Canadian National Railway (NYSE:CNI) (TSE:CNR) and Canadian Pacific Kansas City Limited (NYSE:CP) (TSE:CP) are two great railroad operators that have delivered satisfactory returns to shareholders over the years. With extensive networks of approximately 20,000 route miles each, the two Canadian giants control a massive, capital-intensive infrastructure forming an impressive moat, ensuring sustained success. Still, this unique advantage comes at a hefty price. Thus, I am neutral on both names.
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What are the Most Prominent Qualities of CNI and CP?
Before assessing the less-than-enticing valuations of CNI and CP, it’s vital to review the foundational qualities that underpin these metrics. I’m specifically referring to the firm ability of railroads to generate consistent and predictable cash flows, as well as their ability to uphold strong competitive advantages (i.e., a moat). These qualities contribute to their sustained success, which is unlike any other type of business.
1. Consistent & Predictable Cash Flows
Railroads, particularly when it comes to CNI and CP, which are the biggest Canada-based players, serve as the backbone for the transportation of a diverse mix of goods across vast distances. Basic commodities like wheat, coal, grain, and various agricultural products, which enjoy consistent demand irrespective of economic conditions, ensure that railroad operators remain busy all year round.
The resilience of railroad giants in generating predictable cash flows is further underscored by their unparalleled scalability and operational efficiency compared to alternative solutions. If you want to transport massive volumes of goods over large distances with an emphasis on minimizing your per-unit costs, railroads distinctly outperform alternative modes, such as trucking, by a substantial margin.
Owing to the consistent demand for railroads and clients’ desire to secure their future transportation schedules, prominent railroad players like CNI and CP often enter into long-term partnership agreements. This multi-year focus on sustained collaboration essentially ensures reliable revenue streams, further fortifying the stability and predictability ingrained in the railroad industry.
Evidently, looking at CNI’s and CP’s revenue track records, one will rarely see significant dips, even during recessionary periods. In fact, with commodity prices rising over time and the cargo transported becoming more valuable (including inflationary forces), the two companies tend to charge more over time, slowly growing their revenues in a rather consistent manner. In particular, CNI and CP feature revenue growth compound annual growth rates (CAGRs) of 5.6% and 4.5%, respectively.
2. High Barriers to Entry (Moats) Widens Margin of Safety
Another pivotal factor securing the enduring prosperity of both CNI and CP lies in the high barriers to entry inherent in the railroad industry. The development and operation of a railroad include complex and capital-intensive efforts. It essentially requires massive investments to construct tracks, bridges, tunnels, and the acquisition or leasing of locomotives and railcars.
Such a significant commitment serves as a robust deterrent, reassuring investors of the likelihood of any new entrant successfully establishing a competitive foothold comparable to the infrastructure of CNI and CP. Adding to the moat point, railroads must navigate the complexities of securing government approval and rights of way to operate, further fortifying the protection against potential newcomers.
In an enduring oligopoly, a select few players wield dominance, with consolidation in recent years (Canadian Pacific and Kansas City Southern merging last year) further shutting the industry.
CNI & CN Appear Expensive, Nonetheless
CNI and CP undoubtedly exhibit unique characteristics that distinguish them from the typical businesses subjected to the market’s competitive dynamics. Consequently, investors have consistently demonstrated a willingness to assign a premium valuation to their shares.
Presently, CNI and CP are trading at forward P/E ratios of approximately 21 and 24, respectively. The slight premium of CP over CNI is justified by investors’ anticipation of a 13.3% average annual growth in EPS over the next five years in contrast to CNI’s more moderate 4.9%.
However, both stocks strike me as notably overpriced. Despite their commendable attributes, the railway industry has reached a high level of maturity, with its growth seldom surpassing inflation by a significant margin. Even in the case of CP, poised for medium-term acceleration, one should temper expectations, considering the historical performance of railroad companies, which rarely achieve growth that exceeds the single digits.
Don’t get me wrong, both names have historically been expensive while still delivering satisfactory total returns. It’s just that the margin of safety is thin. A multiple compression is more likely than an expansion at their current valuations, making me uneasy to invest.
Personally, I wouldn’t be willing to pay more than 15-20x earnings for either railroad stock to secure a more favorable shareholder yield. To add to this point, their dividend yields, standing at 1.9% and 0.7%, offer a limited safety cushion in the face of potential multiple compression, further reinforcing my conviction in this point of view.
What are the Price Targets for CNI and CP Shares?
Turning to Wall Street, Canadian National Railway Company has a Hold consensus rating based on four Buys, 14 Holds, and one Sell assigned in the past three months. At $125.09, the average CNI stock forecast suggests 0.9% downside potential.
When it comes to Canadian Pacific Kansas City, the stock features a Moderate Buy consensus rating based on 16 Buys and eight Holds assigned in the past three months. At $84.71, the average CP stock forecast suggests 9.4% upside potential.
The Takeaway
In conclusion, while Canadian National Railway Company and Canadian Pacific Kansas City Limited retain commendable qualities, including a vast and resilient infrastructure, their current valuations appear rich. The railway industry’s maturity and historical growth patterns caution against overestimating future prospects. Despite the industry’s high barriers to entry and consistent cash flows, prudent thinking suggests adopting a cautious approach.
Given that the modest premium assigned to CNI and CP may not align with the industry’s long-term growth potential, waiting for a better entry point may be the smarter option.
