Railroads: Who's the Better Buy?

By Arthur Pinkasovitch - February 17, 2012 | Tickers: CNI, CP, CSX, NSC | 0 Comments

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Over a 5 and 10 year horizon, Canadian National Railway (NYSE: CNI) has outperformed its Canadian rival Canadian Pacific Railway (NYSE: CP) by a substantial margin. Although over the last 12 months these two stocks have moved more or less in tandem with one another, the question still remains – which of these companies is more likely to outperform the other starting today?

Overall CN appears to be more efficient in terms of expense minimization. The operating ratio, which measures expenses as a percentage of revenue, is a key multiple for the capital intensive railway industry. Canadian National operates with a healthy operating ratio of 64.7%, while Canadian Pacific runs with an operating ratio of 78.5%, a year-over-year increase of 150 basis points and is targeting to reduce the ratio to approximately 71% in 3 years. Based on other industry specific metric such as car miles per day, terminal dwell hours and locomotive utilization (gross ton miles per total horsepower), CN is performing significantly better than the competition – see figure 1. Despite the stronger performance by CN, CP has been displaying substantial year-over-year improvements.

Figure 1: Comparison of Metrics

Despite being a bigger and more efficient player, Canadian National trades at a lower earnings and cash flow ratio than Canadian Pacific. CN, with a P/E and P/CF multiple of 14.32 and 10.27 respectively, appears relatively undervalued to CP which supports respective multiples of 21.9 and 11.75. Although the larger railway corporation appears overvalued when assessed by the sales and price to book ratios, earnings and cash flow are a better measure of value for the industry. Furthermore, CN offers a bigger dividend, a more attractive dividend growth rate and a lower payout ratio – see figure 2. The overall ratio and dividend analysis reflects that Canadian National is the undervalued firm, relatively.

Figure 2: Comparison of Dividends and Trading Multiples

Canadian National Railway also has a stronger balance sheet than Canadian Pacific Railway, judging from a liquidity and solvency perspective. CN currently holds $600 million of cash and cash equivalents (including restricted) with $6.5 billion in long term debt, $135 million of which is the current portion. On the other hand, CP holds only $47 million of cash and equivalence, with long term liabilities amounting to $4.7 billion; $50 million of long term debt is maturing within one year. Therefore, CP does not even have enough cash to satisfy the current portion of its long term debt and thus will have to rely on subsequent financing and operational activities within the upcoming year. Although this is quite normal for a large corporation, CN has an advantage in terms of basic balance sheet strength. Furthermore, as a percentage of total assets, pension liabilities are significantly lower for CN Rail (4%) than CP Rail (10%).

In terms of business operations, Canadian National also has a much broader diversified portfolio of revenue streams. Canadian Pacific is overly concentrated in 3 primary revenue business components: grain, industrial & consumer products and intermodal. CN on the other hand generates significant freight revenues from there aforementioned segments, in addition to petroleum/chemical, metals & minerals and forest products. Both firms do not extensively rely on coal and automotive shipments to sustain their operations, despite that these are substantial revenue components. Because CN has a more diverse strong customer base, they will not be as adversely affected if one of the industries faces a downturn.

The Canadian National railway network extends further south into the U.S. than that of its Canadian counterpart. While CP does, with 14,800 track miles owned does not go further down than Kansas City, the CN railway network, which is around 5,000 miles larger extends all the way down to New Orleans. All of this is not all to say that Canadian Pacific Railway is a bad stock; in fact it is more attractive than some of its American counterparts such as CSX Corporation (NYSE: CSX) and Norfolk Southern (NYSE: NSC), both of which have underperformed CP on short term and long term timeframe and lag behind fundamentally in my opinion.

CN is just a better investment alternative.

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