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Canadian National Railway: Enduring Company, Enduring Stock

Summary

Canadian National Railway is a true backbone of the economy, transporting more than $250 billion worth of goods annually for a wide range of business sectors.

The company's rail network consists of 20,000 route miles of track spanning Canada and mid-America and connecting three coasts: the Atlantic Coast, the Pacific Coast, and the Gulf of Mexico Coast.

Its freight revenue spans seven different commodity groups, representing a diversified and balanced portfolio, with no individual commodity group accounting for more than 23% of revenues.

Canadian National Railway Co. (NYSE:CNI) is the largest railroad operator in Canada and a major operator in North America.

The Canadian National Railway was formed between 1918 and 1923, when the Government of Canada purchased or acquired several government and privately owned railways that had gone bankrupt.

On December 20, 1918, the Canadian government created the name Canadian National Railway and adopted the slogan "The People's Railway." Notably, in 1818, Canada was not yet a country.

2015 was the 20th anniversary of CN's highly successful IPO. After many years of steady growth, the slowdown in the economy in 2015 forced the company to shift its focus and show how nimble it could be when shipping volumes declined.

CN is more than just a great railroad; it is a great company. It has been acknowledged for its achievements over the years in numerous areas representing meaningful measures of how it contributes to society. In 2015, it was recognized in the Globe and Mail's annual review of Corporate Governance in Canada, where CN ranked fifth overall and first in its industrial group. Its sustainability practices earned CN a place on the Dow Jones Sustainability World Index (DJSI) for the fourth consecutive year, and the company has been listed on the DJSI North America Index for seven years in a row.

The Montreal-based carrier is a true backbone of the economy, transporting more than $250 billion worth of goods annually for a

wide range of business sectors, ranging from resource products to manufactured products to consumer goods, across a network of 20,000 route miles of track spanning Canada and mid-America and connecting three coasts: the Atlantic, Pacific, and the Gulf of Mexico. CN's network access to three coasts and across the U.S. mid-west results in a highly diversified revenue mix.

CN serves the port cities of Vancouver and Prince Rupert, British Columbia, Montreal, Halifax, New Orleans, and Mobile, Alabama, as well as the metropolitan areas of Toronto, Edmonton, Winnipeg, Calgary, Chicago, Memphis, Detroit, Duluth, Minnesota/Superior, Wisconsin, and Jackson, Mississippi, with connections to all points in North America. CN's sole access to the Port of Prince Rupert is a competitive advantage - the railway connects with Vancouver and Prince Rupert in a long arc, providing opportunities for the company to move containers from Asia to the U.S. heartland.

CN's freight revenue spans seven different commodity groups, representing a diversified and balanced portfolio, with no individual commodity group accounting for more than 23% of revenues in 2015. From a geographic standpoint, 17% of revenues relate to U.S. domestic traffic, 33% trans-border traffic, 19% Canadian domestic traffic, and 31% overseas traffic. The railway is the originating carrier for approximately 85% of traffic moving along its network. Canadian National also operates one of the largest trucking services in Canada.

Since early 2015, it has been a challenging environment for North American railways, including Canadian National. Declining shipments, blamed in part on China, stemmed as well from a number of other forces, including weak industrial activity amid a sluggish North American economic environment and outlook, low commodity prices, declining demand for coal and steel, and the prolonged slump in oil prices that has made moving it by rail uneconomical.

One of CN's hallmarks has been its ability to accommodate growth with low incremental cost. With the economic slowdown in 2015 and the first drop in CN volumes in many years, the company faced a different kind of challenge, which it has reacted to effectively.

CN responded in part by reducing its workforce by 2,400, including 1,200 train operators. The cut represents about 10% of its workforce, which now stands at about 23,000. The company's natural annual attrition rate of close to 8% gives it the flexibility to reduce further, if necessary - hiring or not, depending on market conditions. It hopes to call back some of its laid-off conductors as attrition moves through the system.

Despite the challenges, CN's share price is up 7.84% over the past year, while most of its North American peers' share prices are flattish to down. Canadian Pacific Railway's (NYSE:CP) share price, for example, has dropped by 12.4%.

CN capped off the taxing 2015 fiscal year by growing diluted earnings per share 15% to C$941 million, or C$1.18 per share, in the fourth quarter. This compared with C$1.03 per share, or C$844 million, a year earlier.

However, CN's revenue in 2015 decreased 1% to C$3.17 billion as carloads declined by 8%, while revenue ton-miles declined 5%, largely as a result of a weakened Canadian economy. Analysts had expected per-share profit of $1.11 and revenue of $3.2 billion.

Analysts have slashed profit expectations for the major North American railroads, and debt rating agency Moody's Investors Service recently downgraded the sector's outlook to negative from stable, citing the declines in freight and the unprecedented and likely long-lasting drop in coal shipments.

To date in 2016, the number of rail carloads in the United States has fallen by 13%, amid economic weakness and a drop in demand for commodities, coal in particular.

However, CN is better positioned to avert the coal headwinds compared to rival Canadian Pacific and U.S. peers like Norfolk Southern (NYSE:NSC), CSX Corporation (NASDAQ:CSX), Union Pacific (NYSE:UNP), Genesee & Wyoming (NYSE:GWR), and Kansas City Southern (NYSE:KSU) because it derives proportionally less of its revenue from coal. Only 5% of CN's total revenues in 2015 came from coal transportation. In the same year, coal's contribution to the company's total carloads was less than 8%.

This is especially important given the bleak long-term outlook for coal. Not only is the outlook poor for metallurgical coal, which is used in making steel, as demand for steel from China, the world's largest consumer, continues to fall, but thermal coal is facing intractable secular headwinds that will eventually remove it from the global energy mix.

Moreover, in the recently completed second quarter of calendar year 2016, the number of intermodal cargo containers hauled by the major railways in North America declined by a larger-than-expected 7%, reflecting the worrisome condition of the North American economy - intermodal is an indicator of North American economic conditions.

The business of hauling containers - which generally carry imported consumer goods arriving by ship from Asia and are carried cross-continent by train to a truck for the final leg of the journey to a warehouse, store or factory - has until recently been a growth area for railways.

It appears that as consumer spending and retail sales slowed from the middle of 2015, inventories continued to rise and are now sitting just above the historical average.

The intermodal business contributed approximately 24% to CN's 2015 revenues. Of its total carloads in 2015, intermodal's share was 40.7%, which was a 37% increase from 2014.

The...


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