Canadian National Railway, Canadian Pacific Railway – Best Railway Stocks

This is a guest contribution from The Financial Canadian.

“These companies will never go away,” – T. Rowe Price equity analyst Andrew Davis on the railway sector

Railways are great companies to own.

They have one of the widest economic moats due to the high barriers to entry that exist in this industry. The tracks for Canada’s great railways were laid centuries ago, when land could be bought for pennies per acre and regulation was nonexistent. Just thinking about all the work that would be required to start a new railway company today gives me a headache.

Railroads are also a good investment because they are considered a proxy for the overall economy, and historically, the economy has gone nowhere but up. Some investors may counter this argument by saying that railroads are an outdated industry. While the railroad sector has existed for centuries, current railroads are optimized for maximum production – and regardless of future innovations, there will always be a need for the movements of good from one place to another.

So railways possess the economic moat that investors like Warren Buffett have come to recommend, and they have good future prospects based on the assumption of future economic growth. You can see Buffett’ 20 highest yielding stocks here.

That begs the question – which railway is the most attractive investment currently?

In Canada, there are two main players. These are Canadian National Railway (CN) and Canadian Pacific Railway (CP). Both are Class I railroads, of which only 7 exist in North America. Their size and operational scope serve to increase their already massive economic moat.

Looking into the fundamentals of these companies shows us that there is a clear choice for an investment right now. Let’s find out which one it is.

Company Overview – Canadian National Railway

Canadian National Railway, Canadian Pacific Railway Source:  CN 2015 Annual Report
Key Stats

  • Stock Price: $85.76
  • Market Cap: $66.47B
  • P/E Ratio: 18.90
  • P/B Ratio: 4.42
  • Dividend Yield: 1.75%
  • Payout Ratio: 30.35%

Source: Google Finance, YCharts, & Yahoo! Finance

From their website:

“A rich history and a bright future. We are more than just a railroad. We are a transportation company that offers integrated transportation services: rail, intermodal, trucking, freight forwarding, warehousing and distribution. We continue to deliver the goods year in and year out. We are an engaged corporate citizen, committed to the safety of our employees, customers and the public.

CN is invested in building shareholder value and stronger communities, focused on environmental stewardship and developing an exceptional environment in the workplace.”

With the slogan “North America’s Railroad”, Canadian National Railway is Canada’s largest railroad. They are headquarted in Montreal, Quebec, were incorporated in 1919 and have been transporting goods across Canada ever since.

This company is led by CEO Luc Jobin, who assumed the role in July 2016. While new to the CEO role, he was the company’s Executive Vice-President and Chief Financial Officer since 2009. This is a positive for me as I am personally biased towards CEOs who were previously CFOs or COOs of the same company – I feel as though they have a greater sense of the company’s finances and operations.

Jobin is surrounded by a talented management team with a healthy mix of new talent and old heads. With Jobin, Mike Cory (Executive Vice-President and Chief Operating Officer), and Ghislain Houle (Executive Vice-President and Chief Financial Officer) assuming their roles in July 2016, the company seems to have a solid management team in place for the foreseeable future. Both the COO and CFO are new to their roles but veterans to the company, joining in 1981 and 1997, respectively.

Company Overview – Canadian Pacific Railway

Canadian National Railway, Canadian Pacific Railway Source:  CP 2015 Annual Report
Key Stats

  • Stock Price: $200.19
  • Market Cap: $29.61B
  • P/E Ratio: 20.49
  • P/B Ratio: 6.22
  • Dividend Yield: 1.00%
  • Payout Ratio: 15.83%

Source: Google Finance, YCharts, & Yahoo! Finance

Although CP’s website doesn’t seem to offer a succinct company overview like CN’s does, I’m sure you get the idea- – CP is a large Canadian railway company with operations that run nearly coast-to-coast. They are also much older than their rival. CP Rail was incorporated in 1881.

CP is led by CEO E. Hunter Harrison, who has been in the position since 2012. Previously he was the President and CEO of CN, where he also served as Executive Vice-President and Chief Operating Officer. CP’s management team (including Harrison) is set to undergo some serious changes in the near future (more on that later).

CP is a much smaller company than CN, although they have existed for longer. CP’s market cap of $29.61B is more than doubled by CN’s $66.47B. As you can see, Canadian National Railway’s track system is also much larger than rival CP’s (again in line with their differences in market capitalization):

Canadian National Railway, Canadian Pacific Railway

How to Analyze Railway Stocks

Before I dive into the fundamentals of each of these companies, I’m going to write a word on analyzing railroad stocks.

In a sense, railways operate in a very straightforward line of business. They get paid to move cargo from Point A to Point B along railway tracks. In some ways analyzing railway stocks is no different than any other companies – look for earnings growth, revenue growth, strong return on equity (ROE), and dividend growth.

There are also some particular metrics that are unique to the railway industry. The most important is Operating Ratio, calculated as operating expenses divided by revenue. Operating expenses are those required to do business, but not directly involved in the production of goods. Savvy investors will recognize that operating expenses are the opposite of operating margin (which is operating income divided by revenues).

Capital expenditures (or CAPEX – them money required to maintain fixed assets) are also a major concern for railways (though I won’t discuss it in my analysis). It requires massive amounts of capital to maintain the tracks that these companies use to do business. Given that CN had 108,411 carloads and CP had 52,246 carloads in the last reported week alone, these maintenance costs definitely add up.

Canadian National Railway, Canadian Pacific Railway
Source:  CN Website Canadian National Railway, Canadian Pacific Railway Source:  CP Website
This section was included because I’m going to be using the Operating Ratio to compare these two companies. Now, let’s begin to look at the investment theses of CN and CP.

Investment Thesis – Canadian National Railway

In 2015, Canadian National Railway had a fantastic year. Their operating ratio of 58.2% was lower than in 2014 (61.9%) or 2013 (63.4%). The company’s adjusted diluted earnings per share were up 18% year-over-year to $4.44. This was translated to a dividend increase of 25%, from $1.00 in 2014 to $1.25 in 2015. CN has also been generous with share repurchases, committing $1.75B in 2015, $1.505B in 2014, and $1.4B in 2013.

Year-to-date, CN’s impressive results continue. Let’s take a look at their second quarter. Adjusted diluted

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