2 Canadian Rail Stocks at a Crossroads

01/11/2012 8:30 am EST

Focus: GLOBAL

Tom Slee

Retired- Financial Advisor, Money Manager, Gordon Pape Enterprises LTD

As some railroad stocks get bid up, it’s important to know which ones are worth chasing and which are simply overvalued, writes Tom Slee in The Canada Report.

When we look at the stock market, it’s almost a relief to see one bright sector in a bleak landscape. The railways are doing well.

Despite moderating volume growth, the six major North American Class 1 railroads turned in an excellent third quarter. Industry earnings jumped 23% year-over-year. Profit to date in 2011 is up 17% over last year. It was a strong performance with higher volumes, cost cutting, and price increases all contributing. Looking ahead, the companies are now well placed to weather any economic downturn and continue to grow.

Most railway executives issued optimistic guidance along with their quarterly numbers. In particular, they pointed to price escalator clauses in their freight contracts that protect the railroads from rising energy costs, a continuing problem in the past. The American carriers are also poised to raise rates on coal shipments when contracts are renewed in April.

It’s all very positive…but there are two things to keep in mind. First, all this success has not gone unnoticed. Railway stocks have surged recently. There are no bargains and we have to shop carefully.

It’s also apparent that accident-prone Canadian Pacific (CP) is becoming a special case. Investors have been concerned for some time about the company’s inability to streamline operations, and an activist hedge fund has now taken a 12% stake, causing the stock to jump 8%.

If nothing else, this has partially discounted the capital appreciation we were expecting in 2012. My updates follow.

CN Railway (CNI)
CN Railway continues to perform well. Third-quarter earnings of $1.38 per share were up 16% year-over-year, and well ahead of the $1.30 analysts were expecting (figures in Canadian currency). Despite a spluttering economy, results were good across the board.

Freight revenues jumped 12%, more than 8% as a result of higher volumes and the rest from price increases. Car loadings rose 4% and the company generated a free cash flow of $580 million.

Most impressive was CN’s operating ratio of 59.3%, a 1.4-percentage-point improvement over 60.7% the year before. This is the ratio of operating expenses to revenues, and the measure used by analysts to gauge a railway’s efficiency. In effect, it’s the amount of income used to run the system, so the lower the better.

To put CN’s efficiency into perspective, Norfolk Southern (NSC), a relatively tight operation, has a 67.5% ratio, while the troubled Canadian Pacific has run at a sobering 80.9% during the last 12 months.

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What I find encouraging about CN is that it remains market-focused. Instead of basking in his excellent operation ratio, CEO Claude Mongeau is busy building top-line growth through customer service. That is the life blood of any company. Expansion and upgrading of the railway’s facilities in Chicago and Indiana will also allow for future growth.

I think that CN will continue to use its low-cost competitive edge to gain market share from Canadian Pacific and the trucking industry. Price incre ases will continue to stick. As a result, the railway should earn about $4.90 a share in 2011 and $5.40 next year. The stock has surged recently but still has upside potential.

CN Railway, one of our core stocks, remains a buy with a new target of $88. [The stock closed near $77 on Friday.]

Canadian Pacific Railway (CP)
When Canadian Pacific was added to our Buy List in March, I realized that the company had problems. However, management seemed to have a grip on the situation and earnings were likely to improve. Brutal weather and avalanches hurt profits during the first half, but CP was set to rebound in the third quarter.

That did not happen and I am disappointed. The company reported third-quarter earnings of $1.10 a share, down 9% from the year before (figures in Canadian dollars). Revenues actually increased 8%, but a lot of that was a combination of fuel surcharges and a better price mix. Actual carloads declined 2.5%.

It was a respectable performance, but there was no sign of the company regaining market share lost earlier in the year due to bad weather. The operating ratio improved slightly to 75.8%, but remains far too high. As I say, the numbers are respectable, but once again CP is lagging its peers.

The company’s substandard performance has now attracted the attention of at least one predator. Pershing Square Capital Management, a US-based hedge fund with a 12.2% stake in the company, has opened discussions with management. There is speculation about a takeover bid from a pension fund or another railway and the stock has strengthened.

It’s all very exciting…but tread carefully. Pershing has had mixed success with its interventions, and it will be extremely difficult to change a railway dramatically. Moreover, CP’s customers may turn elsewhere if there is prolonged uncertainty.

The Canadian government is going to take a long hard look at any bid for CPR, one of the country’s national icons. Note too that Pershing has already booked a substantial capital gain as a result of the intervention, and that may have been one of its goals.

Therefore, Canadian Pacific Railway becomes a hold. I will monitor the situation closely.

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