In the global marketplace, North American railway companies are on full throttle, overtaking trucking companies hampered by high fuel costs, in the battle for market share. Japanese railway companies, too, are winning kudos for efficient transportation of passengers.

In economic downturns, railways usually take a beating. But not this time around. Railway companies, particularly those in the U.S., are in such a strong position that they have been able to increase prices, as well as collect surcharges, that cover most of their ever-rising fuel costs. The four major U.S. railway companies have all posted higher earnings so far in 2008 than in 2007.

The two big Canadian railways — Montreal-based Canadian National Railway Co. and Calgary-based Canadian Pacific Railway Ltd. — have not been as quick as their U.S.-based peers to pass along higher fuel costs to clients. So, both CN and CP have seen earnings drop in the six months ended June 30, CN by 8.3% and CP by 36.2%. CN’s earnings, much of which come from its U.S. operations, were negatively affected by the high Canadian dollar.

Still, CN is the most efficient railway company in the U.S., with an operating ratio (operating costs as a percentage of operating revenue) that is usually about 10 percentage points less than any of its peers. It is also the only railway firm to offer services not only across continental U.S. and Canada, but also south to the Gulf of Mexico.

North American railways have come a long way in recent decades, thanks to deregulation and consolidation. Until the 1980s, the sector was fragmented and inefficient. Now, there are only six major railways; all are well run companies that offer good service and have positive returns on capital. This has persuaded savvy long-term investors, such as Warren Buffett, to invest in the sector.

Railway companies in Japan are also in good shape. In this case, the railway firms that analysts recommend carry mainly passengers. The passenger business tends to be less affected by sluggish growth, making these companies good defensive holdings during economic slowdowns and recessions.

Charles Burbeck, head of global equities with HSBC Halbis Partners in London, maintains Japanese railways are the most efficient in the world. In addition, they own prime real estate, which has significant development potential. Tokyo-based East Japan Railway Co. , for example, has real estate holdings unrelated to railway operations that have a book value of US$2 billion.

Here is a closer look at CN, CP and East Japan Railway:

> Canadian National Railway Co. The company reported net income of $770 million in the six months ended June 30, down from $840 million in the same period a year earlier. The high C$ reduced the six-month earnings by about $55 million, accounting for much of the decline. The previous year’s first-half earnings, however, were already hurt by a conductors’ strike that reduced earnings in that period by $35 million.

The real drag on earnings was fuel prices. Operating expenses were up by 9.1% in the six months, led by a 51.5% rise in fuel costs. As a result, CN’s operating ratio was 69.4% in the six months, up somewhat from 65.1% in 2007. But it’s still significantly less than Norfolk, Va.-based Norfolk Southern Corp.’s 73.8% and Jacksonville, Fla.-based CSX Corp.’s 76.1% — both of which have passed on more of the fuel costs to customers — and way below the 80%-82% for the other three big North American railway companies, including CP’s 81%.

CN’s revenue in the six months was $4 billion, vs $3.9 billion in the same period a year earlier. Net cash flow after non-cash working balances was $574 million vs $1 billion. Long-term debt was $6.4 billion as of June 30.

CN has much more exposure to the forest-products industry, which has been hit hard by the collapse of the U.S. housing market, than does CP. In CN’s first half, revenue from this sector was down by 16.6% to $687 million; but even so, forest products accounted for 18.9% of CN’s total rail freight revenue. At CP, by comparison, forest products generated revenue of $116.4 million, only 5% of its freight revenue.

Revenue from shipping automobiles was down at both companies, but accounts for a smaller percentage of overall revenue: 6.6% for CN and 6.9% for CP.

@page_break@CN’s freight revenue was up in all other categories, including petroleum and chemicals, metals and minerals, coal, grain and fertilizers, and intermodal.

A report by UBS Securities Canada Inc. ’s Toronto office has rated CN stock a “buy”, with a 12-month share price target of $61, significantly more than the $54.09 a share at which it closed on Aug. 15. The report’s thesis: “[Assuming the U.S. economy recovers in 2009], CN’s earnings per share growth should accelerate, reflecting continued investment in productivity, ongoing share buybacks and projected ramp-up of some revenue initiatives.”

The last item includes CN’s new container terminal in Prince Rupert, B.C.

A report issued by Toronto-based RBC Capital Markets suggests CN stock will outperform the sector average; the 12-month price target is $60 a share. The report notes the increased volumes at the Prince Rupert terminal and says that the difficult weather and fuel surcharge lag that affected first-half results “will not likely be a significant factor in the second half of 2008.”

As well, the report states: “CN is well positioned to capitalize on its solid network, important efficiency initiatives and interesting growth opportunities.”

A report by Montreal-based National Bank Financial Ltd. gives a share-price target of only $57 in 12 months but still suggests CN stock will outperform its sector. This report also notes the increased volume at the Prince Rupert terminal and says that CN believes revenue at that port will increase by $100 million this year.

One thing that would boost CN’s already bright prospects is the acquisition of Elgin Joliet and Eastern Railway Co., which would allow CN to bypass the rail congestion in Chicago’s metropolitan area. But the Chicago suburbs through which this line runs are objecting to the acquisition. The NBF report notes that CN is “cautiously optimistic that the deal will close by yearend.”

A report by New York-based J.P. Morgan Securities Inc. is less enthusiastic about CN, rating it “neutral.” The report is forecasting 2008 EPS of $3.47, a mere 2% more than EPS of $3.40 in 2007; the company is expecting a mid-double-digit gain. CN’s expectation of stronger volume growth may be “somewhat optimistic,” the report says, and it “may be a bit early” to buy the stock. The report suggests waiting until CN’s EPS posts growth similar to that of the big U.S. railway firms.

CN is widely held, with 512 million shares outstanding.

> Canadian Pacific Railway Ltd. CP reported net income of $245.7 million in the six months ended June 30, vs $385.3 in the same period a year earlier. Operating expenses were up by 6.9%, with fuel costs up by 34.4%.

CP also took a $24.4-million after-tax loss as a result of its 2007 acquisition of Sioux Falls, S.D.-based Dakota Minnesota & Eastern Railroad Corp., as well as a $15-million after-tax charge concerning the change in the value of the company’s asset-backed commercial paper holdings. The higher C$ also shaved $10 million off CP’s earnings.

Six-month revenue was $2.4 billion, up slightly from $2.3 billion in the same period in 2007. Operating cash flow fell to $343 million from $592.2 million after changes in non-cash working capital balances related to operations. Long-term debt was $4 billion as of June 30.

Some analysts’ reports, including UBS’s, suggest the company will do better in the second half of this year and post good results through 2009. UBS’s report calls for “accelerated pricing growth, improved fuel recovery, easier comparisons to year-ago figures and a moderating foreign-exchange headwind.” As a result, the report has rated the stock a “buy” with a 12-month target price of $80 a share, well above the $63.40 at which it closed on Aug. 15.

But other analysts’ reports suggest weak results will continue. Reports by NBF and RBC Capital Markets rate the stock “neutral” and have lowered their 12-month price targets to $67 and $68 a share, respectively, from an earlier $73-a-share target. A J.P. Morgan report also rates the stock “neutral.”

The J.P. Morgan report calls for “sluggish earnings for a few more quarters,” based on high fuel costs and weakness in economically sensitive customer segments. The NBF report agrees, although it notes that CP’s long-term potential looks good, particularly its exposure to bulk commodities (coal, fertilizer and grain) and emerging economies. CP’s acquisition of Dakota Minnesota & Eastern Railroad gives it access to the Powder River Basin, which contains the largest deposit of low-cost, low-sulphur coal in North America.

CP operates from Vancouver to Montreal and in 16 U.S. states. It is widely held, with 159 million shares outstanding.

> East Japan Railway Co. Although this is Japan’s largest railway company, it is only about half the size of Britain’s National Rail and a third the size of the French National Railway. Yet, it transports seven to eight times as many passengers. Half its revenue comes from the Toyko area: 28% from bullet trains and 21% from local lines outside of Tokyo.

East Japan Rail is not a strong growth company because there is little potential to grow its customer base. But it’s a steady business that’s little affected by economic conditions. Nevertheless, as with the other two big Japanese passenger rail companies, West Japan Railway Co. and Central Japan Railway Co., East Japan Rail has the potential for earnings growth because of its real estate holdings and cost-cutting.

All three railway firms own substantial amounts of real estate, a good deal of which is in major cities. They all lease retail space in their stations and operate shopping malls. They also rent out land near the stations, which, Burbeck says, can be either further developed into shopping centres or sold.

Even though the Japanese railway companies are already very efficient, further cost-cutting is possible by reducing employment as older workers retire. It’s difficult to lay off people in Japan, Burbeck adds, but it is “socially acceptable” to reduce costs by not replacing retiring workers.

Another plus is that the Japanese railway firms have maintained their capital investment levels; their systems are built up and modern, Burbeck says. Service quality is high and trains are on time. Bullet trains go as fast as 300 kilometres an hour, so people can commute from that distance.

Burbeck expects Japanese railway firms’ revenue to increase by 2%-3% a year and their EPS to increase by 7%-8%. He expects East Japan Rail’s EPS, however, to rise by 8%-9% a year.

East Japan Rail is Burbeck’s favourite at the moment. A large portion of its real estate is in cities, particularly Tokyo, and the demographic profile of its workers is more favourable, with a larger portion of them close to retirement.

A report by UBS Securities Ltd. in Japan rates the stock “neutral,” with a 12-month price target of ¥890,000. The four million widely held shares closed at ¥830,000 ($8) a share on Aug. 15, vs a high of ¥1 million in April 2007.

Some analysts suggest demand could shift to railways from private cars due to higher gasoline prices, but, the UBS Japan report notes: “At this stage, no notable changes can be confirmed.” Indeed, revenue from metropolitan lines rose by only 0.1% in the first quarter ended June 30, despite the opening of a new Tokyo subway line.

East Japan Rail reported net income of ¥63.8 billion ($615.5 million) in its first quarter, vs ¥54.9 billion in the same period a year earlier. First-quarter revenue was ¥660.2 million, vs ¥652.8 billion a year ago. Cash flow after net change in non-cash working balances was ¥103.8 billion vs ¥55.9 billion. Long-term debt was ¥1.9 trillion as of June 30.

Railway service accounted for ¥464.8 million, or 62.5%, of the revenue (excluding corporate but before eliminating double-counting), and ¥90.3 billion, or 75.5%, of the ¥119.6 billion in operating income. Utilization of station space accounted for 14.1% of revenue but only 7.5% of operating income. Shopping centres and other buildings accounted for 7.6% of revenue but a bigger, 14.9% portion of operating income. Other services — advertising and publicity, hotel operations, wholesale trucking, cleaning, information processing and credit cards — accounted for 15.8% of revenue but only 2% of operating income.

East Japan Rail has a program to increase tourist flows by targeting specific regional destinations. It also has a “station renaissance” program, under which it opens new stores and reinvigorates existing ones; it opened two new shopping malls in the fiscal quarter. IE