Canadian National Railway Co. (TSX:CNR, Financial) is Canada's largest railway and one of seven Class 1 North American rail companies. The company's network consists of approximately 20,000 route miles of track spanning across Canada and mid-America, connecting the East and West Coasts as well as the Gulf of Mexico via its Chicago hub. If rival Canadian Pacific Railway Ltd. (TSX:CP, Financial) takes over Kansas City Southern (KSU, Financial), there will be only six class 1 railways left.
The company has a huge footprint, an impressive balance sheet and operating record. Along with its peers, it enjoys an oligopolistic position in the North American market. The following chart shows that Canadian National earned over 4 billion Canadian dollars ($3.16 billion) in net income, which translated into nearly CA$3 billion in free cash flow, over the past 12 months.
The railroad company is now moving past its failed combination with Kansas City Southern with a $700 million breakup fee and by focusing on shareholder returns, so the stock price has perked up in anticipation. Canadian National announced share buybacks (to the tune of CA$5 billion).
Canadian National has also been feeling some pressure from its second-largest shareholder, TCI Funds, which was unhappy with management following the failed takeover bid. The firm gave the railroad company 21 days to call a shareholder meeting, at which it plans to attempt to oust the chairman, CEO and two directors. The company has indicated it will begin unlocking its earnings potential to focus on further improving its operating margins as well as reduce capital expenditures to improve free cash flow. The company, which in the past boasted the best operating margins in the industry, has fallen into the middle of the pack on this key metric.
The following table from GuruFocus gives the profit margins for the publicly traded North American Railroads. (Note: Burlington Northern, the second-largest Class I railway, is part of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)).
Insiders buy
Insiders have started to acquire shares. On Sept. 21, Director Margaret McKenzie bought 3,000 shares at a price per share of CA$147.29, taking her stake to 4,675 shares. Previously, Independent Chairman of the Board Robert Pace invested over CA$7.6 million in shares of Canadian National Rail on Sept. 20. He bought 50,000 shares at a price per share of CA$152.55 for an account in which he has indirect ownership (MBS Realty Ltd.), after which this account held 54,900 shares.
Conclusion
While the GF Value chart indicates that Canadian National is modestly overvalued, I think it is modestly undervalued. The insiders certainly seem to think so. If the company manages to succeed in boosting its operating margin by 2%, net margins will gain 7%. This, together with the anticipated stock buybacks, should power the stock much higher. I think a gain of 30% in three years in not unreasonable for this high-quality, wide-moat company.
