Here at Canadian Value Investors, we focus on the actual earnings that shareholders would be able to receive after all actual cash expenses are paid and investments are made. This is not the earnings per share number flashed in the news at earnings time. For some companies, it might be a good proxy, but for others it can vary widely, and cause real earnings – what matters - to be significantly higher or lower depending on what is driving the line items. And with inflation all the rage these days, both literally and figuratively, it can exacerbate these differences, and yet people still quote earnings per share (EPS) like it’s no big deal. Canadian National Railway (TSX:CNR) is a great example of this.
We want to say up front that we like CN’s financial statement presentation and disclosures. They give you the information you need to do your own analysis and make your own adjustments. The issue is with how standard accounting principles work and making sure we understand the pitfalls and potholes.
CN is a relatively simple business. They move freight around North American on their rail line. They have ongoing operating costs like fuel and people to operate the railway. They also have major capital investments - like rail, engines, and IT systems - that are needed to keep the trains running on time and on the tracks. Certain costs like fuel are expensed every year as they are used, but other items like track have very long lives and so are capitalized and depreciated over time.
Assets with very long lives that need to be replace periodically – like CN’s mainline tracks - can lead to huge differences in depreciation versus actual cash capital expenditures that must occur every year. Rail today costs more than it did the last time they replaced it. However, if you compare CN’s depreciation rate to their actual capex, it is significantly lower. In fact, actual capex is, on average, exactly 100% more than depreciation if you look back to 2001. Now some of this spending can be considered expansion capex, like a new rail siding or terminal, but a significant proportion of this is related to just maintaining its existing business.
If you then adjust earnings available to owners, it cuts earnings up to half.
Why does this difference occur? Reasonable accounting estimates
CN provides disclosure on depreciation, which we have taken from their 2020 annual report and heavily condensed to simplify this discussion.
Properties are carried at cost less accumulated depreciation including asset impairment write-downs. The Company has a process in place to determine whether or not costs qualify for capitalization, which requires judgment. The cost of properties, including those under finance leases, net of asset impairment write-downs, is depreciated on a straight-line basis over their estimated service lives, measured in years, except for rail and ballast whose services lives are measured in millions of gross tons. The Company follows the group method of depreciation whereby a single composite depreciation rate is applied to the gross investment in a class of similar assets, despite small differences in the service life or salvage value of individual property units within the same asset class. The Company uses approximately 40 different depreciable asset classes…
See their annual report for the full note, which takes up a whole page (2020 – pg 41) - https://www.cn.ca/en/investors/reports-and-archives
They also provide a table breaking down how they group into the overall categories.
Going back to our track example, track and roadway is depreciated at 2% a year. That means that a piece of track has an implied lifespan of 50 years (1/2% year). Let’s say there is a section of track that was last replaced in 1971 for $1 million and it needs to be replaced in 2021 (of course this is greatly simplified, there’s ballasting, tie replacements, repairs, and other things happening over the years). Will it cost the same? No, because the suppliers have suffered from 50 years of cost inflation. CN has to continually replace track, engines, and everything else it needs to maintain its existing business, and this means that if there is any cost inflation since the last purchase, the actual cash capex costs will always outstrip historical depreciation, meaning that actual real cash available to owners will always be less than stated earnings (when only adjusting for this one item). This is not accounting shenanigans, it’s just the way accounting does and should work. But is also means it is prudent to keep this issue top of mind. Assuming 2% inflation and all else being kept equal, that piece of rail will cost 2.7x as much to replace as compared to the original cost. And if we get higher inflation, this issue gets exacerbated. One could also argue that the actual depreciation rate could be adjusted higher. We, as analysts, can adjust for ourselves.
It should be noted though that CN is just maintaining their existing business, replacing only a small percentage of their overall infrastructure every year, and so cost inflation affects CN slowly over time. However, if we were back in the late 1800s/early 1900s where railroads were building new lines across Canada from scratch, a short period of very high cost inflation would be devastating. Interestingly, CN is a collection of previously bankrupt railroads - https://en.wikipedia.org/wiki/Canadian_National_Railway#Creation_of_the_company,_1918%E2%80%931923
Beware of EPS headlines; do your own work
Doing your own work will help you make sure you don’t end up overestimating or even underestimating how much you are truly earning from your investments. Trying to collect a phantom dollar that doesn’t exist that instead has to go back into the business to keep it rolling is no fun.
As we said earlier, we like CN’s disclosures. They even provide a free cash flow calculation table to help analysts along in understanding the business. We do our own math, but this is a good starting point.
And for those interested, this is where a few billion of capex every year is going.
