Canadian National Railway (CNI) has increased its dividend every year since its initial public offering in 1995, averaging 17% annual growth over that time period.

Since they were deregulated in the 1980s, railroad operators have enjoyed a boom in productivity and fortified their position as an essential piece of North America’s supply chain.

The slump in commodity prices has caused a number of railroad stocks to go on sale, and CN looks particularly interesting since it has less exposure to the weakest commodity – coal.

Despite commodity price volatility, CN raised its dividend by 20% earlier this year and expects to continue increasing its dividend at a faster rate than overall earnings growth.

Let’s take a closer look to see if this high quality railroad operator is worthy of inclusion in our Top 20 Dividend Stocks portfolio.

Business Overview

CN was formed in the early 1900s through the combination of several financially-challenged railways and was later privatized in 1995.

Today, CN owns and operates approximately 20,000 miles of railroads across Canada and mid-America, connecting the Atlantic, the Pacific, and the Gulf of Mexico.

The company handles more than $250 billion worth of goods each year and carries over 300 million tons of cargo for exporters, importers, retailers, farmers, and manufacturers.

CN’s freight revenue is primarily composed of seven commodity groups – intermodal (24%), oil and chemicals (21%), grain and fertilizer (17%), forest products (15%), metals and minerals (12%), automotive (6%), and coal (5%).

By geography, 33% of the company’s revenues relate to transborder traffic, 31% overseas traffic, 18% U.S. domestic traffic, and 18% Canadian domestic traffic.

Business Analysis

The Canadian railroad industry was deregulated in 1987 under the National Transportation Act, resulting in the cancellation of transportation subsidies and deregulation of freight rates for most commodities. It also resulted in the privatization of CN in 1995 (CN was previously government-owned).

The Canada Transportation Act went into effect in 1996 and further transformed the Canadian rail industry to make it more competitive.

Unlike the National Transportation Act, which provided little room for rail operators to restructure their operations and become more productive, the Canada Transportation Act allowed railways to speed up their restructuring via employment reductions, investments in more efficient equipment, and elimination of low-traffic lines.

Since the act was passed, CN has seen its operating ratio fall from about 80% to less than 60% today, representing a remarkable improvement in productivity.

Today, freight rail service in Canada is essentially a duopoly between CN and Canadian Pacific Railway.

Given the company’s geographic diversity, it’s worth quickly reviewing the U.S. railroad industry, which was deregulated by the Staggers Rail Act of 1980.

Similar to the situation in Canada, U.S. railways have enjoyed substantial improvements in productivity to become more profitable and competitive with alternative modes of transportation.

The industry also consolidated to further boost productivity, and the three largest U.S. railroad operators account for more than 60% of total rail miles in the country today.

Warren Buffett is a fan of railroad operators and acquired Burlington Northern Santa Fe (BNSF) in 2010 for $34 billion, adding the company to Berkshire Hathaway’s portfolio of high quality dividend stocks.

Railroads possess many of the characteristics Warren Buffett admires in a business. They own hard-to-replicate assets, provide essential services, have strong pricing power, and enjoy higher demand as the world’s population grows.

CN has invested billions of dollars to build a railway network that is capable of reaching about 75% of the population in North America. The company reinvests close to 20% of sales into capital equipment, which dwarfs most companies’ capital spending of 2-4% of revenue.

Few companies have the capital needed to build and maintain competitive railroads.

There are also only so many routes available in the market, making it harder for potential new entrants to enter the industry.

Incumbent railroad operators already have access to largest markets in North America and maintain the economies of scale needed to price their services at rates that potential new entrants cannot match.

Take Canada’s grain market, for instance. According to The Economist, “Of the 340 inland grain terminals on the Prairies, only six are served by both railways [CN and CP] and another 22 are within 30km of both.”

As a result of the industry’s concentration, railway operators also enjoy consistent pricing power. CN’s pricing policy is inflation plus and has delivered 3-4% annual pricing gains over the last 10 years.

In addition to pricing power, CN’s investments in track infrastructure, technology, and other equipment have helped it maintain industry-leading productivity measures in a number of categories.

As seen below, the company has the lowest terminal dwell time and the highest train velocity of any major operator. These factors help it maintain an operating ratio below the industry’s average.

Canadian National CNI Dividend

Source: Canadian National Railway 2015 Annual Report

As long as the company continues to invest in productivity, it should remain a critical part of North America’s supply chain for many years to come.

The railroad industry is very durable, and freight volumes tend to track population growth over the long term.

For example, between 2010 and 2035, the Federal Railroad Administration expects that the U.S. freight system will see a 22% increase in the total amount of tonnage it moves driven by continued growth in the country’s population.

CN will likely remain a critical component of North America’s supply chain thanks to its cost-effective railroad network, productivity investments, and strategically located assets.

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Key Risks

The fiscal year 2015 was filled with records for CN – revenues, operating income, net income, and earnings per share all reached new all-time highs in Canadian dollars. The company also attained a record operating ratio of 58.2%.

However, not all is well in the railroad business today. The slump in commodity prices is weighing on shipping volumes.

CN is experiencing the greatest weakness in coal, crude oil, and sand for fracking. It’s no secret that railroads have benefited from the boom in commodity prices and shipments over the last decade.

No one knows when commodities will find a bottom, but it’s hard to imagine most prices remaining lower than where they are today in five years.

In other words, outside of coal, I don’t see commodity weakness threatening CN’s long-term earnings power.

It’s also important to keep in mind that coal only accounted for 5% of the company’s freight revenue last year. While new power plant emission regulations and low gas prices have accelerated the decline in coal, CN simply doesn’t have that much exposure to the commodity.

Oil is probably the bigger risk since the Alberta oil sands have a higher cost of production than other regions. There is also some uncertainty over the impact, if any, new pipeline capacity could have on railroad demand since it represents an alternative transportation method.

No one knows what commodity prices and shipments will look like over the next year, but CN will likely be just fine over the long run given the cost-effectiveness of rail and its duopoly status in Canada.

Despite the weaker volume environment today, the company continues generating solid performance. CN recorded a record first

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