Railway companies on the right track

In Canada, Montreal-based Canadian National Railway Co. (CN) remains the most efficient railway company, as well as the favourite stock in the sector for most analysts – at least, in the medium and longer term. Analysts particularly like CN’s ability to find new lines of business.

Calgary-based Canadian Pacific Railway Co. (CP) is both a riskier investment but has the most upside potential, as it continues to improve its efficiency under new CEO Hunter Harrison, who had led CN from 2003 to 2009.

In the U.S., Omaha, Neb.-based Union Pacific Corp. (UP) tends to be the favourite medium- to longer-term stock. Not only is UP very efficient, but it’s also well positioned in terms of railway lines and product mix.

In the short term, there also are opportunities in Jacksonville, Fla.-based CSX Corp. Inc. and Norfolk Southern Corp. of Norfolk Va., whose stock prices have been beaten down due to their earnings suffering from declining shipping volume for coal, an important product for both firms. With no further coal declines expected – and perhaps some pickup in volume – share prices could rise.

But neither CSX nor Norfolk are considered particularly good medium- or long-term investments. Consumption of coal is on a downward trend because of its negative environmental impact; this decline is being hastened by the emergence of shale natural gas, which has driven down the price of that commodity and thus is encouraging greater use of it for generating electrical power.

Kansas City Southern Railway Co. of Kansas City, Mo., is doing well, but its stock is very expensive.

Canadian regulators already have made some regulatory changes in the wake of the Lac-Mégantic disaster, but Joe Mastrolonardo, portfolio manager with Mackenzie Financial Corp. in Toronto, says both CN and CP already had most, if not all of these rules in place internally.

Still, Mastrolonardo anticipates that regulations for transporting hazardous materials in the U.S. and Canada will become more onerous in the next few years, given what happened in Lac-Mégantic and public sensitivity to environmental issues in general.

But there’s some offset to these negative factors in increasing demand for the shipment of crude by rail as pressure from environmentalists delays construction of pipelines. Joe D’Angelo, portfolio manager with Signature Global Advisors, a division of CI Financial Corp. in Toronto, says transporting oil is a high-margin business for railways because little capital expenditure is needed – the firms shipping the crude provide the needed railcars.

CP and the privately owned Burlington Northern Santa Fe Railway Co. of Fort Worth, Tex., are the best positioned railways to benefit from increased oil shipments, says Mastrolonardo, as both have rail lines running through the oil-rich Bakken formation in North Dakota and southern Saskatchewan.

Still, UP and CN also will benefit, D’Angelo says. UP’s network can move Texas oil to many U.S. states in the West and Midwest. CN’s railway network allows it to ship heavy oil from Alberta to U.S. refineries on the Gulf Coast, as well as to Eastern Canada.

U.S. refineries on the Gulf Coast want heavy crude oil because they have retooled their facilities to process it, D’Angelo notes, pointing out that CN has developed a good business in shipping the diluting agent (needed to transport heavy oil) from the Gulf Coast to Alberta; thus, railcars going in both directions are full.

Nevertheless, transporting oil and petroleum products aren’t that big a part of railways’ overall business, says Mastrolonardo, averaging about 3% of railcar loads. So, the railway firms need more to drive their growth.

Here’s a look at CN, CP and UP in more detail:

– Canadian National Railway co. not only is at the top of the heap in operating metrics, such as efficiency and margins, but the firm is very customer-centric. CN constantly looks for ways to help clients be more efficient and keep costs down. CN’s suggestion to refiners to ship diluting agent from the Gulf Coast to Alberta in the empty railcars that had carried heavy oil south is a case in point: this practice maximizes the round trip for the refiners.

Such client-focused thinking, characteristic of Harrison, also seems to be a trademark of Claude Mongeau, who took over in 2010. Tim Caufield, co-lead portfolio manager of Bissett Equity Fund in Calgary, sponsored by Toronto-based Franklin Templeton Investments Corp., considers CN’s management to be very strong.

CN also is shareholder-friendly, steadily increasing its dividend and buying back shares.

There’s not much potential for CN to bring its efficiency ratio (operating costs as a percentage of revenue) down further, but the firm can grow by finding new markets. Mastrolonardo says CN’s intermodal business from Prince Rupert, B.C., has been a “tremendous success” in the five years since the port has been open. CN also is taking some market share from CP in potash transportation.

Despite this enthusiasm, analyst reports issued by Desjardins Securities Inc.’s capital-markets division in Montreal, J.P. Morgan Securities LLC in New York, Royal Bank of Canada’s (RBC) capital-markets division and TD Securities Inc. (the latter two firms both are based in Toronto) rate CN stock as either “neutral” or a “hold.” The 12-month price targets range from $99 (RBC) to $110 (TD). The 429 million outstanding shares closed at $99.83 on Sept. 9.

Net income in the six months ended June 30 was $1.3 billion on revenue of $5.1 billion vs net income of $1.4 billion on revenue of $4.9 billion in the corresponding period a year prior.

– Canadian Pacific Railway co. Harrison already performed wonders at CP, which was the laggard in the industry.

CP’s efficiency ratio was 73.9% in the six months ended June 30 vs 81.3% in the corresponding period a year earlier. CP is targeting mid-60% for 2016; although that target still isn’t as good as CN’s ratio, it’s in line with other North American railways’.

Many of CP’s efficiency gains are set to come from a 20% cut in the workforce, of which about 25% remains to be accomplished. The question is whether these goals are realistic in this time frame. But, given the high esteem in which Harrison is regarded, reaching the targets is already priced into the stock.

CP’s business is more cyclical than CN’s. CP transports a significant amount of resources to the West – and that has caused analysts with TD and RBC to put “reduce” or “underperform” ratings on CP’s stock. Desjardins analysts are less pessimistic and have a “hold” rating, while J.P. Morgan analysts still rate the stock a “buy.”

The report from J.P. Morgan lowered EPS estimates modestly to reflect slower revenue growth in several segments but says forecasts “continue to reflect very strong operating ratio improvement and EPS growth. [CP] remains the most compelling name to own in the transport group.”

On the other hand, the Desjardins report says that most of the operational upside is already priced into CP’s share price.

The RBC report states that the shares now are overpriced, pointing out that revenue per revenue ton mile has been declining because of the shift in the revenue base, which is expected to continue. The RBC report also notes that CP’s share price takes into account revenue growth greater than CP’s management guidance.

Twelve-month price targets range from $105 (RBC) to $148 (J.P. Morgan). The 176 million outstanding shares closed at $125.77 on Sept. 9.

Net income in the six months ended June 30 was $469 million on revenue of $3 billion vs net income of $245 million on revenue of $2.7 billion in the corresponding period a year earlier.

– Union Pacific Corp. D’Angelo considers UP to be the best of the U.S. railway firms, saying it has a good product mix, benefits from growth in Mexico and gradually is adding more capacity to make routes more productive. UP has a sizable coal-transport business – but for Powder River coal, which is cleaner than most coal and, thus, demand for it doesn’t drop to the same extent as for other grades of coal. As a result, D’Angelo says, UP is “solid and steady” and he prefers it to CP.

UP, much like CN, is very shareholder-friendly, with a track record for increasing both dividends and share buybacks.

The J.P. Morgan report gives an “overweight” rating on the stock, describing the firm as a “diverse franchise with multiple drivers of growth in the medium term and what we believe to be meaningful runway for further margin improvement.” Specifically, UP has leverage related to the improving U.S. housing market, as the transport of lumber, chemicals and intermodal pick up. UP also should benefit from increasing oil transport and shipments to and from Mexico.

Even though TD’s report currently rates the stock a “hold,” the report also calls UP an “outstanding franchise.”

The TD report gives the highest 12-month price target, at US$174, vs J.P. Morgan’s US$167 and RBC’s US$160. The 468 million outstanding shares closed at US$156.63 on Sept. 9.

Net income for the six months ended June 30 was US$1.1 billion on revenue of US$5.5 billion vs net income of US$1 billion on revenue of US$5.2 billion in the corresponding period in 2012.

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