Contents
In my January 23, 2022 Union Pacific (UNP) post, I determined that I would patiently wait for a better valuation before adding to my position in one of the 'Side' accounts within the FFJ Portfolio. With the release of Q4 and FY2021 results and FY2022 guidance on January 25, my analysis leads me to conclude Canadian National Railway (CNR.to) is overvalued.
Despite the periodic addition to my CNR.to position over the last few years, CNR.to has gone from my 12th largest holding in mid-August 2020, to my 15th largest holding in mid-April 2021, and is my 16th largest holding as per my early January 2022 investment holdings review.
The reason for this slippage in ranking is that I have not made any sizable CNR.to additions to my 'Core' account position since February/March 2016 and my 'Side' account position since January 2018. In addition, other holdings have increased in value to a greater degree than CNR.to.
With CNR.to trading at ~$155 at the January 25, 2022 market close and the recent earnings release, I now take a look at the company's valuation to determine if I should add to my position.
NOTE: All dollar values are in CDN $.
Business Overview
CNR.to’s rail network consists of ~20,000 route miles of track. It serves several ports on three coasts and it has 23 strategically located Intermodal terminals across its network.
Interactive maps to aid in determining the magnitude of CNR.to's operations are accessible here.
I encourage investors unfamiliar with CNR.to read the material in the Reports, Presentations and Archives section of the company's website as well as Management's Discussion and Analysis (the Q4 2021 version will be uploaded to the website on February 1, 2022).
Kansas City Southern Railway (KCS)
By now, readers are likely well aware that CNR.to's effort to acquire KCS was unsuccessful; this takeover attempt was widely criticized as being unlikely to receive the appropriate regulatory approvals. Sure enough, the effort collapsed when U.S. regulators blocked a key provision in the proposed deal. On the bright side, however, CNR.to forced Canadian Pacific Railway Ltd. (CP.to) to pay billions more to win KCS.
I am, therefore, dispensing with any analysis of this failed acquisition attempt other than to note that on September 15, 2021, CNR.to received Notice of Termination of KCS Merger Agreement. In connection with KCS’ termination of the merger agreement, KCS paid a US$0.7B termination fee as well as US$0.7B that CNR.to paid when KCS broke its initial deal with CP Rail to accept CN’s offer.
Proxy Contest - TCI Fund Management
TCI Fund Management, run by billionaire Chris Hohn and CNR.to's second-largest holder, believed the bid was doomed for failure and stated an acquisition of KCS exposed CNR.to to unacceptable financial risk. Furthermore, TCI criticized CNR.to for underperforming its peers under Chief Executive Officer (CEO) Jean-Jacques Ruest.
The CP.to takeover attempt fueled TCI’s decision to try to force out Ruest and change the board. TCI also pressed for Ruest to be removed and for it to also receive 4 board seats.
Ruest announced his retirement in October and TCI will receive two seats on the board as part of a settlement that prevents a proxy fight; the directors will be named at a future date.
The dispute is now settled.
On January 25, 2022, it was announced that Ruest's replacement is Tracy Robinson. Her background is 27 years at rival CP.to and most recently, at Calgary’s TC Energy Corp. (TRP.to) since 2014 where she has been in charge of its Canadian natural gas pipelines. At TRP.co, she was also president of Coastal GasLink, a $6.7B under-construction natural gas pipeline to connect natural gas fields in Western Canada with Canada’s first LNG export project.
Milton Hub
CNR.to plays a major role in moving traffic to the Greater Toronto and Hamilton Area, the fastest growing area in Canada. To meet this area's growth and demand, CNR.to needs to expand. In this regard, the company is investing ~$0.25B to build the new Milton Logistics Hub.
Shut Down and Divestiture
Precision Scheduled Railroading (PSR)
PSR is a concept in freight railroad operations that shifts the focus from older practices to emphasize point-to-point freight car movements on simplified routing networks. PSR was first introduced at the Illinois Central Railroad (IC) and was then implemented at CNR.to when it acquired IC in 1998.
Typically, service is eliminated on shipping lanes that have low traffic levels. Intermodal terminals have been consolidated with railroad relying on trucks for the last hundred miles.
The use of PSR means freight trains operate on fixed schedules, much like passenger trains, instead of being dispatched whenever a sufficient number of loaded cars are available. Advocates claim that shippers benefit from reduced costs and more reliable schedules.
The benefit of PSR is a reduction in freight car and locomotive inventories and fewer workers for a given level of traffic. This often results in substantial improvement in railroad operating ratios and other financial and operating metrics; PSR has contributed to dividend and share price increases by the major North American railroads over the years.
PSR, however, is not without criticism. Shippers complain about poorer service and railroad employees have raised concerns about safety due to reduced inspections and staffing.
Financial Review
Q4 and FY2021 Results
CNR.to's Q4 and FY2021 results are accessible here.
Q4 results demonstrated CNR.to's resiliency and profitability as evidenced by adjusted diluted EPS growth of 20%, an adjusted operating ratio of 57.9%, and FY2021 free cash flow of $3.3B (the upper end of guidance).
CNR.to also achieved some noteworthy records in 2021:
- safety performance on personal injuries;
- performance on fuel efficiency; and
- Operating Ratio for a Q4.
Volume, however, was softer mainly because of the BC line washout and a lower level of Canadian grain.
The British Columbia washout took out CNR.to's mainline to Vancouver between November 14 - December 4. This major segment of the rail network normally sees about 21% - 23% of total revenue running over these tracks on any given day.
Source: CNR.to - Q4 and FY2021 Earnings Presentation - January 25, 2022
CNR.to's all-important adjusted Operating Ratio improved to 61.2% from 61.9% in the prior fiscal year. In FY2018 and FY2019, it reported 61.5% and 61.7%.
Source: CNR.to - Q4 and FY2021 Earnings Presentation - January 25, 2022
Free Cash Flow (FCF)
CNR.to's FY2012 - FY2021 FCF track record (in billions of $) is: $1.329, $1.575, $2.084, $2.434, $2.507, $2.843, $2.387, $2.058, $3.302, and $3.296.
Source: CNR.to - Q4 and FY2021 Earnings Presentation - January 25, 2022
FY2022 Outlook
Included in CNR.to's FY2022 outlook is:
- ~20% adjusted diluted EPS growth, versus 2021 adjusted diluted EPS of $5.94; and
- Free cash flow of ~$4B compared to $3.3B in FY2021.
Source: CNR.to - Q4 and FY2021 Earnings Presentation - January 25, 2022
Investors should note that CNR.to generates more revenues than expenses in US dollars. Its results, therefore, are affected by foreign exchange fluctuations. Management estimates that a $0.01 depreciation/appreciation in the value of the Canadian dollar increases/decreases its annual EPS by ~$0.05.
Risk Assessment
CNR.to's domestic unsecured credit ratings are:
- A2 from Moody's with a stable outlook; and
- A from S&P Global with a negative outlook
Both ratings are the middle tier of the upper medium-grade investment-grade category.
The ratings define CNR.to as having a strong capacity to meet its financial commitments. However, it is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.
These ratings satisfy my conservative investment preferences.
Dividends and Dividend Yield
CNR.to's FY2012 - FY2021 dividend history is $0.75, $0.86, $1.00, $1.25, $1.50, $1.65, $1.82, $2.15, $2.30, and $2.46.
On January 25, 2022, the company announced a ~19% increase in the 2022 dividend. Commencing with the Q1 dividend payable on March 31 to the shareholders of record at the close of business on March 10, 2022, the quarterly dividend will be $0.7325. This increase from $0.615 marks the 26th consecutive year of dividend increases.
Based on the ~$155 share price, the dividend yield is ~1.9%.
The weighted average number of shares outstanding is 875, 846, 824, 805, 779, 757, 738, 723, 713 and 710.3 (in millions) in FY2012 - FY2021.
The low level of share repurchases in FY2021 is because CNR.to paused share buybacks in light of its proposal to combine with KCS.
We see from the Consolidated Statement of Cash Flows, share repurchases of $0.379B and $1.582B in FY2020 and FY2021. $1.024B of these repurchases, however, occurred in Q4 2021 following receipt of funds from KCS. This Q4 share repurchase distorts the weighted average of shares outstanding in FY2021; the weighted average at the end of Q3 was 711.3 million.
On January 25, 2022, the company's Board approved share repurchases under a new normal course issuer bid which allows for the repurchase of up to 42.0 million common shares in the range of $5B. CNR.to is now permitted to purchase common shares, for cancellation, between February 1, 2022 - January 31, 2023. This authorized amount represents 6.80% of the 618,826,610 common shares issued and outstanding of the Company not held by insiders on January 18, 2022. On that date, 701,740,872 CN common shares were issued and outstanding.
Valuation
CNR.to's FY2012 - FY2020 diluted PE levels are 14.76, 19.95, 22.41, 18.20, 19.95, 20.32, 13.01, 19.01, 29.34, and 23.44.
CNR generated $6.89 in diluted EPS in FY2021. With shares at ~$155, the diluted PE is ~22.5.
However, when adjustments are made to account for various items such as:
- recovery on assets held for sale;
- amortization of bridge financing and other fees; and
- merger termination fee
the FY2021 adjusted diluted EPS is $5.94 resulting in a ~26 adjusted diluted PE ratio.
Management's FY2022 adjusted diluted EPS guidance is a ~20% increase from $5.94 or $7.13. Using the current share price, the FY2022 adjusted diluted PE ratio ~21.
I expect the brokers' forward-adjusted diluted PE levels reflected on the two online trading platforms I use will change over the next several days. Until such time, however, the forward valuations using the current data is as follows:
- FY2022 - 22 brokers - mean of $6.97 and low/high of $5.70 - $7.40. Using the mean estimate, the forward adjusted diluted PE is ~22 and ~21 if I use $7.40.
- FY2023 - 18 brokers - mean of $7.84 and low/high of $7.37 - $8.25. Using the mean estimate, the forward adjusted diluted PE is ~20 and ~19 if I use $8.25.
- FY2024 - 5 brokers - mean of $8.69 and low/high of $7.98 - $9.05. Using the mean estimate, the forward adjusted diluted PE is ~18 and ~17 if I use $9.05.
Only 5 brokers have provided FY2024 estimates so I disregard this guidance.
As with UNP, I think the current forward-adjusted diluted PE is somewhat rich. A multiple of ~20 is at the top end of what I think is reasonable and is not completely out of the realm of the possibility under current market conditions.
Final Thoughts
Rail stocks, in general, have been trading at elevated multiples in recent years because of the low-interest-rate environment and improving industry returns on capital.
Based on my analysis, however, I am currently in no rush to increase my CNR.to exposure.
I wish you much success on your journey to financial freedom!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclosure: I am long CNR.to, CP.to, and UNP.
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your own research and due diligence. Consult your financial advisor about your specific situation.
I wrote this article myself and it expresses my own opinions. I do not receive compensation for it and have no business relationship with any company mentioned in this article.
