With the economic outlook so cloudy, railways may not seem like a good bet; still, Montreal-based Canadian National Railway Co. is considered a good defensive stock by some. In contrast, Calgary-based Canadian Pacific Railway Ltd. does not fall into the “defensive” category — although it has the potential for greater upside if an economic downturn is avoided.
Railways are sensitive to economic cycles, and their stock prices tend to swing more than the broad stock indices. Of the two, only CN has the operational efficiency that keeps the impact on earnings and its stock price relatively modest when the economy slows.
CP and the four major U.S. railways — Jacksonville, Fla.-based CSX Corp., Kansas City-based Kansas City Southern Railway, Norfolk Va.-based Norfolk Southern Railway and Union Pacific Railroad of Omaha, Neb. — can have large drops in their stock prices during slowdowns/recessions and big increases when the economy and railway volumes are accelerating. Because these firms are less efficient than CN, there’s additional upside potential if they can narrow the gap.
Still, even with the economic outlook uncertain, analysts with UBS Securities LLC in New York and TD Newcrest, a division of Toronto-based TD Securities Inc., currently have “buy” or “overweight” ratings on CP as well as CN. The UBS analysts have a “buy” rating on CSX and Union Pacific, but “hold” ratings on the other U.S. railways. The TD analysts had rated CP and CSX as “overweight” before they recently upgraded the whole sector to “overweight.”
But analysts with New York-based J.P. Morgan Securities LLC rate both CN and CP as “neutral,” while they give the four U.S. railways an “overweight” rating.
Over the medium and longer term, many analysts favour the sector. Joe Mastrolonardo, portfolio manager with Mackenzie Financial Corp. in Toronto, says there are many reasons to keep railways in your clients’ portfolios, including: a strong focus on returning value to shareholders; high barriers to entry, given the cost of tracks and trains; the potential for market-share gains from trucks; energy efficiency and low emissions; and pricing power, as witnessed by these firms’ ability to raise rates during the past decade.
A closer look at CN and CP:
> Canadian National Railway Co. has a “very strong culture that has produced smart strategic moves and a very proactive return of capital to shareholders,” says Tim Caulfield, co-lead manager in Calgary of Bissett Canadian Equity Fund, sponsored by Toronto-based Franklin Templeton Investments Corp. “It’s not something you do in months but build over years, [as a result of] really strong, capable management and great leaders.”@page_break@A key acquisition was Illinois Central Railroad in 1998, which connected the rail lines running between Vancouver and Halifax to a line running between Chicago and New Orleans — making CN a major North American railway.
The 2003 purchase of B.C. Rail’s operations is still paying off as the port in Prince Rupert, B.C., continues to expand; CN is the only railway that serves this port. The 2008 acquisition of Elgin Joliet & Eastern Railway Co. is important because it allows CN to bypass the congestion in Chicago.
Mastrolonardo points out that CN’s earnings per share had declined by only 12% in the recent recession vs 27% for CP’s EPS. For 2011, CN’s EPS is expected to be 27% above the 2008 high, while CP’s is expected to be still below its 2007 peak. He notes that CN’s aggressive share buybacks are partly responsible, with 471 million fully diluted shares outstanding as of Sept. 9 vs an average of 534 million in 2006.
Current 12-month target prices for the stock are $75 (J.P. Morgan), $83.50 (UBS) and $84 (TD Newcrest). The shares closed at $68.31 on Sept. 9.
Net income was $1.2 billion on revenue of $4.3 billion in the six months ended June 30 vs $1 billion in net income on revenue of $4.1 billion for the corresponding period a year earlier.
> Canadian Pacific Railway Ltd. operates mainly in Canada and has struggled to be efficient. But Joe D’Angelo, portfolio manager with CI Investments Inc. ‘s Signature Global Advisors division in Toronto, prefers CP to CN if a recession is avoided. He believes the measures that the company has put into place to increase productivity by running longer and heavier trains will result in better earnings.
Indeed, D’Angelo thinks that the drop in CP’s earnings this year — a result of difficult weather conditions — would have been greater if the company had made real progress in increasing efficiency. This opens the door for strong increases in EPS and stock price appreciation. “CN is safe and steady,” he says. “With CP, you get a chance for a little extra return.”
Current 12-month target prices are $60 (J.P. Morgan), $70.50 (UBS) and $66 (TD Newcrest). The 170.7 million outstanding shares closed at $51.60 on Sept. 9.
Net income was $161.7 million in the six months ended June 30 vs $267.6 million for the corresponding period a year prior. Revenue was virtually unchanged year-over-year, at $2.4 billion. IE