Canadian National Railway: Valuation Dip Is An Opportunity

seekingalpha04-26

Buy rating for Canadian National Railway Co. due to dip in valuation and positive carload volume growth.CNR operates railways in North America with a broad network and little competition.Labor costs ...

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(NYSE:CNI) (TSX:CNR:CA), as the dip in valuation presents a compelling entry point to long the stock. I believe the market is too myopic on the step-up in operating ratio [OR], but if we were to take one step back, 1Q24 OR is actually still pretty good relative to history. The recent weekly data also suggests that volume is picking up to positive growth, and with more volume, OR should come down due to operating leverage. Business description CNR is in the business of operating railways in North America and is one of the five class 1 rail carriers with more than 20,000 miles of rail routes. As you can see from the map below, there is little overlap. CNR rails run across the entire Canada and penetrate the US from the eastern part of the country, alongside the Mississippi River all the way to New Orleans. CNR's competitive advantage stems from the fact that North America is unlikely to have another cross-national railway (class 1 category) as the routes are already in place. Any new routes are likely to be on a small scale to allow accessibility to deeper parts of the country. Which means there is no new entrant competition. In the areas where CNR operates, it competes against other class 1 rail operators, and its advantage is its broad network that allows freight transport from entire Canada to the east of the US and to the Gulf of Mexico. ACWR 1Q24 earnings (announced on 23-04-2024) CNI revenue fell by 1.5% to CAD4.25 billion, coming 70bps below consensus expectations for CAD4.28 billion. But EPS at CAD1.72 was in line with estimates of CAD1.71. Driving the revenue decline was total carloads falling by 70 bps, while revenue/carload fell by 120 bps, primarily on lower fuel surcharges. The major takeaway was that CNR fared poorly on OR, which saw 210bps decline to 63.6%, the worst OR since the past 7 quarters. As a result, the share price took a beating, falling by ~6%. Thankfully, this drop has made the valuation slightly more attractive today, at 20x forward earnings vs. 22x a few weeks ago. Improving carload trends should drive OR down May Investing Ideas I believe the market might be too myopic on the tick-up in OR. While this uptick breaks the trend over the past quarters, when compared to past years, 63.6% OR is actually still in very good territory. I am expecting OR to fall back to <60% as CNR sees improvement in carload (i.e., volume), which carries a high incremental margin. The data reported in 1Q24 earnings showed that carload growth remained negative into 1Q24 and was largely unchanged vs. 4Q23 (at -1% y/y growth), but if we look at the weekly available data, most of the decline was seen in the early weeks of 1Q24, and the trend line has turned positive from week ~10 onwards. What I can infer here is that 1Q24 performance was basically dragged down by the bad weather (especially for January) and is not due to any structural reasons. The recent positive growth suggests CNR carload growth to be up around 3 to 4%, and looking at the momentum, 2Q24 carload growth should turn positive, hence pushing down OR due to the incremental volume. There are a few areas to monitor here. First is the potential y/y headwind from Grain against the tougher comp in 1H23 through 1H24, but I note that this is just a relative measure. Second is coal, which volume should see support from mines in Canada coming back to full production (management noted production issues impacted volume) but US export thermal coal is likely to remain under pressure due to the surplus of natural gas. Elsewhere, demand seems to be improving steadily, with management calling out areas such as international intermodal, potash, refined petroleum products, and frac sand. Management is also progressing very well on their internal initiatives (expected to contribute half of their RTM guide), as can be seen from the weekly RTM trend, which is now up about a mid-to-high single-digit percentage based on the past 12 weeks of data. Therefore, with this backdrop, I believe CNR can easily meet management's FY24 guidance for mid-single-digit percentage revenue per mile [RTM] growth. Debate on labor costs The question at hand is whether the rise in labor costs will be greater than the increase in incremental volume. I don't know the answer yet, but this is definitely an area to monitor because it appears to be one of the key drivers for the step-up in OR. Due to increased recrews caused by work/rest regulations that make scheduling more difficult, CNR's labor and fringe benefits costs increased 10% in 1Q24 (3% headcount growth + 7% wage growth). Management is currently negotiating with the unions to find a middle ground between the competing goals of providing employees with predictable schedules and removing the stacking effects caused by previous agreements and other work/rest regulations. My view is that the CNR proposal is sound and should be accepted. The proposal includes an hourly agreement with scheduled time off that meets the need for rest. After the present round of talks concludes on May 1, there will be a cooling-off period of 21 days before either side can initiate a lockout or strike. Given that this is a regulatory decision, I think taking a more conservative approach would make sense; hence, I expect CNR to continue experiencing elevated labor costs throughout the near term (2Q24). Valuation May Investing Ideas Based on my research and analysis, my expected target price for CNR is ~CAD196.  Revenue should grow 4% in FY24 and 5% in FY25, trending back towards mid-single-digit growth eventually. FY24 4% growth is 100 bps lower than historical 5% growth to reflect the weak 1Q24 performance, followed by high single-digit growth in 2Q24 (extrapolated from the weekly data), followed by ~5% normalized growth for 2H24. Earnings should reach CAD6.06 billion in FY25 at a 33% earnings margin. I expect the weak OR performance to be a temporary issue, and once volumes (carload) start coming back online (like it did in recent weeks), OR should go back to historical levels. The stock should trade at a 20x forward PE multiple. Historically, CNR has traded at a ~6% premium to other listed class 1 rail operators, and because of the 1Q24 weakness, CNR now trades in line at 20x. Without making an aggressive assumption that CNR would trade back to a premium and assuming CNR completes the CAD4 billion share buyback, I get an upside of 17%.  Risk CNR's OR could see further spikes if the labor issue turns out to be a bigger problem than expected. This could permanently impair CNR, if labor costs are reset at a higher base rate, or if certain arrangements (for CNR to better utilize labor) are made impossible moving forward. Conclusion  I give a buy rating for CNR. My view is that the market overreacted to the short-term weakness in OR, which I expect to improve as carload volumes pick up. So far, the positive weekly carload trends suggest the company can achieve its full-year RTM guidance, which supports a mid-single-digits revenue growth outlook. While rising labor costs pose a risk, CNR's proposal to unions seems reasonable and should be accepted.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2430276207"}