CN Rail’s share price skidded Tuesday despite upbeat earnings. Here’s why

Open this photo in gallery:

Canadian National Railway Co. CNR-T issued a downbeat outlook for the economy, adding to a growing chorus of companies that are warning of deteriorating operations as rising interest rates weigh on activity.

“Our current volumes reflect that we are in a mild recession,” Tracy Robinson, CN’s chief executive officer, said during a call with analysts on Tuesday.

“We are uncertain about how deep or how long it will go on, but what we are modelling is negative North American industrial production for the full year,” Ms. Robinson added.

The gloomy outlook detracted from the railway’s strong first-quarter financial results, released after markets closed on Monday.

CN reported a profit of $1.82 a share, up 39 per cent from the first quarter of 2022 and well above analysts’ expectations for earnings of $1.72 a share. As well, revenue rose 16.3 per cent year-over-year.

The railway also dazzled on a number of metrics: Trains ran faster during the quarter and fuel efficiency improved. Its operating ratio – or expenses as a percentage of revenue, where a smaller number is better – declined to 61.5 per cent.

Yet the share price fell nearly 4 per cent in Toronto on Tuesday, to $161.63, suggesting that investors are putting little stock in past financial results amid evidence of a shifting economy.

Central banks have been raising their key interest rates aggressively in a battle against high inflation over the past year. While the latest readings on inflation show that it is subsiding, many commentators expect that recessionary risks are building, with the U.S. regional banking crisis contributing to the dour outlook.

The yield on the 10-year U.S. Treasury bond fell on Tuesday by a substantial 10 basis points. The yield is now about 60 basis points below a recent high at the start of March (there are 100 basis points in a percentage point), potentially reflecting a darker outlook for economic growth.

What’s more, financial markets now expect the Bank of Canada will cut its key rate by a quarter of a percentage point by October, marking a shift for the central bank from dampening economic growth with rate hikes to promoting it with cuts.

CN appeared to give an indication that it sees a good year unfolding by raising its outlook for 2023. Management now sees profit growth in the “mid-single digit range” in 2023, which is an improvement from previous guidance of “low-single digit” growth.

Yet, this outlook was really just a response to the strong first quarter, which raised growth for the full year without signalling an acceleration over the next eight months.

Steve Hansen, an analyst at Raymond James, expects the new outlook points to flat – or even declining – profit at CN for the remainder of the year against a backdrop of deteriorating traffic trends in April.

Rail traffic, which reflects demand for hauling commodities used by producers, has fallen 4.8 per cent in the second quarter, according to Mr. Hansen, who believes the trends suggests that the economy is already in a modest recession.

“While we continue to admire CN’s long-term outlook, we reiterate our neutral rating based upon our sustained macroeconomic concerns, deteriorating traffic growth and the company’s lofty relative valuation,” Mr. Hansen said in a note.

Canadian railway stocks have generally traded in line with the S&P 500 over the past five years, based on estimated price-to-earnings ratios.

But CN and Canadian Pacific Kansas City Ltd. CP-T – the new name for CP after it completed its merger with Kansas City Southern this month – currently trade at a considerable premium. CN’s P/E is 20.5, according to Bloomberg, compared with 18.4 for the diversified index of U.S. stocks.

Still, analysts expect CN can navigate the current headwinds.

Bank of Nova Scotia analyst Konark Gupta expects the share price will trade at $169 within 12 months, suggesting a modest gain from its price on Tuesday. Kevin Chiang at CIBC World Markets has a price target of $175, implying a gain of 8 per cent, but he maintained a neutral recommendation on the stock.