Description

I am recommending a purchase of shares in Canadian National Railroad; I like the rail space in general and own Canadian Pacific, Canadian National and Kansas City Southern, however this write-up will focus on Canadian National. 

Thesis

This is an opportunity to buy an excellent business, with favorable long term growth prospects, that is worth twice what it is selling for in the market.  The stock, at today’s price of 140 CAD is selling at a 3.6% free cash flow yield based on 2022 street estimates.  I think that the street is too low, I expect the company to generate around CAD 6.69 per share in free cash flow in 2022 or a 4.7% free cash flow yield to the equity.  For a business that should be able to grow volumes, pricing ahead of inflation, and has opportunity to cut costs, in the current interest rate and asset pricing environment, I think that the valuation is absurdly low. 

Business analysis:

Competitive position – CNR is considered to have the best rail network in North America.  Nobody will ever build another railroad in NA for obvious reasons.  Everywhere that it operates, it is either a monopoly or a duopoly.  It does compete with trucks, however in Canada, due to the harsh winter, trucks are at a disadvantage.  Management seems to be very bullish on long term volume growth, as Canadian ports continue to take share from US ports and rails continue to gain share from trucks.  It has also outlined quite a few growth opportunities in its presentations.

Operating results

Over the past decade, volumes have grown on average at 2% per annum.   Company has been able to get price increases ahead of inflation, and costs as a % of revenues have been reduced.  When looking at the company, one must remember that earnings are overstated, since depreciation and amortization are below replacement cap ex. 

My forecasts, which are above the street, are below:

2021 Revenues = 16.47bn, EBIT = 7.08bn, EBITDA = 8.69bn, EBITDA – cap ex = 5.89bn, EPS = 6.91

2022 Revenues = 17.47bn, EBIT = 7.9bn,   EBITDA = 9.6bn,    EBITDA – cap ex = 6.8bn,   EPS = 7.88

I think that post 2022, it will be able to grow volumes at 1-2% per annum for a decade and get price increases of inflation+1% per annum over that time frame. 

Management

In my opinion, they are not the best operators – I think that the Canadian Pacific team is better, however they are o’k.

Capital structure

Debt = 14.7bn (on 09/30/2020 including the unfunded portion of pension obligations) or less than 2.3x 2021 EBIT estimates.

Equity market cap = 99.8bn CAD (using CAD 140 stock price as of 12/10/2020.)

Capital allocation

Historically, and on a going forward basis, the company will first invest in the business, then pay dividends, and will use remaining cash for share buy-backs. 

Valuation:

The EV = 114.5bn CAD on 12/10/2020.  I expect unlevered free cash flow to the firm to = $4.4bn CAD in 2021 (8.69bn CAD of EBITDA and 2.8bn CAD of cap ex, and 25% tax rate.)  I expect free cash flow to the firm to be CAD 5.1bn in 2022 driven by volume growth, price hikes and cost cuts.  (CAD 9.6bn of EBITDA, 2.8bn of cap ex.)  The company is trading at a free cash flow yield to the enterprise = 4.5% based on my 2022 forecasts. 

As Munger says, invert, always invert.  What does 4.5% free cash flow yield to the enterprise imply?  Assuming WACC = inflation + 4%, zero margin expansion from cost savings, 0.5% annual volume decline, pricing = inflation.  I think that the company will be able to surprise on the upside in all of these categories, and the investment is a bet that I am correct.

Post 2022, I expect volume growth to be at 1-2% per annum for a decade, and annual price increases of 1% above inflation for the next decade.   I expect margin expansion driven by cost cuts, volume growth and pricing above inflation. 

So, I expect the company to generate free cash flow equal to its current enterprise value by 12/31/2032, and at that point, have a nominal, unleveraged, annual forward free cash flow = CAD 12bn.  Using a WACC = inflation + 4% for the firm as whole, and perpetual growth rate = inflation, EV = $300bn CAD on 12/31/2032 + CAD 115bn generated over the next twelve years, or future value = CAD 415bn CAD, CAD 400BN to the equity or a 300% increase over a twelve year period. 

Variant perception

I think the street is underestimating volume growth in both 2021 and 2022, price increases in both years, and how much in costs have been taken out of the business both due to the pandemic and automation.

Risks:

Fully autonomous trucks can become competitive with the railroads.  Regulation, although CNR is specifically focused on minimizing shippers’ complaints and is investing ahead of growth in order to minimize the odds of complaints and regulatory scrutiny.

Catalyst

Company beating street estimates in 2021, analysts aggressively raising forecasts and putting out 2023 estimates.  I think that the revenues will be higher, operating margins will be higher and EPS will be higher than street estimates in 2021 and 2022.