CN Rail Metals Transportation
Canadian National Railway reported better-than-expected second-quarter earnings after the bell Monday night, and shares are up 1.5 per cent in early Tuesday trading on the TSX. However, investors should be cautious in buying the stock.
Financial Results
Revenues were $3.125 billion, relatively in-line with the consensus estimate of $3.129 billion. Operating income increased 8 per cent year-over-year to $1.362 billion, and adjusted earnings per share came in at $1.15, well above the consensus estimate of $1.05, with 12 per cent year-over-year earnings growth. Also positive was that management re-affirmed its guidance for double-digit earnings growth for 2015 despite weakness in the energy sector, difficult year-over-year comparisons, and sluggish economic growth in Canada.
Despite declining volumes, management was able to successful execute and deliver solid financial results through effective cost management. The company's strong operating ratio was the key takeaway from the financial results. This ratio is simply the company's operating expenses as a percentage of revenues, with a lower operating ratio being positive. The company's operating ratio dropped 3.2 per cent to 56.4 per cent from 59.6 per cent in the prior year, a record level for the second-quarter. Operating expenses declined mainly due to lower fuel costs and lower labour expenses.
Management has reduced its labour force, trimming its headcount by approximately 3 per cent over the past quarter. The company has a hiring freeze, thereby reducing hiring and training expenses, and is also reducing overtime costs – all of these measures are aimed to reduce its operating expenses. Management has also other operational improvements, reducing dwell time and improving yard productivity.
CN Rail's management team has effectively and quickly adapted to a lower volume environment. Volumes were down in five of the seven segments. Coal, grain and fertilizers, and the metals and minerals segments led the declines, with strength from the automotive and intermodal segments. However, effective cost management combined with higher pricing and the strengthening U.S. dollar benefited the company. Same-store pricing was up 3.9 per cent in the second quarter. The declining Canadian dollar was also positive for the company. CN Rail reports in Canadian dollars but a large percentage of its revenues and expenses are in U.S. dollars with the company generating more revenue than expenses in U.S. dollars.
Dividend Policy
The company's balance sheet remains strong and its free cash flow can support future dividend increases. Management intents to slowly increase the company's payout ratio to 35 per cent. Management is also actively buying back shares. Currently, the company pay shareholders 31.25 cents per share each quarter, equating to a yield of 1.6 per cent.
Valuation
The stock closed on Monday at $78.95, at this level, the stock is trading at a price-to-earnings multiple of 17.1 times the 2016 consensus earnings estimate, above its three-year historical average p/e multiple of 16.0 times.
Chart Watch
The stock is at overbought levels, with a relative strength reading of 70. Generally, a reading at 70 and above indicates an overbought condition. There is upside resistance at $79.50, near its 200-day moving average, and downside support at $76.50 and in the $74 to $74.50 range, the 50-day moving average is at $74.24.
Analysts' Recommendations
There are currently 8 "buy" recommendations and 20 "hold" recommendations. The average one-year price target is $84.40, implying a potential price return of just 6.9 per cent. There have been positive earnings revisions for 2015 and 2016 by analysts. The consensus earnings estimate is $4.16 for 2015 and $4.62 for 2016.
The Bottom Line
Wait for a pullback to accumulate shares. The company delivered a positive earnings surprise and analysts have been revising their annual earnings estimates up. While I recommended shares of CN Rail to readers on June 14 when the stock price was $73.01 as the stock was inexpensive, trading below its three-year historical average, the stock has since rallied over 8 per cent and for this reason. I recommend investors wait for a dip in the stock price.
I continue to like shares of CN Rail. The company has diversified exposure to numerous markets, a solid management team that is committed to containing expenses and returning capital to shareholders through its quarterly dividend that I expect will steadily be increased over the years. CN Rail is an excellent investment for long-term investors - but wait for a dip as the stock price has gotten ahead of itself in the near-term.