16 February 2006
Canada's Railways Rolling to Success
Investors have been riding the rails to profit as the pricing power, service and market share of
Canada's two big railway companies gain steam at the expense of rival trucks.
Profit at Canadian National Railway Co., the country's largest railway, hit a record high of $1.5 billion for 2005, up 24 percent from
the previous year. The railway split its stock two for one and raised its dividend by 30 percent.
In response, its shares soared to a record high of $105.95 recently. It closed on Tuesday at$103.96.
"It was clearly the best year this organization has ever had," chief executive Hunter Harrison told analysts in a conference
call last month.
The railway's operating ratio - operating costs as a percentage of revenue - fell to 61.8 percent in the fourth quarter (the lower the
better), making it the most efficient railway in North America. CP's ratio was 74 percent in the fourth quarter.
At Canadian Pacific Railway Co., in "the busiest and most successful year" of its history, profit hit a record high of $543
million last year, up 32 percent from the previous year. Not only did the company hit all its targets, it handily beat analysts'
forecasts, sending its stock price soaring to a high of $56.16. It closed on Tuesday at $55.35.
The railway renaissance is not a one-year wonder. Indeed, Canadian National has outperformed the wider stock market indices
for six straight years.
This raises a question: Are railway shares too expensive? After all, both companies' shares have soared past the target price set
by analyst David Newman of National Bank Financial in a January research report. Mind you, that was before fourth-quarter
results were out. Newman later raised his target price to $102 for CN and $57 for CP.
"Valuations are getting on the high end," Newman acknowledged in an interview. "But these are obviously not the railways
of yore," he added. "They're much more efficient than they used to be."
These new, better railways command a higher price-earnings multiple, he said. "If there's a dip in share prices, they
should be a core holding."
The folks over at The Successful Investor newsletter agree. In a February report, the newsletter recommended purchase of both companies.
CN was trading at $92 at the time and CP at $48.
"We see Canada's railways as portfolio cornerstones, and we feel all Canadian investors should own at least one railway
stock," the newsletter said.
How did staid, old railway stocks come to be so much in demand?
It was compete or die, analysts say. Historically, service wasn't high on the list of railways' priorities. Trains left when they were
ready; that is, when they had enough cars filled to make the run profitable.
From 1980 to 2004, the railways found themselves unable to raise prices because of growing competition from the newly deregulated
trucking industry. Trucks could deliver goods much more promptly than the railways. Railways were overstaffed and inefficient.
As is often the case, the turnaround began with new brooms slashing costs and jobs by the thousands, a process that seems to be drawing
to a close. CN cut the quickest, leaving CP lagging, which is reflected in its lower price-earnings multiple.
After completing a three-year plan to cut 820 jobs by 2005, CP announced earlier this month it was laying off 400 managers
and office staff, mostly in its Calgary headquarters.
Improvements went well beyond job cuts. The railways also found ways to move rail cars and goods far more efficiently than in the past
- so much so that trucking companies began loading their containers full of goods on to rail cars for long hauls, picking them up at
the other end for delivery to the client's door.
These steps coincided with a boom in demand for goods to be shipped to and fro across the country, including shipments of commodities
and manufactured goods through the Port of Vancouver to and from the Far East, and more recently, with soaring fuel prices, which hit
the trucking industry hard.
Railways have a three to one advantage over trucks when it comes to fuel costs, Newman points out. As well, they have been able to pass
much of the cost on to customers through fuel surcharges.
Add to this aging truckers, recent limits on drivers' hours, high fuel costs and difficulty attracting young drivers and the trucking
industry is losing its advantage, although it still controls short hauls such as the Windsor-Quebec City corridor, where
shipment by rail is not deemed practical.
"Truckers are facing driver shortages, which is expected to continue," said Newman. "It's difficult for independent
truckers to make a decent living."
Mind you, railways are vulnerable to economic downturns and supply glitches so the good times won't roll unbroken. Still, Newman sees
further productivity gains offsetting cyclical dips in revenues.
"All in all, railways are gaining traction," he said. "I think we are in a new secular trend in the railway
industry."
Looking ahead to the current year, the railways do face some headwinds, chief among them higher fuel prices and the strong Canadian
dollar, which eats into U.S. revenue when it is translated into Canadian currency.
CP expects coal shipments to be lower again this year, and revenue from automotive shipments to be modest. Shipments of potash are also
expected to be down.
Looking further out, railways stand to benefit if and when the federal Conservatives loosen the Canadian Wheat Board's control of the
grain business, which they have said they intend to do, Newman notes.
"The wheat board dictates when and where grain is picked up," he said. If participation becomes voluntary and the board no
longer controls the market, its control over the transportation of wheat will slip.
So instead of rail cars travelling down branch lines to pick up small amounts of grain at aging elevators, farmers will be encouraged
to bring their grain to a central elevator, where it will be loaded far more quickly than it is now, he added.
Business would migrate away from small elevators and branch lines. Instead, big trains would travel back and forth from ports to
high-throughput elevators, where grain would be loaded in 12 hours rather than a week.
Finally, railways are benefiting from increased co-operation not only with trucking companies but with each other. When
CN released its fourth-quarter results last month, CEO Harrison noted the railway's efficiency improved through
cost-cutting partnerships with others companies, such as one with Burlington Northern Santa Fe that should improve traffic
at Vancouver.
"There are two or three others on the drawing board that I hope we'll announce before this first quarter is over," Harrison
said at the time.
CN and CP recently agreed to share tracks in the B.C. Lower Mainland, allowing them to travel to the ports more easily.
As CP chief executive Rob Ritchie said recently, "We're poised, I think, for another great year."
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