(The following column by portfolio manager Patrick McKeough appeared in the May 5 issue of the Toronto Star.)
TORONTO — Canadian railways have come a long way in the last few years.
Thanks to aggressive cost cuts and large investments in new locomotives, railcars and tracks, they are now two of the best-run railroads in North America. Both should continue to lure customers away from trucks, and profit from the expansion of free trade.
Canadian Pacific operates a 14,000-mile railroad network between Montreal and Vancouver, and the Midwest and Northeastern parts of the U.S.
Alliances with other railroads extend CP Rail’s reach into Mexico. The company was spun off from former parent Canadian Pacific Limited in October 2001.
CP Rail’s revenues crept up to $3.7 billion in 2001. Revenues slipped to $3.67 billion in 2002, due mainly to a drought on the Canadian prairies that cut grain shipments by 15 per cent. Revenues in 2003 should climb to $3.8 billion now that weather conditions are returning to normal.
Cost controls and higher shipments of automotive equipment lifted profits in 2002 to $2.56 a share.
CP Rail has invested heavily in new equipment in the last few years. The company also keeps its costs low with a hedging program that shields it from rising fuel costs. Consequently, the company’s operating ratio (regular operating costs divided by total revenues) fell to 76.6 per cent in 2002 from 77.3 per cent in 2001.
This is an important measure of railroad efficiency – the lower the number, the better. CP Rail aims to cut its operating ratio to 73 per cent.
Moving freight by rail is generally cheaper than by road (and way cheaper than by air). Railways can also move goods more quickly through congested border crossings.
Following Sept. 11th, CP Rail joined with U.S. and Canadian customs officials to increase security. CP Rail and its main customers now pre-screen most shipments, significantly cutting border delays.
CP Rail’s cash flow rose 3 per cent, to $5.95 a share in 2002 from $5.78 a share in 2001. The company used most of its cash to cut its long-term debt from 1.25 times equity to 0.9 times equity. Regular maintenance will probably account for most of CP Rail’s capital spending in the next few years, so it will probably use any extra cash flow to cut its debt even more.
The stock fell to $22.50 just after the CP break-up, but climbed to $38 in July 2002. It now trades for 13.2 times its likely 2003 profits of $2.42 a share. The $0.51 dividend yields 1.6 per cent.
Canadian Pacific Railway is a buy.
Canadian National operates Canada’s largest railway, with an 29,000-kilometre network that stretches across Canada, and through the American Midwest to the Gulf of Mexico.
The federal government controlled CN until November 1995. That’s when Ottawa first sold shares to the public at $16.25 a share. It sold the remainder of its CN shares in November 1996 at $10.75 each.
Ottawa limits a single investor’s ownership in CN to 15 per cent.
In the last five years, CN’s revenues grew at a compound rate of 10.4 per cent, to $6.1 billion in 2002 from $4.1 billion in 1998. Part of this growth came from the acquisition of two U.S. railroads: Illinois Central in 1999 for $3.5 billion, and Wisconsin Central in 2001 for $1.3 billion.
Profits jumped to $774 million or $3.82 a share in 2000. Restructuring charges cut CN’s profits to $571 million or $2.82 a share in 2002.
Much of CN’s recent growth is due to aggressive cost cutting. Consequently, CN is now one of the most efficient railways in North America, even though its operating ratio crept up to 69.4 per cent in 2002 from 68.5 per cent in 2001.
This focus on efficiency has let CN speed up its trains and improve delivery times. In fact, the company has cut the number of its active railcars by 28 per cent in the last five years.
CN is now selling its expertise to non-railway companies that operate their own private railways. The company is also replacing older railcars with newer ones designed for specific industries, such as refrigerated cars for fresh food providers.
This should help CN lure customers away from trucks. It should also cut CN’s exposure to more cyclical commodities like grain, forest products and coal, which accounted for just over half of its 2002 revenues.
CN’s cash flow has nearly doubled since 1998. It used this to cut its long-term debt to 0.75 times in 2002 from 0.9 times equity in 2001.
The strong cash flow also let CN spend $203 million on share buybacks in 2002. It also let CN recently increase its dividend 16 per cent, from $0.86 a share to $1.00. The new rate now yields 1.5 per cent.
The stock trades for only 12.6 times the $5.15 a share CN will probably earn this year. CN has now fully absorbed the two big U.S. acquisitions, and its focus on cost controls puts it in a strong position to profit as the economy improves.
Canadian National Railway is a buy.
(Portfolio manager Patrick McKeough publishes The Successful Investor newsletter and is author of Riding the Bull: How You Can Profit in the 1990s Stock Market Boom. His column appears online Mondays.)