MOOSE MARKETS

INVESTING THE CANADIAN WAY

Canadian Stocks Analysis

Buy List – October 2023: Canadian National Railway

My buy list for October 2023 has a new entry: Canadian National Railway (CNR.TO /CNI). I just love buying Canadian National Railway when the market expects a recession!

Railways are incredibly stable because there aren’t any other assets that can replace them in North America. Yet each time transportation volumes go down, the market tends to sell them off. It happened last in 2016, and we highlighted CNR.TO / CNI back then as well. Here we go for another round!

Canadian National Railway logoCanadian National Railway has been known as “best-in-class” for operating ratios for many years. CNR continuously worked on improving its margins and was among the first to do so. Today, peers have caught up and all railways are managed the same way.

CNR’s transportation activities are well diversified across seven different industries. Its exclusive access to the Prince Rupert port is advantageous for intermodal transportation. CNR enjoys a very strong economic moat as railways are virtually impossible to replicate.

Learn strategies for generating income for life. Download our guide now.

CNR.TO Business Model

A transportation and logistics company, Canadian National Railway’s services include rail, intermodal, trucking, and supply chain services. CNR rail services offer equipment, customs brokerage services, transloading and distribution, private car storage, and more.

Cute toy train set with wooden rails, trees, a station, signage and conductorCNR’s intermodal container services help shippers expand their door-to-door market reach with about 23 strategically placed intermodal terminals, with services including temperature-controlled cargo, port partnerships, logistics park, moving grain in containers, custom brokerage, transloading and distribution, and others.

CNR’s trucking services include door-to-door service, import and export dray, interline services, and specialized services. Its supply chain services offer comprehensive services across a range of industries and product types. CNR transports more than 300 million tons of natural resources, manufactured products, and finished goods throughout North America every year.

Investment Thesis       

Canadian National Railway owns unmatched quality railroad assets. With its strong economic moat, we can rely on increasing cash flows each year. There isn’t a more efficient way to transport commodities than by train.

The good thing about CNR is that investors can always wait for a down cycle to buy. Since we see railroads as attractive investments, we usually spot the opportune moment. Considering Q2 2023 results, it seems such a moment is here.

Learn strategies for generating income for life. Download our guide now.

CNR.TO Last Quarter and Recent Activities

With its Q2 results Canadian National Railway sent a strong signal that the economy is slowing down with revenue down 7% and EPS down 8% for the quarter. Revenue decreased mostly because of lower volumes of intermodal, crude oil, U.S. grain exports, and forest products. Volumes shrunk as demand for freight services to move consumer goods lowered and Canadian wildfires caused customer outages.

Rounding up the reasons for the decline were lower ancillary services including container storage, and lower fuel surcharge revenues as fuel prices decreased. CNR updated its full-year outlook, now expects flat to slightly negative year-over-year growth in adjusted EPS.

Potential Risks for CNR.TO

Railroad maintenance is capital intensive and could adversely affect CNR in the future. It’s a difficult balance to obtain an efficient operating ratio and well-maintained railroads. To maintain its network, CNR must make substantial reinvestments continually. However, CNR continues to boast one of the best operating ratios in the industry.

From time to time, CNR’s growth can be negatively affected by its dependence on the Canadian resource markets. When demand for oil, forest, or grain products is low, demand for CNR’s services obviously slows down accordingly. For example, the pandemic caused a slowdown in weekly rail traffic of about 10% over the summer of 2020. As you can see in the graph below, even that didn’t derail (couldn’t resist) CNR’s revenue much or for very long.

Line graph showing CNR's revenue growth over 10 years- steady growth except in 2020-2021 due to the pandemic.

When the oil price is low, trucking steers some business away from railroads. CNR is a captive of its best assets since you can’t move railroads!

Get acquainted with other great Canadian stocks, read Canadian Forever Stock Selection.

CNR Dividend Growth Perspective

Canadian National Railway has successfully increased its dividend yearly since 1996. The management team ensures they use a good portion of CNR’s cash flow to maintain and improve railways, while rewarding shareholders with generous dividend payments. CNR exhibits an impressive dividend record with very low payout ratios. To learn more about payout ratios read this article.

Line graph of Canadian National Railway dividend amount for the last 10 years; yearly increases, with a generous increase early 2022 as business normalized after the peak of the pandemic.

While the business faces headwinds periodically, its dividend payment will not be affected. Shareholders can expect more high single-digit dividend increases. The railroad company kicked off 2023 with an impressive dividend increase of 8%. If you can grab CNR with a yield of approximately 2%, you’re making a good deal!

Learn strategies for generating income for life. Download our guide now.

Final Thoughts on Canadian National Railway

Despite CNR’s capital-intensive requirements and reliance on the Canadian resource markets, we believe Canadian National Railway will come sailing through the current economic downturn and maintain its dividend increases.

With CNR’s unmatched-quality railroad assets almost impossible to replicate, and its management taking on the challenges of the current environment, we could see more growth emerging from all this. Also, CNR will benefit from the cancellation of the Keystone XL pipeline which will drive demand for oil transport via railroads. With a current yield above 2%, CNR is definitely worth a look.

Why I Sold Enbridge and TC Energy

Back in February 2023, as part of my quarterly review of the DSR portfolios and my personal portfolio, I sold all shares of Enbridge (ENB) and TC Energy (TRP).

Many wonder why on earth I would do such a thing. After all, they are much beloved pipeline stocks with impressive dividend profiles; generous yields, 28 years of consecutive dividend increases for Enbridge, TC Energy not far behind with 23 years, and both are part of the 15 Canadian stocks with the longest dividend growth streaks.

Are they unsafe investments? Are their dividends at risk? Should you sell them too? The answers are 1) no, 2) no, and 3) you have to decide for yourself by doing your due diligence; review these companies quarterly to see if they are still a good fit for your investment thesis. Just because I sold them does not mean you should too.

Are Enbridge & TC Energy still safe investments?

Both companies will continue supplying an essential service and they will keep generating substantial cash flow. Like railroads, they are not going anywhere. The world needs energy and pipelines are the ones providing it. They enjoy robust contracts with their customers that, usually, are shielded against inflation and include a minimum fee that ensures the customers pay even if the pipeline is not used.

Are ENB & TRP dividends safe?

Despite their triple-digit dividend payout ratio, show in the graph below, ENB and TRP dividends are safe for now.

Enbridge and TC Energy Dividend Payout Ratios 2019-2023

Let me explain. At the time of writing, the dividend payout ratio for ENB is over 200% and close to 200% for TRP, which says that they are paying more than, or close to, twice what they earn as dividends. Not good, right? Well, that’s not the complete picture here.

  • The payout ratio is based on earnings, and the calculation of earnings includes non-cash items such as depreciation and impairments. Non-cash items do not affect the amount of cash a company has to pay dividends.
  • Capital expenditures (CAPEX) are also included when calculating the earnings and payout ratio. Pipelines are capital-intensive businesses. CAPEX fund infrastructure projects, including investments that the company expects will be profitable and generate new revenue in the future.

To get a clearer picture of ENB and TRP’s ability to pay their dividends, we looked at the Distributable Cash per Share (DCF), which does not include non-cash items or CAPEX. The payout ratio, when calculated using the DCF rather than earnings, is well below 100% for both ENB and TRP. So yes, both pipelines can afford to pay their dividends based on the cash they generate. That doesn’t mean everything is perfect and rosy in pipeline land.

 

Reasons for selling Pipelines

While both ENB and TRP have done relatively well in our different DSR portfolios and I believe their dividend is safe for now, the dividend growth has slowed down and I don’t see much potential for capital appreciation going forward.

Slowing dividend growth for both ENB.TO and TRP.TO

ENB was increasing its dividend by 10% yearly before slowing down to 3% per year starting in 2021. TRP had 7% to 8% dividend increases until it lowered the targeted rate to 3% to 5% increases, although the last two increases were closer to 3%.

What is slowing down the dividend growth? Quite simply, it is getting more difficult for Enbridge and TC Energy to make money; inflation is pushing their costs up, and higher interest rates are making their debt more expensive.

It costs of lot money to maintain and expand pipeline infrastructure, so both ENB and TRP rely on borrowing. The rise in interest rates, started in 2022, has already increased ENB and TRP’s interest expenses. With both the U.S. Federal Reserve and the Central Bank of Canada clearly not expecting interest rates to go down in 2023, it will only get worse for ENB and TRP as they pay back their older debt, at the lower pre-2022 rates, and add new debt at the higher rates.

Inflation and increasing interest rates are hurting ENB and TRP. This will go on for a while, limiting their ability to increase their dividends. While their yields are generous, as a dividend investor, I look for robust dividend growth.

ENB & TRP shares price won’t go anywhere

In the current landscape, I do not see a lot of room for capital appreciation for ENB and TRP.

They lack growth vectors. New pipelines are difficult to build; they are subject to substantial regulations and are expensive to build. There are often delays in construction, for a variety of reasons including supply shortages, labor shortages, and regulatory complexities, which translate into higher costs, even more so now that inflation has kicked in.

ENB and TRP will also have to deal with Canadian carbon emissions taxes that are expected to increase to $170 a ton by 2030 from $40 today. Enbridge is already on board to reduce its emissions to offset this increase but doing so requires considerable capital investments.

These obstacles to growth are only made worse by the higher interest rates that make borrowing more expensive.

In closing: Why I sold Enbridge and TC Energy

While both ENB and TRP have done relatively well in our different DSR portfolios and I believe their dividend is safe for now, the dividend growth has slowed down and I don’t see much potential for stock appreciation going forward.

Besides enjoying a generous dividend, I don’t see how ENB and TRP will make me richer over the coming years. Since my strategy is focused on total returns by selecting dividend growers, they do not meet my investing strategy. Both pipelines will either end up as deluxe bonds or dividend traps.

Having said that, I think it’s fair to say both END and TRP will continue to pay their dues for a while. There is a case for holding on to them for stability and income; however, it is essential to follow them with great attention quarterly. If you see more references in their quarterly reports to higher cost of debt, high debt ratio, impairments and charge due to delays and inflation, you’ll know that the dividend safety is under pressure.