Railroads have become a popular value investment lately, largely because of Warren Buffett’s purchase of the Burlington Northern-Santa Fe, or BNSF, system a few years back. Naturally, that makes a lot of investors wonder about Canada’s two transcontinental railroads, the Canadian Pacific Railway (NYSE: CP) and the Canadian National Railway (NYSE: CNI), or CN; do they actually make money?
Are railroads actually a value investment, or is it just certain companies such as the Union Pacific (NYSE: UNP), or UP? The Canadian transcontinental lines do have some interesting characteristics; after all, they do provide a direct transportation link between the West Coast and the Midwest that bypasses the U.S. West Coast ports and their labor troubles. Unlike some U.S. transcontinental lines, the Canadian railways also provide direct connections to the East Coast. These railroads are also well positioned to take advantage of the oil boom in the central continent, particularly Alberta’s oil sands.
Yet value investors will ask the nagging question, do these railroads actually make money? The answer, unfortunately, is sort of, partially because the resources available to Canadian railroads are much smaller than those available to American transcontinental lines such as the Union Pacific and the BNSF.
The best way to begin our little analysis is to take a look at the railroads’ financial numbers. These can show us how much money these companies make and give us some indication of their long-term prospects. We’ll start with the smaller of the lines, the historic Canadian Pacific, or CP.
Is the Canadian Pacific a Value Investment?
From the numbers published on June 30, 2015, the CP seems to be on very shaky ground financially despite its high stock price ($152 a share on October 7, 2015). Here are the numbers the Canadian Pacific turned in for the second quarter of 2015:
- A TTM revenue of $5.774 billion
- A year to year revenue growth rate of -12.85%
- A diluted earnings per share number of -.76%
- A net income of $1.341 billion
- A profit margin of 23.62%
- A free cash flow of $188.64 million
- Cash and short-term investments of $149.42 million
- $1.996 billion in cash from operations
- $1.337 billion in capital expenditures
- Assets of $14.05 billion
- Liabilities of $9.804 billion
Yes, it looks like the CP is making money, but it seems to have little cash left over. Worse, it seems to be losing revenue. One has to wonder how long this railroad can go before it starts posting losses, particularly with falling oil prices and a weak Canadian economy. Another problem facing the CP is the decline in Canadian manufacturing.
Currently the Canadian Pacific is providing some nice returns to investors, including a dividend yield of .74%, a payout ratio of 15.05% and a return on equity of 25.4%. The question we have to ask here is, how long can the CP keep that up with revenues falling and its limited cash reserves?
My take is that the CP is not a value investment. Instead, it looks like a rather risky speculative play right now because of the high stock price and declining revenues. Although, strangely enough, the Canadian Pacific does look underpriced by Mr. Market; it had an enterprise value of $29.29 billion and a market cap of $24.43 billion on October 7, 2015.
Is It a Stock or a REIT?
The problem with that is that the enterprise value could include assets like real estate, which cannot readily be converted into cash. Much of the value of asset-heavy companies such as manufacturers, railroads and retailers consists of real estate holdings. The value exists on paper and not in the bank account.
Real estate in particular is problematic because it has to be sold. If you cannot find a buyer willing to pay the valuation, you have land and not money. It looks as if Canadian Pacific, like Sears Holdings (NASDAQ: SHLD), is real estate or asset rich and cash poor. On paper, it has around $14 billion in assets, but it only has $149.42 million in the bank.
Therefore it is a good idea to view railroads like the CP as more like real estate investment trusts or REITs rather than as straight companies. Their value comes from the investments and not the actual operations, which is one reason why big-time investors like Warren Buffett become interested in them; they can make money by selling off the assets. Although, stockholders do not necessarily profit from this activity, as the case at Sears shows us.
Is the Canadian National a Value Investment?
The Canadian National’s resources are greater than the CP’s, but it truly is facing a serious lack of growth. As at the Canadian Pacific, the numbers the CN reported on June 30, 2015, are a mixed bag of results.
Highlights of the Canadian National’s second quarter financials include the following:
- A TTM revenue of $10.74 billion
- A revenue growth rate of -11.01%
- A diluted EPS of 3.453
- A net income of $2.817 billion
- A profit margin of 28.35%
- A free cash flow of $445.31 million
- Cash and short-term invests of $69.46 million
- $3.995 billion in cash from operations
- $2.328 billion in capital expenditures
- Assets of $27.14 billion
- Liabilities of $15.87 billion
We see some of the same weaknesses at the Canadian National that we do at the Canadian Pacific; for example, capital expenditures (probably maintenance costs) that seem to eat up most of the cash from operations. The level of liabilities at the companies also seems to be high.
Like CP, the National also seems to be asset rich and cash poor. It only had $69.46 million in the bank on June 30, 2015, and assets of $27.14 billion.
Yet Canadian National seems to be a good stock for investors. It offered a dividend yield of 1.6%, a payout ratio of 27.39% and a return of equity on June 30, 2015.
Are Railroads a Value Investment?
So what can we can learn from these financial numbers? I think there are a few important lessons for investors here:
- Impressive profit margins and dividend yields do not necessarily indicate a good stock or a good investment. Both CNI and CP are paying decent dividends and reporting good profit margins, yet they are reporting falling revenues and limited amounts of cash in the bank.
- Even though they have a lot of assets, railroads are not necessarily a value investment, because they have limited amounts of cash. High liabilities, assets and operating costs eat up the cash. That means one reason why investors like Buffett want railroads is for the tax write off, something that might benefit Berkshire Hathaway (NYSE: BRK.B) but not the average investor.
- Canadian railroads are on very shaky ground. Their limited cash reserves and falling revenues could soon lead to losses and other serious problems.
My suggestion would be to stay away from Canadian railroads right now. They are far from a value investment, and they look like they are headed for some rough times now that Canada is in recession.