Since putting out my most recent cautionary note about Canadian National Railway (CNI), the shares are up about 8.9%, against a gain of 11.5% for the S&P 500. Given that the company has reported full-year results since, I thought I’d look in on the name to see if it’s now worth buying. I’ll also update the options trade that I recommended in October and will present a new one. For those who can stand neither the suspense nor my writing, I’ll jump to the point. In spite of the fact that the company has added too much debt over the past six years, Canadian National Railway is very profitable, is well-run, and is very shareholder-friendly. That said, I still cannot recommend the shares at these levels. The company has traded at this valuation three times over the past several years, and the shares have subsequently dropped in price. While I don’t think history repeats, it may rhyme. The last time the shares were this expensive on a P/E basis, they went on to perform badly. For that reason, I must recommend that investors wait for a more attractive entry price.
A review of the financial history here reveals that Canadian National Railway is very well-run company. Over the past six years, revenue and net income have grown at a CAGR of 3.5% and 4.9% respectively. Although the rate of net income growth has slowed somewhat, these numbers are particularly impressive, in my view, in light of the fact that carloads only increased at a CAGR of ~1.28% over the same time period. Clearly, the company is earning more per dollar of assets. I don’t pay much attention to it myself, but others focus on the operating ratio, and it’s improved by about 220 basis points over the past six years. Additionally, as a result of an aggressive buyback program, earnings per share have grown at a CAGR of ~7.2% over the same time period. The aforementioned buyback program has caused shares outstanding to decline at a CAGR of ~2.15% since 2014.
Management has been quite good to owners, in my view, having returned just over $17.6 billion Canadian dollars to them since 2014 in the form of stock buybacks and ever-increasing dividends. This combination of fewer shares and more capital allocated toward dividends has resulted in dividend per share growth of ~9.5%. In my view, a shareholder-friendly management is critically important, because an unfriendly management virtually guarantees disaster.
Nothing’s perfect, though, and Canadian National Railway is no exception. The level of long-term debt has grown at an alarming rate over the past six years, in my view, up at a CAGR of about 4.8%. More troubling still is the fact that the interest expense has grown at an even faster rate (6.4%). In my view, this level of debt growth isn’t sustainable. While the payout ratio remains quite low (37%), it’s been creeping up over the years. At some future date, cash will need to be used to either pay down or service debt. When that happens, obviously, buybacks and dividend increases will suffer. Also, the company’s operating ratio deteriorated significantly to 66% in the fourth quarter of 2019 last year, up from 61.9% the year earlier. This may be a harbinger of lower profitability this year.
Finally, I couldn’t live with myself if I didn’t point out the myopia of some of the contributors on this site. In particular, some have expressed a fear that CNI’s rail traffic was slowing. As can be seen below, carloads were down ~1% in 2019 relative to 2018. This is, technically speaking, a “slowdown.” Getting a tiny sliver of wood in your finger might also be described as an “injury.” The company did slow, but by such a small amount that it’s hardly worth mentioning.
(Source: Company filings)
With apologies to my regular readers who’ve heard this sentiment a few dozen times over the past few dozen articles, investing is about much more than simply buying a great business with a great moat such as this one. At least as important is to not overpay, because the evidence is pretty clear that the more an investor pays for something, the lower will be their subsequent returns. The way I frame this mental exercise is to suggest that it’s a good idea to eschew shares that are optimistically priced. The reason for this is that sooner or later, forecasts that are excessively optimistic will be dashed and the shares will suffer. I judge the optimism embedded in price in a few different ways. First, and most simply, I compare the ratio of price to some measure of economic value (earnings, free cash flow, etc.). On that basis, per the following graphic, the shares are trading near a multi-year peak valuation.
The last time investors paid this much for $1 of future earnings, their short-term returns were very disappointing.
In addition to looking at the simple ratio of price-to-earnings, I want to try to understand what the market must be thinking about the future growth of the business. To do this, I turn to the methodology described by Professor Stephen Penman in his book, Accounting for Value. In this book, Penman describes how an investor can use a fairly standard finance formula and basic algebra to isolate the “g” (growth) variable to understand what the market must be thinking about long-term growth. Applying that methodology in this case suggests that the market is forecasting a perpetual growth rate of about 6.4%. I consider this to be a massively optimistic forecast.
In the previous article cited above, I recommended selling put options. Specifically, I recommended selling the April 2020 CNI puts with a strike of $75. At the time, these were bid-asked at $.85-1. The combination of an 8% uptick in the stock price and time value erosion has reduced the value of these massively, which is quite good, in my estimation. As of now, they last traded hands at $.20 and have a bid of $0. In the spirit of trying to repeat success, I’ll offer another such trade, reasonably safe in the belief that the aforementioned puts will expire.
At the moment, I’d be comfortable selling the July CNI put with a strike of $80. These are currently bid-asked at $.60-$.75. If the investor simply takes the bid on this, and that is subsequently exercised, they’ll be buying at a net price of ~$79.40. I consider this reasonable enough given that this price represents a dividend yield of ~2.1% and a P/E of about 17. Of course, if the shares flatline or rise from these levels on the back of hopes the market has for 2020, recent history will repeat and the options will expire worthless. For my part, I’m comfortable under either scenario, and as a result, I’m comfortable recommending the trade to others.
In my previous piece on Canadian National Railway, I suggested that the shares were overvalued, and they went on to underperform the market. I think the problem has actually gotten worse as the company approaches a multi-year high valuation. Given that the last time the shares were trading at this valuation, they went on to underperform, I think now is a particularly dangerous time to buy. That said, I think there is another short option trade that can generate some kind of return. I think these short puts present a win-win trade because they either generate premia or they lock in a price that is much more attractive long term. I can’t recommend buying the shares at the moment, but I can certainly recommend selling these puts.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I’ll be selling the puts mentioned in this article.