Contributing editor Gavin Graham joins us this week with a look at what's happening in the railroad sector and some bank updates. Gavin has had a long and successful career in money management and is a specialist in international securities. He has held senior positions in financial organizations in London, Hong Kong, and Toronto. He currently is chief strategy officer at Integris Pension Management, a provider of personal pension plans for incorporated individuals. He divides his time between Toronto and the U.K. Here is his report.
Gavin Graham writes:
Railroads have been one of the best performing sectors in North America for the last decade. The six listed U.S. and Canadian railway stocks (Canadian National, Canadian Pacific, CSX, Kansas City Southern, Norfolk Southern (NSC, Financial), and Union Pacific) have produced compound annual returns over the last decade ranging from 23.3% per year for Union Pacific to 11.8% per year for Norfolk Southern. This represents returns between two and four times higher than those from investing in either the S&P 500 or S&P/TSX 60 indices.
The sector was given the ultimate seal of approval in many investors' eyes when Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway made its largest ever acquisition, buying the biggest U.S. railroad, Burlington Northern Santa Fe (BNSF), for $34 billion in 2009. At the time, BNSF was an active IWB recommendation and our readers profited accordingly.
The reasons for this strong performance are relatively easy to find. The railroad industry was deregulated in 1980 as a result of the Staggers Act, named after the chairman of the House Interstate Commerce Committee. That Act effectively abolished government setting of railroad shipping rates by the Interstate Commerce Commission (ICC). Since then, the Association of American Railroads (AAR) estimates that shipping rates have come down by 51%. At the same time, the Staggers Act made it much easier for railroads to close underused rail lines, making for more efficient use of capital.
Freed from the legacy of government regulation, which had been in place for almost a century since the Interstate Commerce Act of 1887, railroads began to invest in their profitable lines of business. These included coal transport for export for CSX and Norfolk Southern, the eastern railroads, and low sulphur coal and intermodal (freight containers which can be loaded/unloaded from trucks to trains) for the western railroads: BNSF, Union Pacific, and Kansas City Southern. Abandoning loss making passenger services to governments (Amtrak in the U.S. and Via Rail in Canada), removed a major distraction.
In the 1990s, there were mergers between railroads, such as the one between Burlington Northern and the Santa Fe and the combination of Union Pacific and Southern Pacific. We also saw the takeover and breakup of government owned Conrail by CSX and Norfolk Southern. These allowed efficiencies of scale in ordering materials, reduced track access charges for running trains on other companies' lines, and lowered borrowing costs through larger balance sheets. The Canadian railroads also benefited from these trends, especially after CN purchased the Illinois Central in 1998, which gave it direct access to the U.S. Gulf coast.
The AAR estimates that US$480 billion has been invested by the industry into their rail systems in the past 35 years, a great deal of which has been spent on larger, more powerful, and more fuel efficient locomotives that can haul much longer trains. Seemingly simple operational changes such as those introduced by former CEO Hunter Harrison at CN Rail, which included having trains leave at specified times rather than waiting until a certain number of carriages had been assembled, as well as running trains with fewer staff, have transformed the economics of the industry.
Railroads have been consistently amongst the most profitable industries in North America over the last two decades, with net earnings for the six listed companies growing from $8.76 billion in 2010 to $10.7 billion in 2014. Return on equity (RoE) ranges from 13%-14% for CP and Kansas City Southern, the two smallest railroads, through 16%-17% for CSX and Norfolk Southern to 23%-24% for CN and Union Pacific.
Dividend yields are low due to the strong performance of the stocks, ranging from 0.5% for CP to 2.2% for Norfolk Southern, with the remainder yielding 1.2%-1.8%. However, the companies have been steadily increasing their payouts, with growth over the last five years ranging from 7% annually for CP to 30% a year for Union Pacific. Given that the highest payout ratio is CSX at 35%, with the rest distributing between 22%-30% of their earnings, the potential for further steady increases looks good.
Railroads have been able to position themselves as the green alternative to transport by road, with trains being much more fuel-efficient than trucks as a means of moving goods. They produce much lower CO2 emissions than either trucks or planes per unit shipped. They have also benefited from the difficulties experienced by trucking companies in hiring and retaining sufficient drivers, given the antisocial hours and huge amount of travel required. Even the halving of the oil price has not helped trucking much compared to railroads, given the fact that railroads benefit from lower fuel costs as well.
Valuations for railroad stocks remain high, with 2014 price/earnings ratios between 18-28 times, but given the strength of the U.S. economy and the benefit from lower fuel costs for an entire year, p/e ratios for 2015 are much more reasonable. Kansas City Southern, CN, and CP sell at 18 times earnings while Union Pacific, CSX, and Norfolk Southern are at 16, 15, and 14 times respectively. The two eastern railroads have grown more slowly and are rated less highly, largely due to their exposure to the export coal market, which is principally dependent upon demand from the depressed European economies and the effect of tighter emissions controls on domestic coal demand.
Railroads remain an attractive industry for investors, benefiting from long-term secular trends such as deregulation, the move from road to rail, the growth in U.S. domestic oil production, and the move to larger and longer trains. There are short-term positives as well, with lower fuel costs an immediate benefit. Also, given the railroads' sensitivity to GDP, the strong growth in the U.S. economy over the last 18 months has been a big plus.
The IWB has two railroads on its recommended list, CN Rail and Norfolk Southern, both of which have performed very well for subscribers. Retired contributing editor Tom Slee retained the Buy rating for Norfolk Southern in his final column in December. I am moving CN back to a Buy from the Hold rating it was given last July on valuation grounds.
CN Rail (TSX:CNR, Financial) (NYSE:CNI, Financial)
Originally recommended by Tom Slee on May 6/02 at C$12.98, US$8.31 (split adjusted). Closed Friday at C$87.29, US$70.04.
CN reported an excellent set of fourth-quarter results, with earnings of $844 million ($1.03 per share) against $635 million ($0.76 per share) the year before. Revenues were $3.21 billion, up from $2.75 billion in 2013. Analysts had estimated revenue of $3.12 billion ($0.97 per share).
The all-important operating ratio of costs as a percentage of revenue fell 4.1 percentage points to 60.7%. Rival CP managed to achieve a lower operating ratio (59.8%) for the first time, reflecting the effect of hiring CN's former CEO Hunter Harrison in 2012.
CN's full year adjusted earnings increased 23% to $3.1 billion ($3.76 per share). Revenues were up 15% to $13.1 billion, with particularly strong performances by petroleum and chemicals, grain and fertilizers (both up 21%), and metals and minerals (up 20%). Intermodal and automotive were up 13% and 12% respectively, while forest products were ahead by 7% and coal by 4%. CN shipped record freight volumes and revenue ton-miles were up 10%
CEO Claude Mongeau told analysts that CN aimed to increase its shipments of oil and fracking sand in 2015, noting that "There's a lot of investments being made by our customers in the energy markets". He added: "the price (of oil) is obviously a key factor." Nonetheless, CN expects to increase the 128,000 carloads of oil and 89,000 carloads of frac sand by a combined 75,000 carloads in 2015. It plans to raise its 2015 capital spending by $300 million to $2.6 billion.
CN forecast double-digit growth in earnings per share and raised its dividend 25% to $1.25 per share, its nineteenth straight increase. The dividend payout target was increased from 30% to 35%.
Action now: CN becomes a Buy on its strong performance in the second half of 2014 and the benefits from lower expenses, particularly fuel costs.
Bank of Nova Scotia (TSX:BNS, Financial) (NYSE:BNS, Financial)
Originally recommended by Tom Slee on Jan. 16/11 at C$56.83 US$57.34 Closed Friday C$67.20, US$53.90.
Both TD and Bank of Nova Scotia (Scotiabank) have chosen to expand outside of Canada's domestic market, TD in the U.S. and Scotiabank in Latin America, the Caribbean, and Asia.
TD is one of the ten largest banks in North America, the largest by assets in Canada, and fifth or sixth largest in the U.S. It has over 1,300 branches in the U.S. (where they are called "stores") and 1,100 in Canada. It derives the majority (over 80%) of its income from retail business, including its 41% stake in discount broker TD Ameritrade. TD is one of the few banks globally to be ranked AA- by S&P and Aa1 by Moody's, albeit with a negative outlook.
As of Oct. 31, TD had assets of $945 billion, assets under management and administration of $317 billion, and a Tier 1 Common Equity Capital Ratio of 9.4%.
In the fourth quarter of fiscal 2014 (to Oct. 31), TD had net income of $1.86 billion ($0.98 per share), up 3%. Revenue was ahead 6% to $7.45 billion. Canadian retail accounted for $1.36 billion (67%), U.S. retail for $432 million (21%), TD Ameritrade for $77 million (4%), and wholesale contributed $160 million (8%). For the year, the bank reported net income of $8.1 billion ($4.14 per share), representing five-year compound growth of 11.5% in earnings and 9.8% in earnings per share (EPS).
Canadian net interest income for the fourth quarter increased 6%, despite the net interest margin declining 0.06% from the third quarter, and non-interest income rose 8% on higher fees from assets under management, insurance growth, and the addition of half of the Aeroplan credit card business in 2013.
In the U.S., revenue was down 2% and both interest and non-interest income declined. Provision for credit losses (PCL) rose 12% in Canada to 0.38% of assets, reflecting the record low levels it had declined to, but fell 29% in the U.S. as credit conditions improved.
TD increased its dividend by $0.04 to $1.88 per share annually at the beginning of 2014, giving a yield of 3.39%.
The stock fell 8% in January as Canadian banks were sold down due to concerns about lower energy prices and the unexpected cut in Canadian interest rates on Jan. 21. However, TD recovered sharply in February.
Action now: At a forecast p/e ratio of 12.1 times 2015 earnings TD remains a Buy for its low risk retail focus and market leading position.
Scotiabank had a worse than expected fourth quarter, having warned investors that it anticipated writedowns on some of its exposures. For the quarter ended Oct. 31, Scotiabank reported net income of $1.4 billion ($1.10 per share) as compared to $1.7 billion ($1.29 per share) a year earlier. This reflected a number of exceptional items, including a $73 million after tax charge in Canada, consisting of a $46 million loan loss provision and a $27 million restructuring charge. These reduced Canadian earnings from $555 million to $483 million.
Internationally, Scotiabank took a $47 million write down on its Venezuelan exposure, $79 million in restructuring charges including closing 120 branches, and further charges on its Caribbean hospitality (hotel) loans. These write downs reduced international earnings from $410 million to $265 million.
However, profits in global wealth and insurance rose to $327 million from $313 million. The bank raised its quarterly dividend by $0.02 a share (3.1%) to $0.66 a quarter in August.
New CEO Brian Porter warned that "the headwinds we have experienced over the last few quarters are likely to persist into the first half of 2015" but went on to say that he expected "more robust growth in the latter part of the year". He confirmed that the bank is targeting 5% to 10% growth in earnings per share for 2015.
Action now: With a forecast p/e ratio of 11.4 times, and a yield of 3.93%, Scotiabank remains a Buy for its international exposure to the rapidly growing economies of Latin America and Asia, its growing wealth management arm, and its strong focus on cost controls.
- end Gavin Graham
