This week, we look at the second company in our Super Stocks series. Given the current state of the market, you may wish to postpone any new buying for now. If so, put our Super Stocks on your bargain-hunting list for future consideration. Also, these stocks should be the last ones sold when you rebalance your portfolio.
CN Rail (TSX: CNR, NYSE: CNI)
The business: A generation ago, the railroads were considered to be a relic of the past. Sure, those ribbons of steel had transported thousands of immigrants from Halifax to Montreal, opened up the Prairies, and linked the country from sea to sea by negotiating the Rockies. But all that was history. Passenger trains had been overtaken by jet planes and freight could be moved more efficiently by transport trucks. Who needed railroads any more?
It turns out we all do. Not only did the trains survive but the companies that run them have prospered. As the highways become increasingly clogged and the price of gasoline and diesel soars, railroads have once again emerged as the most cost-effective way of moving goods from point A to point B. And while long-haul passenger service has become more a luxury than a necessity, the commuter business is thriving, albeit with government support.
One of most successful companies in this business is Montreal-based CN Rail, the old Canadian National in modern dress. For most of its history, CN was a Crown corporation, owned and operated by the Government of Canada. In November of 1995, the company was privatized and that opened up a new era of expansion and prosperity. Since then, CN has made several key acquisitions and streamlined its operations to the point where it is now the most efficient major railway on the continent.
Many people still think of the CNR as a pure Canadian railroad but it is much more than that. The company actually bills itself as "North America's railroad", with justification. Its tracks extend through the heartland of the United States, down the Mississippi River corridor to the Gulf ports of Mobile, Gulfport, and New Orleans. All told, CN has approximately 20,600 route-miles of track on the continent.
The security: The common shares of CN trade on the Toronto Stock Exchange under the symbol CNR and on the New York Stock Exchange as CNI.
Why we like it: CN is a well-run, highly efficient company in a sector that offers a great deal of growth potential. Contributing editor Tom Slee, who recommended the stock to IWB members in May 2002, wrote in a column earlier this year that the railroads are well-positioned to grab an even larger share of the freight business as fuel prices rise. "To put it simply, a train can ship one ton of cargo 400 miles on one gallon of diesel. A truck can ship one ton of cargo 125 miles on one gallon of diesel. End of story," he said.
We're seeing that advantage in the company's results. In the second quarter, to June 30, CN reported a year-over-year increase of 8% in revenue to $2.26 billion, while carloadings increased 4% and revenue ton-miles by 5%. Those are very positive numbers in a sluggish economy.
Shareholders have benefited from this growth, both in terms of capital appreciation and cash flow. When we first recommended the stock, it was trading at C$25.95, US$16.62 (adjusted for splits of 3-2 in 2004 and 2-1 in 2006). Even after last week's market sell-off, it was trading at C$69.15, US$70.58. Canadians who bought at the time we first mentioned the stock had a capital gain of 166% while Americans were ahead 325% thanks to the increase in value of the loonie.
While the stock was rising in price, dividends increased every year from 1996 to now. The latest bump was a hefty 20% move to $0.325 per quarter or $1.30 a year.
One negative note: CN does not have a dividend reinvestment plan.
Financial highlights: CN reported second-quarter net income of $538 million. That was up only slightly from $534 million in the same period of 2010. However, on a per share basis earnings were $1.18 (fully diluted), up 4% from $1.13 last year. The 2011 results included net deferred income tax expense of $40 million, or $0.08 per share. Stripping out this one-time expense, adjusted net earnings were $1.26 a share, 12% more than last year.
The 8% rise in second-quarter revenue was mainly due to higher freight volumes, the impact of a fuel surcharge, and freight rate increases. These factors were partly offset by the negative impact of the stronger loonie on U.S. dollar revenue.
Risks: CN's revenue and profits are strongly influenced by economic conditions. Volumes fall off during a recession or when the economy is sluggish, leaving equipment underutilized or idle. During periods of strong growth, demand may exceed capacity in some areas. If growth does not pick up, CN's stock price could languish for a while but it will rebound strongly when conditions improve.
Weather can be another important factor. Bad growing conditions on the Prairies will result in lower grain shipments, an important source of revenue for the railway. Extreme cold and high volumes of snow may cause equipment failure or block mountain passes, delaying deliveries.
Distribution policy: For 2011, CN pays quarterly dividends of $0.325 a share. At the current price, the stock yields a modest 1.9% but given the company's track record for annual dividend increases this should improve over time.
Tax implications: The dividends are eligible for the enhanced dividend tax credit for Canadian investors who hold the shares in a non-registered account. For U.S. residents, the dividends qualify for the low 15% tax rate.
Who it's for: CN Rail is best suited to long-term investors who are willing to accept a modest level of cash flow now in return for excellent capital gains potential and steady dividend increases.
Action now: Hold current positions. Be prepared to start building a position if the share price falls below $60. - G.P.