Canadian National Railway Initiated Hold At Loop Capital

Loop Capital has started coverage of Canadian National Railway (USA) CNI with a Hold rating and $64 price target, saying the continued fall in operating ratio and pricing surpassing inflation could result in greater regulatory scrutiny.

"With the railroad operating ratio falling from 89 percent at the time of the IPO to ~56 percent this year, and with pricing continuing to outpace productivity-adjusted cost inflation, it's only a matter of time before management will be forced to choose whether or not to cross the 50 percent Rubicon, triggering greater regulatory scrutiny including possible re-regulation," analyst Rick Paterson wrote in a note.

Paterson said the business should remain "somewhat stagnant" in to 2017 due to weak energy markets and lower demand from industries. However, grain and intermodal are the two bright spots in otherwise dull story.

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The analyst expects the company's intermodal volumes in 2017 to be positive versus year-to-date decline of 2.2 percent in 2016. In terms of materiality, intermodal and agriculture combined represent 40 percent of total year-to-date sales at Canadian National.

Meanwhile, pricing is inflating faster than costs and the analyst expects 2017 core pricing to be in the low- to mid-2 percent range. In fact, the Canadian Transportation Agency, in formulating its latest grain cap projects the company's (and Canadian Pacific Railway Limited (USA) CP's) wage and benefits inflation in 2016/2017 projected to be 1.4 percent, materials inflation of 1.5 percent, and other non-fuel items up 1.2 percent.

"So the margin story isn't, quite, over for CN, and if we factor in some headwind from likely higher fuel prices in 2017 we still come up with a 60 basis point improvement in the operating ratio to 55.1 percent and EPS a little over $5/share," Paterson noted.

Shares of Canadian National currently trade at an industry-high 18.2x next twelve months (NTM) consensus earnings. But, Paterson said the stock doesn't deserve this valuation, especially given limited margin expansion potential. The analyst's C$85 target is based on 16x 4Q17–3Q18 estimated EPS of C$5.30. The U.S. equivalent price target on the NYSE-listed shares of Canadian National is $64.

Canadian National shares closed Monday's trading at $63.72 on the NYSE.

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