Why investors were quick to dump shares in the Canadian railways this week

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Canada’s two big railways reported quarterly profits this week that were slightly below analysts' expectations, and the selloff that followed suggests that high stock prices – and hefty valuations – could be challenging in the months ahead.

The shares of Canadian Pacific Railway Ltd. and Canadian National Railway Co. had been on a tear since March, rising to record highs as recently as last week. But the gains raised their respective price-to-earnings ratios to puzzling levels that were well above their long-term averages.

CP’s share price hit a record high of $429.75 last week, prior to the company’s earnings release. That’s up 60 per cent from the stock’s recent low in March and, perhaps more impressive, nearly 20 per cent above its pre-pandemic high in February, before the lockdown and arrival of the economic downturn.

CN shares have been on a similar trajectory. They hit a record high of $147.42 last week, up 48 per cent since March and more than 17 per cent above their pre-pandemic high.

But the remarkable gains have pushed valuations into unfamiliar territory for an old-school sector.

CN’s price-to-earnings ratio, based on estimated profits, surged to 23, according to Raymond James. That’s well above the average P/E of 17.6 over the past five years – a period during which the ratio never rose above 20.

CP shares recently traded at 21.5-times estimated profits, also well above the five-year average of 16.3. Previously, the P/E ratio hadn’t cracked 19.

The stocks are pricey, but why?

The Canadian railways have good company; U.S. railroads, too, have been performing well. CSX Corp. shares recently eclipsed their pre-pandemic high, for example. And valuations across six publicly traded North American railways stand at an average of 21-times estimated profits, according to Desjardins Securities, putting CP and CN in line with U.S peers such as Union Pacific Railroad Co. and Kansas City Southern.

Part of the attraction: Railways have bounced back from the pandemic selloff in February and March relatively quickly, underscoring their durability.

Though revenue in the third quarter, ended Sept. 30, declined at both CN and CP from the third quarter of 2019, both railways showed impressive recoveries from the dismal second quarter in terms of demand for their freight-hauling services.

“Canadian rail traffic continues to impress, in our view, staging a convincing surge back into positive territory as grain, potash, auto and forestry traffic accelerate and the broader economic recovery continues,” Steve Hansen, an analyst at Raymond James, said in a note.

He added that CP’s management now expects that railway’s traffic will increase 8.2 per cent in the fourth quarter, year-over-year, which implies that the pandemic – at least from the railway’s perspective – is a fading threat.

But railways are operating other levers that are exciting investors.

Growth is one of them. Though railways aren’t laying down new tracks, they are expanding with new infrastructure and customer relationships that are adding new revenue streams.

CP, for example, announced this week that it has a deal with container shipping company AP Moller-Maersk to move cargo unloaded in the ports of Vancouver and Montreal. Last week, the railway said it is buying full control of the 2.6-kilometre Detroit River Tunnel, which connects Windsor with Detroit.

Efficiency is another lever. Railways have been getting significantly better at controlling their expenses by shedding tracks and through leaner labour forces. As a result, their operating ratios, which compare costs with revenues, have fallen below 60 per cent (low is good here) from about 90 per cent in the mid-1990s.

The pandemic pushed railways to ratchet their efficiency even more, through longer and heavier trains.

“[CN] Management is confident that some of these cost savings will be permanent, which should naturally help the operating ratio in 2021 and beyond,” Benoit Poirier, an analyst at Desjardins Securities, said in a note.

Mr. Hansen expects that CP’s earnings per share in 2021 will increase 13.5 per cent above the railway’s 2020 expected profit. For CN, the Raymond James analyst expects earnings to increase about 22 per cent in 2021.

No wonder investors are giddy. But here’s the problem: With high valuations, railway stocks are already reflecting good times ahead. Disappointment could be costly.

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