(The Toronto Star posted the following article by Pat McKeough on its website on March 14.)
TORONTO — Despite the lower earnings in 2003, CP Rail’s business is improving. Grain shipments rebounded after droughts in 2001 and 2002. Coal and fertilizer volumes also improved. However, the sluggish economy hurt shipments of forest products and automotive equipment.
CP Rail is now preparing for heavier traffic by upgrading its tracks and buying more fuel-efficient locomotives and freight cars. This will let it cut costs by running longer trains. Although this spending will hurt its short-term profit growth, the benefits should last for years.
A railway’s operating ratio (regular operating costs divided by revenues) measures its efficiency – the lower the number, the better. In 2003, CP Rail’s operating ratio rose to 80 per cent from 77 per cent a year earlier. This was partly due to rising fuel costs. However, new trains and tracks should help CP Rail cut its operating ratio in 2004. A new, seven-year computer outsourcing deal with IBM should also lower its costs.
The rapid rise of the Canadian dollar in 2003 has hurt all Canadian companies with significant operations in the United States – particularly Canada’s two leading railroads. CP Rail’s cash flow fell 10 per cent in 2003, to $5.35 a share from $5.95 in 2002. However, recent restructurings have dramatically cut their operating costs. That, and higher shipments of natural resources and agricultural products, should help CP Rail and CN Rail prosper regardless of future currency movements.
CANADIAN PACIFIC RAILWAY (TSX: CP) provides freight transportation by rail over a 22,200-kilometre network between Montreal to Vancouver, and the Midwest and Northeastern areas of the United States. Alliances with other railroads extend CP Rail’s reach into Mexico. In October 2001, former parent Canadian Pacific Limited spun off CP Rail as an independent company.
CP Rail’s revenues have hovered around $3.6 billion in the last five years. Profits before restructuring costs and other non-recurring items rose to $3.17 a share in 2000 from $2.56 a share in 1999, but fell to $2.53 a share in 2001. Profits improved to $2.56 a share in 2002, but a 22 per cent jump in fuel prices and unfavourable foreign exchange rates cut profits in 2003 to $2.11 a share.
In 2003, the Canadian dollar rose 11 per cent against the U.S. dollar. That means CP Rail’s U.S. revenue (about 30 per cent of total revenues) translated into fewer Canadian dollars.
However, about 75 per cent of the company’s long-term debt is denominated in U.S. dollars. So a lower U.S. dollar cuts its interest expenses, which helps offset the negative impact on revenues.
The company also uses hedging contracts to protect itself from rising fuel costs.
CP Rail’s restructuring and cost controls should raise its 2004 profits to $2.58 a share, and the stock now trades for just 13.6 times that figure. The extra earnings should help CP Rail pay down its long-term debt, which now stands at 0.9 times equity. The $0.51 dividend yields 1.5 per cent.
CP Rail is a buy.
CANADIAN NATIONAL RAILWAY (TSX: CNR) operates Canada’s largest railroad with 28,600 kilometres of track between Halifax and Vancouver, and 14 U.S. states. (Note that per-share amounts and stock prices have not been adjusted for a 3-for-2 stock split which should take effect near the end of February.)
CN’s revenues grew to $6.1 billion in 2002, mainly due to the acquisition of two U.S. railroads. Profits rose to $3.82 a share ($774 million) in 2000 from $2.98 a share (total $603 million) in 1999. But restructuring costs cut profits to $2.82 a share ($571 million) in 2002. Profits in 2003 soared to $5.23 a share ($1.0 billion).
If you disregard unusual items, per-share profits in 2003 grew just 3.5 per cent, to $5.40 from $5.22 in 2002.
Much of the company’s recent profit growth is due to strict cost controls. In fact, CN is one of the most efficient railroads in North America with an operating ratio in 2003 of 69.8 per cent, up slightly from 69.4 per cent a year earlier.
CN aims to cut its operating ratio in 2004 by least 1 per cent. CN’s profits in 2004 should also gain from buying BC Rail Ltd. for $1 billion. The deal gives CN the right to use BC Rail’s network for 60 years, with an option for 30 more years.
The BC Rail purchase should expand CN’s share of the forest products market, which accounted for 22 per cent of its 2003 revenues. The deal should close in the second quarter of 2004. The company is also close to completing its acquisition of two small Midwestern U.S. railroads and a fleet of Great Lakes vessels for $380 million U.S.
This will expand CN’s capacity between Chicago and Western Canada, and increase the company’s access to U.S. steel shipments. The purchase should add $285 million to the company’s annual revenues. CN ended 2003 with only $131 million in cash, so it will have to finance these deals with new debt.
This will probably increase its long-term debt from 0.5 times equity to a still reasonable 0.7 times. The company stands to receive $133 million in cash from the pending dilution of its minority interest in a UK railroad. It will probably use this in cash to pay down debt.
CN’s stock has gained about a third in the past year, but still trades for just 14.0 times the $5.91 a share ($3.94 post-split) that it will likely earn in 2004. The company recently raised its quarterly dividend 17 per cent, from $0.25 a share to $0.2925 a share. The new annual rate of $1.17 ($0.78 post-split) yields 1.4 per cent.
CN Rail is a buy.