Thursday, July 5, 2012


Why Canadian National Railways is a good long term investment. 

I first came to this investment because I knew Warren Buffet really liked the railroads (Berkshire Hathaway (BRK.A, BRK.B) purchased BNSF railroad in 2010 in a deal worth 40 billion).  And why wouldn’t he, railroads have a HUGE competitive moat.  It is estimated that 35% of North America’s rail traffic is considered “captive.”  The railroad companies own their own rails and since parallel rails aren’t generally profitable, many routes are operated by a single company.  Their competitive position is strengthened because they are on average three times as fuel efficient (per ton) as trucks. 
This monopoly like control over rail lines translates into strong pricing power.  Railroads increase their prices by an average of 5 percent a year.  Assuming a generous 3% inflation rate on their capital expenditures and other costs, 2% of revenue is added to profits every year due to price increases. 
Canadian National Railways (CNI) owns over 20,000 miles of railroad mostly in Canada all the way down to New Orleans.  In comparison, their main competitor Canadian Pacific (CP) owns about 14,000 miles of railroad mostly in Canada.  Before its IPO in 1995, Canadian National was owned by the Canadian government, which built up its railroad network. 
The rail network is much better maintained than Canadian Pacific and the company seems well managed.  The return of investment is slightly higher than the Weighted Cost of Capital (10.32 vs 9.6) which is somewhat comforting considering how capital intensive the railroad business is (although it is not as high as I would like it to be).  Returns of equity and profit margin at 22.37% and 27.22% respectively are much higher than any of its competitors including Canadian Pacific and the major US railroads (returns on equity and profit margins are in the high teens for most competitors).  This suggests that Canadian National may have even higher pricing power than the other railroads, a fact helped by their often exclusive network connecting smaller cities and towns in Canada.  This pricing power allows them to increase earnings at consistent rate which translates into a steadily increasing share price. 
CNI Chart
CNI data by YCharts
Like most of the railroads CNI has gone nowhere but up.  Some people may tell you that railroad stocks have gone up because gas prices have made trucking more expensive in the most recent decade.  That is only half true.  The other half of the story is pricing power, made in part by high gas prices, but even if trucks run on natural gas, which is about half as expensive as diesel, railroads will still be able to ship at more efficient prices.  That is how strong their competitive advantage is.

Disclosure:  I have no positions with any of the stocks mentioned and no plans to initiate positions within the next 72 hours.