Star-Studded Canadian Stocks Tour: CNR, Has the Stock Price of North American Rail Titan Entered the Batter's Box?

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CNR's main business includes the transportation of intermodal containers, bulk commodities such as metals, oil and grain, and retail commodities such as forestry and automotive products. In 2023, Canadian National Railways generated $16.8 billion in revenue from shipping intermodal containers (23% of consolidated revenue), petroleum and chemicals (19%), grain and fertiliser (19%), forest products (12%), metals and mining (12%), automotive shipments (6%) and coal (6%). Regionally, CNR provides its customers with local transport in Canada and commercial channels to the United States and Mexico.

As a railway transportation company, the profitability of CNR mainly depends on the change of the output of the goods transported and the transportation price. Most of CNR's main businesses are in cyclical industries, which are greatly affected by macro factors in the North American market.

CNR has more than 20,000 miles of rail lines across Canada and from the eastern United States through the United States to the Gulf of Mexico. CNR's extensive and mature cross-border rail network optimizes its transport efficiency and cost-effectiveness. Meanwhile, the cross-border railway development in North America has been relatively mature, with less overlap and high utilization rate. The return of developing entirely new cross-border railway lines is not sufficient to cover the development costs. This raises the entry barrier of transnational business and guarantees the long-term competitive advantage of CNR in multinational transportation business. As the Canada's largest and North America's third-largest railway company by revenue, CNR's price-to-earnings ratio is 19.27%, just below BNSF (Burlington and Santa Fe Northern, North America's largest railway company ) and ahead of its western rival, Union Pacific. While the latter's operating income is 1.67 times that of CNR'S. This proves the market's recognition of CNR's growth.

CNR's operating strategy focuses on efficiency, and its operating ratio (a company's operating expenses as a percentage of revenue) has been stable in the 50%-60% range over the past decade, significantly better than the industry average, which only reached the same level until 2019. Although M&A activity briefly affected margins, since the arrival of new CEO Tracy Robinson in 2022, the operating ratio has decreased significantly by focusing on improving operational efficiency, reaching 57.9% by the end of 2022, returning to the forefront of the industry.

Although labor costs, which represent about 20% of operating costs, have increased over the past two quarters as a result of the review of the company's labor contracts, labor disruptions are expected to be short-lived and labor costs are expected to decline significantly in the second and third quarters, driving overall operating costs down and margins are expected to recover.

CNR's proportion of capital expenditure in the 2017-2023 period is about 5 percentage points higher than the industry average, reaching 21%. Meanwhile, the company's revenue performance continues to exceed industry standards, and its return on invested capital has steadily improved over the past three years, highlighting the company's efficient return on capital investment. This virtuous cycle of capital investment and revenue growth has resulted in a stable free cash flow for CNR, which has remained stable at around 22%, even in the face of high development and installation costs due to the US tax reform and PTC (positive train control reform).

At the same time, CNR's debt situation is relatively stable. CNR has a debt-asset ratio of about 0.62, compared with nearly 0.77 for Union Pacific, its peer. Even during the pandemic and the period with decline performance, CNR maintained an A rating from all major rating agencies, underscoring the soundness of CNR's financial structure.

In CNR's main businesses, multimodal transportation revenue accounted for 27% of total revenue in 2023. Although the disruption in the Red Sea will have negative impact on the East Coast intermodal trade market, potential customers may choose to enter the North American market from the West Coast, and these goods will need to be transported to the central and East by rail intermodal transport. With keen market insight, CNR is actively responding to the impact of the Red Sea disruption on the East Coast intermodal market, and instead grasp the growth potential of the West Coast intermodal market. In April, the company added eight trains between Vancouver and Prince Rupert, an increase of about 20%. The company accurately captures the new demand for cargo transshipment from west to east, which is expected to offset the possible downturn in the retail goods market and expand the market share of the multimodal transport business.

While Canadian grain production was disappointed in the first quarter of 2024, signs of recovery in the second half of the year point to a pick-up in demand for rail transport. According to the US Department of Agriculture, grain production in Canada will increase by 6% in the third quarter, which will be the second strongest growth since 2017. This recovery will directly benefit CNR's grain and fertilizer transportation business. In addition, the commissioning of Côté, a new gold mine in Ontario, and the resumption of full capacity production of Canadian mines further enriched transportation demand in North America. Although the coal market still faces challenges from low natural gas prices, overall, the growth of rail transportation demand is positive.

Since the supply of rail transportation is relatively fixed, the increase in the demand for goods transportation may push up the transportation price. CNR's revenue-per-mile (RTMs, a better measure of potential rail demand) growth is already outpacing volume growth by several percentage points, putting the 2024 median growth metric within reach. According to the company's forecast, its RTM will reach 5% this year. This will drive up earnings per share and thus increase the value of the company.

Although CNR already developed more established cross-border routes, it continues to invest in its rail network, including key commercial corridors through the "No Regret Capital" program. With 25 per cent of North American rail traffic passing through Chicago, CNR is continuing to develop additional double track along the Vancouver to Chicago corridor, as well as extending the rail sidings in British Columbia. By expanding the capacity of key routes, CNR can effectively reduce traffic congestion at key commercial points and continue to support growing demand.

In its 2023 annual report, CNR proposed to repurchase 320 million ordinary shares between February 1, 2024 and January 31, 2025 (it had repurchased 35 billion as of March 31), accounting for about 5% of the total share capital of 636 million. Based on last year's dividend yield of 2%, the company's annual return to shareholders in 2024 would be about 7%. Higher shareholder returns reflect a company's commitment to sustainable growth and profit distribution and will have a positive impact on the company's share price, as investors may buy or hold shares in anticipation of higher returns.

Overall, despite the disappointing performance of the CNR in the first quarter, the expected increase in Canadian grain production and the recovery of the mining industry in the second half of the year are expected to boost rail transport demand. In addition, the company continues to expand the railway network and increase the frequency of trains, which will effectively support the increase in business demand. At the same time, CNR's sound and conservative financial strategy and stable cash flow in the face of adversity also suggest its long-term growth potential.

It is worth noting that at a time when the market generally undervalues the rail transport sector, although management initiatives have improved CNR's margins, the current negative sentiment is still depressing the valuation of the entire group due to the development of competitors in the past. There is reason to believe that CNR's high margins and effective operational improvement measures are not fully reflected in its market valuation. Meanwhile, combined with the gradual recovery of the global economy and the interest rate reduction environment in North America, it is expected that CNR's financial costs will be further reduced, injecting more growth momentum into its main business. So, in the long run, CNR's current share price may present an opportunity for investors to get into quality assets.

In addition, higher shareholder returns in 2024 will also have a positive impact on the share price, which is expected to provide support for the company's share price and improve the yield for investors.

However, because the rail transportation industry is heavily dependent on price and output conditions in its goods and cost markets, factors such as fluctuations in commodity markets, fuel costs and labor expenses may also pose risks to the company's operating margins and profitability. For investors, identifying and taking advantage of the possible undervaluation opportunities in the current market and paying attention to the changes in macro factors affecting railway transportation demand and cost control will be the key to grasp the value of CNR investment.