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.
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.
