Canadian railway and trucking companies that transport commodities had seen their freight volumes slashed as a result of the recession. But rather than playing victim to poor circumstances, they have been aggressively revamping operations. And analysts say these companies will see profit margins catapulting to new heights when the economy bounces back.

The depressed economy of the past year has caused the prices of many commodities, such as potash, coal and grain, to tumble. In turn, the companies that transport these goods saw their carload volumes drop substantially. For example, Montreal-based Canadian National Railway Co. saw a big drop in volume in the quarter ended March 30, 2009, when carloads of coal were slashed by 56%, to 100,000 from 226,000 during the same period a year earlier.

However, the recent recovery of freight revenue, resulting from a rise in commodities prices, has left many analysts bullish on the performance of companies that transport bulk commodities — especially railways — for 2010.

For instance, in less than a year, Calgary-based Canadian Pacific Railway Ltd. saw its freight revenue for coal recover, rising to almost $120 million for the quarter ended Sept. 26, 2009; this is a sharp bounce-back from $95.1 million in the quarter ended June 30, 2009, and more in line with the $116.4 million seen in the quarter ended Jan. 31, 2009.

Another positive is that although railway volumes will continue to return slowly, costs will not, says Walter Spracklin, an analyst with Royal Bank of Canada’s capital markets division in Toronto: “[Railways] have been able to restructure [their fixed] costs so they do not come back on a one-for-one basis when volumes return.”

For instance, companies have been experimenting with new initiatives, such as adding more containers to trains and temporarily reducing the number of trains headed to specific locations because of volume declines, adds Cherilyn Radbourne, a railways and infrastructure analyst with Toronto-based Scotia Capital Inc.: “Railways did better than expected in managing a 16% decline in the past year by leveraging their operating efficiencies.”

A well-known advantage that trucks have over railways is door-to-door delivery. However, as railways improve their speed and frequency of service to offer a more trucking-like service experience, Radbourne says, more customers will begin shifting to railways for shorter distances. Currently, the distance threshold for whether or not a customer would use rail service is 800 kilometres. Although railways are between three and four times more fuel-efficient than trucks, says Radbourne, the cost of getting goods to railway terminals outweighs the fuel savings as the distance of a corridor decreases.

Competition has been especially steep between railways and trucks travelling the Toronto-Montreal corridor, Radbourne says. And with more efficient operations, the concept of railways gaining more business in this zone should improve.

Rising oil prices are another factor favouring railways this year. “Higher fuel prices accentuate the fuel efficiency of railways vs trucks,” says Radbourne, “and may cause customers to reconsider how they move their goods.”

Although higher fuel prices do increase the cost of running trains, railways pass on the additional operating costs to customers through a fuel surcharge. Because customers need to be given about a month’s notice for price increases, and the fuel price in a contract is calculated using the previous month’s 30-day average, Radbourne warns that railways must stomach higher operating costs for about two months after fuel prices rise. Also, the opposite occurs when fuel prices decline, as customers will still be charged extra for fuel. “The lag can be a headwind or a tailwind,” she adds.

The railway player in Canada most likely to benefit from rising commodities prices is CP. For the year ended Dec. 31, 2009, revenue for freight and other operations was $4.3 billion, down from $4.9 billion in 2008. Net income fell slightly, to $900 million vs $1 billion in 2008.

“A case for CP, relative to its peers, is it suffered more severe volume declines due to its potash traffic,” says Radbourne. “We foresee that it will have one of the biggest recoveries.”

Radbourne states in a report that CP will see its earnings per share grow at a rate of 27%, higher than any of its competitors.

CN is another player worth watching. For the year ended Dec. 31, its revenue dropped to US$7.4 billion from US$8.5 billion a year earlier. Much like CP, CN’s net income also fell slightly, to US$1.85 billion from US$1.9 billion in 2008. Part of the reason revenue dipped but net income was relatively steady had to do with the drop in fuel costs, to US$769 million from US$1.4 billion a year earlier.

@page_break@Although rising fuel prices might be a bonus for these players, the exchange rate is a major “headwind” for the railways, says Radbourne, because neither CP nor CN are immune to the consequences of a rising Canadian dollar, as both receive more revenue in U.S. dollars than they pay for their expenses in US$ terms. According to Radbourne’s report, a 1¢ appreciation in the loonie vs the US$ could reduce CN’s earnings per share by 2¢ a year and trim CP’s earnings by 1¢ per share annually.

Aside from exchange rates, investors need to be aware of pricing pressure on the railways coming from the trucking industry — specifically, at longer distances. “It’s highly competitive,” says Spracklin, “with unsophisticated trucking players discounting on long hauls to stay afloat.”

Still, says Radbourne, railways will maintain their pricing power over long distances, because volumes are increasing and customers prefer the fuel efficiency of railways at these distances.

However, trucking companies will also feel the upswing of more buoyant commodities prices, because bulk commodities such as coal and gravel make up 50% of trucking freight, says Jason Granger, an analyst with Toronto-based Bank of Montreal’s capital markets division: “Trucks don’t have the same degree of fixed costs [as railways], they have more opportunity to [benefit from positive] changing market conditions” as fixed costs are related mainly to terminals and fleet maintenance.

Although trucking companies try to go head to head with railways at longer distances, they are king when it comes to short hauls and inner-city transportation.

“There’s always going to be a need for trucks to get to final destination points that aren’t on the railways,” says Granger. But, to avoid competition with railways, more trucking companies are trying to position themselves as short-haul operators. “There is more growth in shorter-haul distances; we are seeing more trucking companies trying to get in that market to take advantage of that growth.”

The Canadian trucking sector still remains extremely fragmented. It’s mostly a sea of minnow-sized operations, in which growth for larger players will come from acquisitions and/or smaller players leaving the business.

Among the publicly traded trucking companies most affected by commodities prices is Calgary-based Trimac Income Fund, owner of Trimac Transportation. The company operates a fleet of vehicles that haul commodities such as wood chips, industrial gas and petroleum. Says Spracklin: “From a volume perspective, [Trimac] will benefit substantially from a rise in commodities prices and volumes.”

For the 12 months ended Sept. 30, 2009, Trimac had $273.1 million in revenue, a sizable drop from the $327.9 million it brought in for the same period a year earlier. And its net earnings fell to $7.2 million from $13 million. Its revenue fell mainly as a result of a substantial drop in the volumes it hauled, as well as downward price pressure on the rates it could charge its customers.

Unlike the railways, Trimac constantly faces pricing pressure from many small trucking operators. With so many trucks on the road, firms are constantly lowering their bids just to stay in business. “The fall in demand has bottomed, but pricing continues to be under pressure,” Granger says. “And it’s estimated that there’s 15% to 20% more trucks in business than needed.”

For the supply/demand balance to improve, more trucks need to come off the road. That will most likely happen through smaller firms going bankrupt, Granger says. However, it takes a stronger economy for that to occur — during the recession, more trucks were able to stay in business, as low gas prices allowed them to continue operating. Also, banks are more reluctant to foreclose on firms during poor economic times, as the sale value of a firm’s vehicles wouldn’t be worth as much as they would be during good economic times. Relative to the first nine months of 2008, says Granger, bankruptcies were down by 25% vs the same period in 2009 for these reasons.

Luckily, for a public player such as Trimac, with the economy looking brighter and oil prices on the rise, it’s only a matter of time before it sees trucking volumes rise because of a supply contraction in the sector. “Banks will become more aggressive in foreclosing on companies in the second half of 2010,” Granger explains. “[And] that can be a very short-term catalyst for a slow recovery in trucking demand.” IE