A Value Play in Railroads
Piyush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Just because the demand for coal has declined doesn’t mean that all railroad companies are doomed. I believe that coal will rebound due to strong steel demand and higher electricity demand on the back of a recovering domestic economy. Additionally railways are used to transport other industrial commodities as well, and it’s just unfair to write them off on the back of a coal slump.
Canadian National Railway (NYSE: CNI) is Canada’s largest railroad freight transportation company offering intermodal services across North America. Its shares are up by around 99.8% over the last 5 years, and around 17% over the last 1 year. Trading at a forward P/E of 14.98x with a PEG of 1.5x, its shares may appear to have a limited upside, but I beg to differ. The company shares its market space with Norfolk Southern (NYSE: NSC), Union Pacific (NYSE: UNP), CSX Corp (NYSE: CSX) and Canadian Pacific (NYSE: CP).
Solid Cash Flows
Despite its cash flows declining from $1.328 billion to $1 billion in the first nine months on a YoY basis, its financial results were spectacular. Management explained that the annual pension contribution of $450 million was paid out in Q1FY12 as compared to Q4 in FY11. On excluding the pension contribution, its free cash flows actually rose by 9.1% in the first 3 quarters, YoY. On a quarterly basis, its diluted EPS increased by 4% on the back of lower interest expenses and higher margins.
Diversifying its Operations
Most importantly, its intermodal revenues were up by 6% and container units were up by 7% in Q3 on a YoY basis. Most of the railroad companies are counting on intermodal transportation, in order to diversify their operations and also to reduce their dependence on coal. The management expects its intermodal revenues to further increase in Q4, and told that it would be looking to expand its network in 2013.
According to Wikipedia, “Intermodal freight transport involves the transportation of freight in an intermodal container or vehicle, using multiple modes of transportation (rail, ship, and truck), without any handling of the freight itself when changing modes. The method reduces cargo handling, and so improves security, reduces damage and loss, and allows freight to be transported faster.”
This allows railroad companies to extend their reach to international destinations, which presents a tremendous growth opportunity to the industry.
A Solid Balance Sheet
Coming back to Canadian National Railway, its balance sheet appears to be solid. The company enjoys the highest net profit margin amongst peers, which is also significantly above the industry average. It also has the highest ROE and its shares carry the lowest lowest debt/equity ratio amongst the mentioned peers. Moreover, management has been able to shrink its debt/equity ratio from 77% in 2009, to 57% in 2013, which is a clear 25.9% decrease.
|
Company |
Debt/Equity |
Net Profit Margin |
ROE |
|
Canadian National Railway |
57% |
27.27% |
23.19% |
|
Canadian Pacific |
89% |
12.32% |
13.23% |
|
Norfolk Southern |
87% |
16.28% |
18.03% |
|
CSX Corp |
101% |
15.84% |
21.69% |
Additionally its shares have outperformed most of its peers in terms of stock appreciation, over a period of 5 years.
Over a period of 1 year, Canadian Pacific has outperformed all of its peers, and might appear to be an attractive investment option. But if we take a look at the free cash flow generated over the last 5 years, a scary picture pops up.
CNI Free Cash Flow TTM data by YCharts
Canadian Pacific’s free cash flows have shrunk by a whopping 682%, while its shares managed to gain 69.5% over the last 5 years. Over a period of 2008-2012, shares of Canadian Pacific have risen only 9.6%, which only explains the erratic pricing of its stock. Additionally its shares appear to be overvalued with a trailing P/E of 26.7x and a PEG of 1.66x.
Wrapping It Up
In my opinion, Canadian National Railways has good fundamentals and financials to continue delivering solid growth. I believe that the demand for coal will not fade away abruptly, which would give railroad companies enough time to diversify and reduce their dependence on coal transportation. In this comparative analysis, Canadian National Railways appears to be the best investment option in the railroads sector, and it gets a strong Foolish Outperform Rating.
PiyushArora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!
