Why Canadian rail stocks may stop in their tracks

Crude, coal, grain headwinds on the horizon

Canadian railway stocks have been a great place to be for investors and not just for the long term. Canadian National Railway Co. is up more than 25 per cent on the year, Canadian Pacific Railway Ltd. has risen about 35 per cent, and both reported strong first-quarter results earlier this week, seemingly clearing the track for more room to roll.

But all is not rosy for the rails. For one thing, there is some uncertainty about revenues from moving commodities such as grain, coal and oil, tougher comparisons to previous quarters and lofty valuations to consider.

That’s not to suggest investors should jump off, but perhaps they might want to think a bit more before buying more tickets, even if everything appears fine on the surface. CP continues to set new records for both itself and the industry. Its Q1 operating ratio improved a remarkable 880 basis points year-over-year to 63.2 per cent. That’s the profitability gauge, which measures operating costs as a percentage of revenue, which chief executive Hunter Harrison promised to reduce to 65 per cent by 2015 when he emerged out of retirement, after running CN Rail.

CN, meanwhile, upped its 2015 guidance, and continues to have best-in-class operating metrics. It is also in a good position from a commodity perspective to capitalize on positive secular trends in forestry products (U.S. housing recovery), autos (Chrysler contract win) and intermodal freight, which appears to have benefited from U.S. West Coast port labour uncertainty.

But dig a little deeper into their results and several hurdles appear.

CN trimmed its crude oil and frack sand carload growth assumptions for 2015 to reflect a more challenging market environment. To compensate for this negative impact, Desjardins analyst Benoit Poirier noted that the company now assumes an average exchange rate of US80 cents versus the Canadian dollar, down from US82.5 cents previously.

“In our view, the decision to lower FX assumptions reflects the more optimistic scenario required to meet current guidance,” Poirier told clients, downgrading CN from buy to hold on Tuesday.

It’s the weaker outlook for segments such as grain, coal and crude — which CN management acknowledged — that investors should be worried about in 2015 and beyond. The economics of its crude-by-rail business may be particularly impaired if oil prices remain weak.

The company also faces tougher quarterly comparables going forward since the Polar Vortex in Q1 last year pushed volumes into Q2 and Q3. That will produce a significant slowdown in volume growth as the year continues.

The big question is whether CN can generate enough growth to justify its higher-than-usual valuation, which sits near 18.7x on a forward basis.

“We think operating improvements through the cycle suggest a higher valuation is warranted, but the stock appears to be fully discounting this improvement,” said David Tyerman, an analyst at Canaccord Genuity.

The stock has pulled back since the Q1 results were announced, but investors might want to wait for an even better entry point.

CP, for its part, is leveraging its diversified franchise, but it’s still considered a bulk railroad and for good reason. Its revenue ton miles were up five per cent in Q1, but crude was down 10 per cent yearover -year, the metals, minerals and consumer products segment dipped 16 per cent, and autos fell 18 per cent.

The recent decline in oil prices reined in CP’s leading crude-by-rail growth, and coal volumes are vulnerable to lower output from Teck Resources Ltd. in Q2. CP doesn’t sound concerned about Teck, but the miner represents a significant portion of CP’s coal business.

And with grain volumes trending downward in Q2 and Q3, Poirier warned investors to “be ready as a tough comparison is around the corner.”

Without big volume growth drivers such as crude-by-rail and large Canadian grain crops, gains similar to recent years may be hard to come by.

Management’s message is that CP’s low-cost model is the key to strong growth going forward.

But, as Tyerman points out, slower growth, even in an easy comparable period like Q1, suggests at least some risk to the company’s thesis.

CP shares trade at a roughly 3x P/E premium to its peer group, but there are just too many uncertainties to warrant that price tag.

DARRYL DYCK / THE CANADIAN PRESS FILES While both Canadian Pacific and Canadian National appear to be running with all cylinders firing, looming weakness in the coal, grain, crude, metals and minerals, consumer goods and auto sectors may put the brakes on results.