(The following story by Scott Deveau appeared on the Financial Post website on April 24.)
OTTAWA — Despite a rocky first quarter, Canadian railroads are currently priced attractively relative to their U.S. counterparts, with Canadian National Railway Co. (CN/TSX) representing a better buy at this point than its smaller rival, Canadian Pacific Railway Ltd. (CP/TSX), according to a new report from David Newman, National Bank Financial analyst.
The two railways reported disappointing first-quarter results this week resulting from weaker merchandising volumes, higher fuel expenses and unusually harsh winter weather. While both the railways and analysts lowered their earnings estimates accordingly, few said it was time to jump off the rails.
In fact, with the shares of Canadian railways trading where they are, CN and CPmay prove a compelling investment relative to their U.S. counterparts, Mr. Newman said.
“Although we continue to like the long-term rail story… we believe the sector as a whole could be somewhat overvalued at this point,” he said in a note to clients Wednesday. “Investors should become more sensitive to entry point valuations at this stage in the cycle.”
Traditionally, railroads trade between 12 and 16 times their estimated forward earnings. When they trough, they typically rebound in a matter of months.
However, given the improving fundamentals of the sector recently — pricing power, improving returns, and gaining market share on trucks — that range might in fact move above where it is today to between 13 to 16 or 17 times, Mr. Newman said.
Currently, Canadian railways are trading at roughly 14.9 times forward earnings, while their U.S. counterparts are up at 16.3 times, he estimates, making Canadian railways a more attractive buy than their competitors south of the border. In addition, a 1.4 point differential is a discount to the 0.5 they typically trade at, he added.
“With stronger cash flow generation and a healthier balance sheet, we estimate CN shareholders are in a better ‘starting position’ vis-a-vis CP counterparts,” he said.
CN trades at about 14.4 times estimated 2008 earnings, Mr. Newman noted, while CP is trading at about 15.4 times.
While the lagging U.S. economy, unfavourable foreign exchange and the process of renegotiating their fuel surcharges in the coming months will cause some headwinds going forward, the mid-to-long term fundamentals of both businesses remain sound, he said.
“The most relevant fundamental factor remains price, and at current levels, the Canadian rails are attractively priced,” he said.