Canadian National Railway
I am interested in buying a new Canadian Company for the sake of diversifying my portfolio and because of the different exchange rates of the US and Canadian dollars compared to the Euro. However, I do need to find a company I like for the long term and which has a good valuation. For this purpose I will research different Canadian companies that are on my wish list and see how they perform on both the quality side of the company as on the valuation side of the company. I start this series with Canadian National Railway Co.
Before really starting I want to thank Passive Income Pursuit. I read some of his analysis on Seeking Alpha like the one you can find here about Pepsi and I like the way he analyses companies. Therefore I “borrowed” his ways of analysing a company and combined this with my own thoughts. You can find the site of Passive Income Pursuit here.
What does the company do?
Canadian National Railway Co (CNR) is engaged in the rail and related transportation business. The Company transports goods for business sectors. The goods include resource products, manufactured products and consumer goods.
CNR is one of the greatest railways in Canada. I really like the company for its track record to increase stock holder value which it can do through an outstanding service and some sort of monopoly because of the railways it owns. The company has a great dividend history and the share prices grows very well over the last 10 years. The way the company generates money is easy to understand which helps me understanding the business itself. Let’s look into more detail how the company performs.
Let’s take a look at the dividend history of Canadian National Railway. CNR has increased its dividend each year since it went public in 1995 which results in an impressive 22 year dividend increase streak. Not only that, but the company managed to grow its dividend with 16,4% a year on average.
This growth is actually pretty impressive. Especially because it’s made without a single cut or stagnation. I entered the dividend data into the table below and added the 1-year, 3-year, 5-year and 10-year growth percentages to the table.
As you can see the growth fluctuates quite a bit when looking at 1 year growth rates. However, when you look at the Multi year growth rates it smooths out very good which indicates that CNR is steadily growing its dividends.
I have established that the dividend growth of Canadian National Railway is great. Next up is the Cash flow statement of the company. What I would like to see is steadily increasing cash flow and revenues.
CNR has a great growth in Earnings over the past 10 years. The company grew earnings with 4,3% annually since 2006. The total growth is 51% over these years.
The growth of the Operating Cash Flow is even more impressive. The company managed to grow the OCF with 5,8% annually for a total growth of over 76%.
The growth of the Free Cash Flow is a nice average of the two. The FCF grew with 4,6% annually with a total growth of 55%.
When looking at the Operating Cash Flow margin we see that it has improved over the same time period. Not surprising seeing the bigger growth compared to the revenue growth. The Free Cash Flow Margin had its up and downs but it increasing nicely since 2013 and just passed the margin of 2006.The rising trend of both margins is clearly visible in the graph, especially since 2012 / 2013. It would be nice to see how far the company can take this. Those margins indicate how much cash the company generates for every dollar invested in the company. Seeing this increase increases profitability without revenue increase and this in turn increases the possibilities to increase the dividend or share buybacks.
Free Cash Flow is the most important metric in determining the profitability of a business. To be worthy of an investment a company must have a positive and growing Free Cash Flow. We already found out that this is the case for CNR. The next step is to find out what the company does with the Free Cash Flow. Most mature companies pay dividends and a lot of them buy back shares. CNR does both of them. Therefore I use the following metrics to see how CNR uses the FCF.
- Free Cash Flow (FCF). This is the Operating Cash Flow of a company minus the Capital Expenditures (CAPEX).
- Free Cash Flow after Dividends (FCFaD). This is the Free Cash Flow minus the payment of Dividends.
- Free Cash Flow after Dividends and Share Buybacks (FCFaDB). This is the FCFaD minus the money used to buy back shares.
These 3 metrics give a great view on how CNR uses its Free Cash Flow. In a great world the company still has money left after they paid for Dividends and Share Buybacks. That would mean that they won’t have to access the capital markets for future dividend increases.
We already established that CNR grew the Free Cash Flow with 55% over the past 10 years. This means that the company has money to pay dividends and / or buy back shares.
The FCFaD is still great. After all dividends have been paid for the company still has a lot of spare cash to use for buy backs or to reduce debt and strengthen the balance sheet. The FCF pay out ratio averages 38,7% over the last 10 years. At the moment it’s a bit higher with 46%, but this is still a great percentage. However, it looks like the trend is going up which might indicate that dividend increases can slow if the company can’t grow faster in the coming years.
The FCFaDB is a bit worrisome. In only 2 of the years analyzed the company managed to have a positive FCFaDB. This means that in all the other years the company had to take on loans to finance the share buy backs. Although the debt does not seem to be a big burden for the company this is something to keep an eye on. I would prefer to see positive FCFaDB.
While analyzing the dividends we have seen that Canadian National Railway has a great dividend history with every growing dividends. During the quantitative analysis we have seen that revenues and FCF are increasing very well. So this all looks great. The only thing that worries me a bit is the FCFaDB since that is negative in almost all the analyzed years. However, I don’t see this as a big problem at this moment in time.
So we established that there is a lot to like in CNR. The next thing on my to do list is to see if the valuation is good or not. In the end, I don’t want to end up paying too much for a company. That means less dividends in the long run and less capital appreciation and that can eat profits away very fast.
CNR realized Earnings per Share (EPS) of CAD 4,67 in 2016. According to Morningstar analyst estimates for 2017 are CAD 4,94 and for 2018 the estimates are CAD 5,42. This means analysts expect the stock to grow 5,8% in EPS in 2017 and 9,7% in 2018. For my calculation I assumed that the EPS will grow by 6% for the next 5 years and with 4% for the years after that.
The annual dividend payment in 2016 was CAD 1,50 which represents a pay out ratio of 32,1%. I assume that Canadian National Railway increases its dividend with 10% the first 5 years and with 8% after that. This is lower than the average annual increases in the past, but I’m assuming this growth because of the negative FCFaDB that we looked at earlier.
When we look at the historical PE of CNR we see that the average PE ratio according to Morningstar was 18,3 during the past 5 years. At the moment the PE ratio of the stock is 20,7. However, when we look further back then 5 years we can see that the average PE was much lower than the 18,3 average of the past year. So it seems that the stock is trading at a higher PE since 2013 up till now. The question is if this higher PE will be stable for the future or that it will revert back to the long term mean. I personally expect that the current PE is on the high side. Therefore I expect the company to trade between a PE of 15 and 22 in the future.
I start with calculating the current reasonable prices to pay at the different PE ratios in the future by assuming an 8% Internal Rate of Return. When I do this I get the following figures.
When we look at the above table you can see that, assuming a PE of 18,5 five years from now, a current purchase price of CAD 95,25 would realize a 8% internal rate of return. This is above the current price, so when you expect a PE of 18,5 5 years from now and you are happy with an 8% return, now could be a good time to buy. However, when you compare the price for a holding period of 10 years you should buy below CAD 90,75 to realize the same return.
When we increase the internal rate of return to 10% (in other words, we raise the minimum we want to earn on the stock), we get the following table.
As you can see you now need a future PE of 20 before you can call the stock fairly values. This implies a certain risk you must be willing to take if you want a 10% rate of return. If you look at the value 10 years from now it seems that the stock is even more over valued and none of the PE ratio’s match the 10% return rate.
All in all it seems that Canadian National Railway is slightly overvalued at this time. I am certainly interested in the stock, but I prefer a pullback to around CAD 90,00 maximum before initiating a position. On the other hand, I believe my estimates are fairly conservative. That means that a deviation to the upside is more likely than a deviation to the downside.
What do you think of CNR? Do you have CNR in your portfolio? And how do you look at the current value of the company? Don’t hesitate to share your comments below!
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