. The full year 2019 had 5% adjusted earnings per share growth and 6% revenue per share growth. The full year 2018 had 8% adjusted earnings per share growth and 11.5% revenue per share growth. The full year 2017 had 10% adjusted earnings per share growth and 13% revenue per share growth.
INDUSTRY SPECIFIC STATISTICS: Car loadings in the past eight quarters starting with the most recent (Q4 2023) were down 1% down 10%, down 7%, and unchanged.  Revenue ton miles in the most recent four quarters were up 2%, down 5%, down 8%, and up 6%.  For 2023 as a whole, car loads were down 5% and  revenue ton miles were down 1%.  For 2022 as a whole, car loads were unchanged and  revenue ton miles were up 1%. For 2021 as a whole, car loads were up 2% and revenue ton miles were up 4%. For 2020 as a whole, with the pandemic, car loadings were down 5% and revenue ton miles were also down 5%. Growth in these figures turned negative in the latest 3 quarters.
Earnings Growth Scenario and Justifiable P/E: The trailing P/E was recently about 22. This is pricing in growth in earnings per share of perhaps 8%.
VALUE RATIOS: Analysed at CAN $177 and U.S. $132. The price to book value ratio at 5.69 is ostensibly or at least potentially 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 Canadian land and land rights, much of which was acquired many decades ago are not reflected on the balance sheet at anything close to current market value. And the 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 interest-free for many years. The adjusted P/E  is unattractively high at 24.3 (It’s been as high as about 26 in the past but 20 is more normal). The forward P/E is moderately high at 22. The dividend yield remains modest at 1.9% (It’s modest due to the high price to book value ratio and despite large annual dividend increases.) and amounts to a pay-out ratio of 46% of trailing adjusted earnings. Return On Equity is extremely strong at 23% and has historically averaged about 23%. Revenues per share have grown at an average 7.4% in the past 5 fiscal years. Adjusted EPS growth over the last 5 fiscal years has averaged a strong 9.1%. As detailed below, we calculate the intrinsic value to be $129 to $170, assuming five-year growth of 5% to 8% and a P/E in five years of 17 and 20 respectively, and using a required rate of return of 7.0%.   The Value Ratios in isolation,  indicate a  very strong company that maybe about fully valued and would indicate a rating of Weak Buy.
TAXATION: Nothing unusual. The dividend qualifies for the Canadian dividend tax credit.  
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: $16,828.0
Latest four quarters annual earnings $ millions: $5,625.0
P/E ratio based on latest four quarters earnings: 20.7
Latest four quarters annual earnings, adjusted, $ millions: $4,800.0
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 although they can be significant.
Quality of Earnings Measurement and Persistence: The reported Earnings seem “real”. But, the company has noted in the past 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. But maybe not – the high returns on pension investments have lowered the pension expenses and this has persisted for many year. 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 24.3
Latest fiscal year annual earnings: $5,625.0
P/E ratio based on latest fiscal year earnings: 20.7
Fiscal earnings adjusted: $4,800.0
P/E ratio for fiscal earnings adjusted: 24.3
Latest four quarters profit as percent of sales 28.5%
Dividend Yield: 1.9%
Price / Sales Ratio 6.92
BALANCE SHEET ITEMS  
Price to (diluted) book value ratio: 5.69
Balance Sheet: (Updated Q2 2022) CN’s balance sheet is very strong.  Assets are comprised as follows: Properties 85% (Predominantly track and roadway and also rolling stock – they have only a small investment in land but that may be because the land under tracks has mostly been on the books for many decades), current assets 7% (predominantly accounts receivable and materials and cash), a prepaid pension amount 7%, less than 1% is capitalized leases and less than 1% is intangibles. These assets are financed as follows: Common share owners equity 44%, debt 29%, deferred income taxes 19%, accounts payable 5%, and other deferred liabilities 2% and capitalized lease liabilities less than 1%. Debt is 66% of the book equity level which is relatively modest especially considering that the market value of the equity 4.7 times higher than its book value.  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  almost 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 over four times its paid in common share equity (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 and which does not bear interest  is not much like a payable soon 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 – or effectively never repaid as new deferrals exceed amounts paid each year. 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 (assuming they own the land under the tracks)  is not reflected on the balance sheet. However, with the shares trading at 4.7 times book value, the company is valued for earnings and not the book value of its assets.
Number of Diluted common shares in millions:                                     647.6
Controlling Shareholder: (Updated based May 2022 circular) None, partly due to a 15% ownership restriction imposed by government. Melinda Gates and the Gates foundations are major owners.
Market Equity Capitalization (Value) $ millions: $114,463.3
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 39.5%
Interest-bearing debt as a percentage of common equity 92%
Current assets / current liabilities: 0.6
Liquidity and capital structure: The company has a very strong balance sheet and ample 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: 23.1%
Adjusted (if applicable) latest four quarters return on market capitalization: 4.2%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE  
5 years compounded growth in sales/share 5.6%
Volatility of sales growth per share:  Moderately volatile
5 years compounded growth in earnings/share 7.8%
5 years compounded growth in adjusted earnings per share 5.8%
Volatility of earnings growth:  moderately volatile
Projected current year earnings $millions: $5,186.0
Management projected price to earnings ratio: 22.1
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in (adjusted)  earnings per share? Yes
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 12.6%
More conservative estimate of compounded growth in earnings per share over the forecast period: 5.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 8.0%
OUTLOOK AND AMBITIONS FOR BUSINESS:  CN projected a 10% growth in adjusted earnings per share as of January 23. It now appears that Q1 may be somewhat weaker than they expected. Industry Rail car loadings for Canada (both rail companies together) have been running noticeably above the 2023 year to date while U.S. industry total  car loadings are below 2023 figures. CN’s own figures show car loads down 2.1% and revenue ton miles down 1.4% in 2024 to date (near the end of March)
LONG TERM PREDICTABILITY: 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 even if there has been some effort to “re-shore” certain products to lower supply-chain risks..
Estimated present value per share:  We calculate $129 earnings per share grow for 5 years at an average compounded 5% and the shares can then be sold at a reduced P/E of 17 (which is probably conservative). And $170 if earnings per share grow at a compounded 8% for 5 years and the shares can then be sold at a P/E of 20. 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 a substitute for rail but tends to be more efficient that trucks  (marginal pass), Apparently very limited  tendency to compete excessively on the basis of price due to competitive advantage over trucks in many cases (pass). Overall, appears to be an 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 – although it seems to have slipped in that regard lately. 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: Rail car loadings turned noticeably lower in 2023. And carloads are down 2.1% in 2024 to date. Revenue ton miles are down 1.4% in 2024 to date. Industry data show that Canadian total car loadings are up noticeably in 2024 while U.S. industry total car loadings are down noticeable. Strangely, virtually the entire Board is very new. Only one member from the 2019 Board remains!. CN in late 2021 came under major criticism from an activist share owner that proposed to replace the CEO, the chair of the board and several other board members. CN responded swiftly and aggressively by announcing that their CEO would retire, naming a new CEO, releasing a strategic plan, refuting the criticism, announcing a $5 billion share buy-back program  raising the dividend and soon naming three new Board members. All of these actions resolved the dispute with the dissident shareholder. The new(er) CEO is Tracey Robinson who comes from TC Energy and has three decades of experience with CP Rail. The dividend was increased by 7% at the end of 2023, by  8% at the end of 2022, by 19% at the end of 2021 and by 7% at the end of 2020 which continues a long 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. However, that may be due to high returns on the pension assets and this situation has persisted for many years. Also depreciation is a large expense and by its nature must be estimated. A discussion on the impact of regulation of farm-related revenue was added in or around 2023 and this was an improvement. The positive or negative net impact of the fuel surcharge (if any) was not much discussed.
COMMON SHARE STRUCTURE USED: Normal common shares, 1 vote per share.
MANAGEMENT QUALITY: They named a new CEO (Tracey Robinson) at the start of 2022 but there will not likely be any big changes in management style. Historically, excellent management. It appears that these people definitely know how to run a railroad. Their recent focus on digitization seems very wise. Their long-time focus on efficiency including asset utilization such as moving the trains faster and limiting idle time seems very logical. Efficiencies also include more fuel-efficient engines and running longer trains. 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 22% over the ten years ended 2023. The last four CEOs going back over 20 years appear to have pursued the same steady methods that have worked in the past and that keep on working.
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 apparently attractive prices.
EXECUTIVE COMPENSATION:  Compensation is generous ranging from $3.9 million to $13.7 million U.S. dollars for the named officers for 2022. The top officers are paid in U.S. dollars and this has been the case since 2002. Overall, given the size and profitability of this company, we are  not concerned about executive compensation at this time.
BOARD OF DIRECTORS: (updated May 2023)  11 members. Surprisingly, five members left the Board in early 2021. Another six have left since then and all except one of the Board members are relatively new. CN has had a strong Board in the past and hopefully this remains the case.
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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