Declining oil prices will likely have a negative impact on Canadian railroads given their exposure to the energy sector, but the damage may not be as bad as some expect.
Shares of both Canadian Pacific Railway Ltd. and Canadian National Railway Co. fell sharply on Friday as OPEC’s decision not to cut production caused a sharp retreat in crude prices.
The overall revenue exposure in 2014 for both CN and CP stands at roughly 9%, but CN has higher frac sand exposure and CP has higher crude-by-rail exposure.
Scotiabank analyst Turan Quettawala pointed out that a larger proportion of CP’s growth will come from crude-by-rail so it is clearly more levered than CN. He also noted that the majority of sand on CN’s trains is bound for gas drilling.
“We think that the risk to 2015 volume is relatively minimal considering that low prices likely need to stick around for 6-12 months before there is any major change in production or capex plans,” Mr. Quettawala told clients.
He noted that much of the growth for rails comes from Canadian volumes, while the pullback in prices for domestic producers has been offset by the weak loonie.
Assuming crude-by-rail and frac sand volumes remain flat in 2015, the analyst expects a 5% decline to CP’s EPS and a 5% hit for CN.
That implies a share price decline of $2 for CN and $11 for CP. Both stocks have already declined more than that.
“In our view, with the decline on Friday, both CP and CN shares are already discounting most of the near-term hit to crude-by-rail/frac sands,” Mr. Quettawala said, noting that they are trading at 2015 P/Es of 19.3x and 19.6x, respectively.
“The long-term earnings and free cash flow outlook for both rails remains solid and they may benefit from positive funds flow as investors reduce exposure to the energy sector,” he added.
The analyst also suggested that lower crude prices could prove to be a positive for other areas of the rail’s business, since lower gasoline prices should help improve disposable income and consumer spending.
“While near-term crude oil production out of Western Canada should remain resilient despite the drop in crude oil prices, all eyes are on what happens longer-term, especially given the rails have assumed a constructive outlook for crude volumes in their longer-term plans,” CIBC World Markets analyst Kevin Chiang told clients.
He noted that while the growth in crude volume may slow, the rail industry has proven it can achieve aggregate volume growth above of GDP even when one or two fail to meet expectations.
Mr. Chiang highlighted intermodal, forestry products and chemical products, which continue to have positive outlooks.
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