6 February 2006
Railroad Renaissance?
The country's two major railroads look much the same as they did a decade ago - red locomotives
pulling long trains through rock-strewn mountain passes and across windswept prairies.
But things couldn't be more different. Railroads are now making money. Heaps of it. And investors are piling into rail stocks with an
enthusiasm that used to be reserved for dot-coms.
Take the country's largest railway, Canadian National Railway Co. Over the past year it has managed to post record profit despite
skyrocketing fuel prices, several high-profile derailments and the impact of two hurricanes on its U.S. operations. The
reason? The short answer is a boom in global trade - particularly with Asia - and not enough trucks and trains to handle the load.
That's allowed railroads, which have been steadily whittling down costs, to raise their prices and pass along rising fuel costs to
customers in the form of surcharges.
Investors have driven up CN's shares more than 37% in the past year and 11% since January. It's a similar story at rival Canadian
Pacific Railway Ltd., where shares have risen 18% since the start of the year.
All of which raises the question: How long can this "railroad renaissance" last?
While most analysts say the sector's outlook continues to be favourable, there are a growing number of voices warning that railroad
stocks have reached peak valuations and a slightly less-than-rosy future could result in an abundance of investor pain.
"We are concerned that the rails, in general, may be getting expensive, especially given some concerns about the sustainability of
double-digit pricing," wrote David Newman, an analyst at National Bank Financial, in a recent research report on CP
Rail.
Both CN and CP Rail are now trading at about 15 times their estimated price-to-earnings ratios, well above the historical
average. While Mr. Newman argues that current multiples appear justified, given today's strong pricing environment, he nevertheless
lowered his "outperform" rating on CP Rail's shares while increasing his target price to $57 a share from $54. He continues
to rate CN "outperform," with a target of $102 a share, citing the company's "best-in-class" status.
CN's shares closed Friday at $103.36, up $1.06 on the Toronto Stock Exchange. CP Rail's shares closed at $54.40, up 1 cent.
A recent report by BCA Research argues that the recent string of profits has triggered a buying spree among U.S. investors, pushing up
railroad valuations to unrealistic levels. "The share price advance has reached a dangerous phase and we do not see recent
outperformance as sustainable," said the report, referring specifically to such major U.S. railroads as Union Pacific Railroad Co.,
Burlington Northern Santa Fe Corp., CSX Corp., and Norfolk Southern Corp.
The BCA report added that there's no good explanation for the "steady climb" of analysts' long-term growth
expectations for the North American industry. "Extrapolating last year's demand and pricing gains far into the future could prove
overly ambitious."
According to BCA, recent consumer spending patterns suggest demand for cheap consumer goods from China, for example, may soon soften
more, meaning lower volumes of containerized railcar shipments flowing out of ports such as Vancouver. While that could be offset by
continued strong demand for commodities, there is also evidence that demand for coal, one of the more profitable bulk commodities,
could also start falling off as the price of natural gas declines, the report says.
Some analysts, however, say the warnings are premature.
"There's no question the economy will cool, but the U.S. just announced the lowest unemployment rate in years," said Ted
Larkin, an analyst at Orion Securities, who rates both railroads as "overweight" and recently raised his target price on CP
Rail to $65.25 from $56. "So the good times are still rolling down there."
He added that CN and CP Rail have also managed to steal business from trucking companies, which are facing driver shortages, high
insurance rates and soaring prices at the pumps.
Moreover, not all railroads are created equal. For example, plummeting demand for coal would deal a heavy blow to several U.S.
railroads, particularly Burlington Northern, CSX and Norfolk Southern - all of which count on coal to make up nearly a quarter of their
revenue, according to a report last week by UBS Investment Research.
By contrast, coal accounts for only about 5% of CN's total freight sales, while CP Rail is more exposed with 19% of its total freight
revenue from coal, largely through its major partnership with B.C.'s Elk Valley Coal Corp.
Both railroads have significant exposure to the intermodal side of the business. CN, with access to five saltwater ports in North
America, counts on containerized shipments for 18% of its revenue while CP Rail's reliance on the segment is about 27%, according to
UBS.
But revenue is only half the picture.
CN and CP Rail have demonstrated a relentless approach to improving their productivity by reducing staff levels, signing routing
protocols with other railroads and improving the flow of freight over their own networks. In fact, CN is now considered the most
efficient railroad in North America; in the fourth quarter, it boasted an operating ratio - operating expenses as a proportion of
revenue - 61%, the lowest in the industry.
For investors, that makes CN a good bet even if the economy should slow down.
"In a slowdown, the companies that people are going stick with are the ones that have delivered. And CN is one of those
companies," says Jennifer Dowty, an associate portfolio manager with MFC Global Investment Management.
Nevertheless, Ms. Dowty, who manages $1.6-billion in assets, says her pick is CP Rail because, unlike CN, there's still
considerable room for further productivity improvements.
CP Rail recently confirmed it is moving forward with cuts to its white-collar workforce and is taking steps to
de-centralize its management structure - a move that promises to help the railroad operate more efficiently by putting
managers closer to the railroad's operations.
As well, the company recently completed a $160-million expansion project to its operations in Western Canada that is
designed to improve traffic flows. CP Rail also signed an agreement with CN in the Lower Mainland of British Columbia to increase
sharing of tracks, allowing both firms to access the area's ports more easily.
Indeed, many analysts were surprised with CP Rail's fourth-quarter results, which showed a three percentage point
improvement to the railroad's operating ratio - 74% in the quarter - and earnings that beat average analysts' estimates.
"There's a level of co-operation that's leading to operational excellence that we've never seen before," says
Orion's Mr. Larkin, who adds that he expects more surprises from CP Rail and continued strong performance at CN.
In other words, while rich valuations are making railroad stocks more risky, there is ample evidence to indicate the country's
railroads have undergone a profound transformation that will allow them to weather an economic downturn when it arrives.
The big red locomotives are not likely to career off the tracks any time soon.
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