(The following column by Jake Lynch appeared at TheStreet.com on July 28, 2009.)
BOSTON Canadian National Railway is smaller and less well-known than larger U.S. rivals Union Pacific and Burlington Northern Santa Fe.
But Montreal-based Canadian National, which has remained profitable during the recession, is the most attractive North American railroad stock because the company is hitched to the commodities boom, and Chief Executive Officer E. Hunter Harrison, who started as a carman, can cut costs where others can't.
North American economies suffered pronounced contractions in 2008, prompting a selloff in stocks. Even though equities have recovered nearly half of their lost market value, there are many high-quality companies still selling at a discount to the market and their peer group. Canadian National Railway is a glaring example.
Because Canadian National transports petroleum, chemicals, metals and forest products, it offers a play on commodities. The company is pushing into alternative-energy and custom-transport services. It just completed the first-ever rail transport of twin-pack wind-turbine blades for a wind farm in British Columbia. The move was organized by Canadian National Specialized Services.
Each turbine blade was 135 feet in length and required car modifications and support equipment for the haul. The company has extensive experience in customized services for heavy equipment as a result of Canada's concentration of mining, timber and oil companies. Canadian National estimates it has transported more than 2,100 carloads of wind-turbine components since 2005.
Harrison deserves credit for the company's operation excellence and innovation. His career has been defined by a focus on efficiency. He started in the rail-road business as a carman-oiler in 1963 and worked his way up the corporate ladder as an operations specialist.
Since taking the helm in 1993, he has guided Canadian National with the principles of service and cost control. In the most recent quarter, he demonstrated his commitment to efficiency. Car loads dropped 22%, but revenue fell only 15% due to resilient pricing. And cost-containment measures helped shave 14% off operating expenses. Canadian National's operating margins were 33% in the second quarter, compared with Union Pacific's 23% and Burlington Northern's 24%.
Still, Canadian National's net income fell 16% to $387 million and earnings per share dropped 14% to 82 cents. The decline in revenue and earnings was less severe than the industry average, though. And the company outperformed Union Pacific, the second-biggest U.S. railroad company by sales, on the basis of revenue growth and net income growth. Burlington Northern is the largest.
As a result of the recession, Canadian National has bolstered its cash position, having added $270 million to the balance since last year's second quarter. However, a quick ratio of 0.7 indicates that the company has further to go. Our model prefers companies with quick ratios over 1. Still, a debt-to-equity ratio of 0.7 reflects conservative leverage.
We give Canadian National an overall financial strength score of 8.9 out of 10, which isn't only higher than our "buy"-rated average of 7, but is also more than the road-and-rail average of 5.2. Comparable industry investments, including CSX(CSX Quote), Norfolk Southern(NSC Quote) and J.B. Hunt Transport(JBHT Quote) also receive "buy" ratings, but offer an inferior risk-reward profile when considering the durability of the underlying assets.
Canadian National is a classic value investment. Although it trades on par with the S&P 500 on the basis of book value, it's at a vast discount when using profit as a guide. A price-to-earnings ratio of 11.3 makes Canadian National 63% cheaper than its peer group. And since the company has an earnings growth rate superior to its rivals, this discount seems illogical. By comparison, Burlington Northern and Union Pacific are trading at price-to-earnings ratios of more than 13.
Canadian National's stock has risen 25% in 2009, outperforming the Dow Jones Industrial Average and S&P 500. The stock is 17% below its 52-week high, offers a dividend yield of 2% and has a beta, a measure of market correlation, of 1.2. In contrast, Union Pacific has risen 18% this year and Burlington Northern has eked out only a 2.1% gain.
