Turning to the current stock market, it's almost a relief to see one bright sector in a bleak landscape. The railways are doing well. Despite moderating volume growth, the six major North American Class 1 railroads turned in an excellent third quarter. Industry earnings jumped 23% year-over-year. Profit to date in 2011 is up 17% over last year. It was a strong performance with higher volumes, cost cutting, and price increases all contributing.
Looking ahead, the companies are now well placed to weather any economic downturn and continue to grow. Most railway executives issued optimistic guidance along with their quarterly numbers. In particular, they pointed to price escalator clauses in their freight contracts that protect the railroads from rising energy costs, a continuing problem in the past. The American carriers are also poised to raise rates on coal shipments when contracts are renewed in April.
It's all very positive but there are two things to keep in mind. All this success has not gone unnoticed. Railway stocks have surged recently. There are no bargains and we have to shop carefully. It's also apparent that accident-prone Canadian Pacific is becoming a special case. Investors have been concerned for some time about the company's inability to streamline operations and an activist hedge fund has now taken a 12% stake, causing the stock to jump 8%. If nothing else this has partially discounted the capital appreciation we were expecting in 2012. My updates follow.
CN Railway (TSX: CNR, NYSE: CNI)
Originally recommended on May 6/02 (IWB #2216) at C$25.95 (split-adjusted). Closed Friday at C$77.42, US$73.14.
CN Railway continues to perform well. Third-quarter earnings of $1.38 per share were up 16% year-over-year and well ahead of the $1.30 analysts were expecting. Despite a spluttering economy, results were good across the board.
Freight revenues jumped 12%, more than 8% as a result of higher volumes and the rest from price increases. Car loadings rose 4% and the company generated a free cash flow of $580 million.
Most impressive was CN's operating ratio of 59.3%, a 1.4 percentage point improvement over 60.7% the year before. This is the ratio of operating expenses to revenues and the measure used by analysts to gauge a railway's efficiency. In effect, it's the amount of income used to run the system, so the lower the better.
To put CN's efficiency into perspective, Norfolk Southern, a relatively tight operation, has a 67.5% ratio while troubled Canadian Pacific has run at a sobering 80.9% during the last 12 months.
What I find encouraging about CN is that it remains market focused. Instead of basking in his excellent operation ratio, CEO Claude Mongeau is busy building top-line growth through customer service. That is the life blood of any company. Expansion and upgrading of the railway's facilities in Chicago and Indiana will also allow for future growth.
I think that CN will continue to use its low-cost competitive edge to gain market share from CPR and the trucking industry. Price increases will continue to stick. As a result, the railway should earn about $4.90 a share in 2011 and $5.40 next year. The stock has surged recently but still has upside potential.
Action now: CN Railway, one of our core stocks, remains a Buy with a new target of $88. I will revisit the stock if it dips to $72.
Norfolk Southern Corp. (NSC)
Originally recommended on Dec. 14/09 (IWB #2944) at $52.22. Closed Friday at $70.77. (All currency figures in U.S. dollars.)
South of the border, Norfolk Southern had a solid third quarter with earnings of $1.59 a share, a 34% improvement over 2010 and well ahead of the $1.41 consensus forecast. Revenues were up 18% with coal export traffic surging 23% year-over-year. In fact, increased coal shipments accounted for 44% of the higher revenues despite competition from natural gas and electricity among the utilities.
The big story here is that NSC's heavy investments in labour and equipment are paying off. More efficient coal cars, longer trains, and double-stacked loads have improved productivity and provided more capacity. I am also encouraged to see that the company is expanding its intermodal business. These shipments are up 9% in 2011 mainly due to two auto plants located on the network.
Everything points to rising traffic in Norfolk's primary markets as we head into 2012. At the same time, the company's profit margins should continue to improve as the system becomes more efficient. As a result, I think that even if the U.S. economy splutters, NSC should earn about $5.30 a share this year and as much as $5.75 in 2012. One caveat: longer term we may see a tightening of the regulations with respect to the use of coal and there are already fresh initiatives that encourage utilities to reduce their coal dependency. As in the past, however, the demand for more energy will probably require full use of all fuels available. I would also like to point out that about 75% of the coal fired power plants serviced by Norfolk are modern and fully equipped with scrubber technologies.
Action now: Norfolk Southern remains a Buy at $70.77, up 35% from our Recommendation at $52.22, with a new target of $82. I have set a $63 revisit level.
Canadian Pacific Railway (TSX, NYSE: CP)
Originally recommended on March 14/11 (IWB #21110) at C$72.39, US$74.40. Closed Friday at C$58.10, US$55.35.
When Canadian Pacific was added to our Buy List in March I realized that the company had problems. However, management seemed to have a grip on the situation and earnings were likely to improve. Brutal weather and avalanches hurt profits during the first half but CP was set to rebound in the third quarter. That did not happen and I am disappointed.
The company reported third-quarter earnings of $1.10 a share, down 9% from the year before. Revenues actually increased 8% but a lot of that was a combination of fuel surcharges and a better price/mix. Actual carloads declined 2.5%.
It was a respectable performance but there was no sign of the company regaining market share lost earlier in the year due to bad weather. The operating ratio improved slightly to 75.8% but remains far too high. As I say, the numbers are respectable but once again CP is lagging its peers.
The company's sub-standard performance has now attracted the attention of at least one predator. Pershing Square Capital Management, a U.S. based hedge fund with a 12.2% stake in the company, has opened discussions with management. There is speculation about a takeover bid from a pension fund or another railway and the stock has strengthened.
It's all very exciting but tread carefully. Pershing has had mixed success with its interventions and it will be extremely difficult to change a railway dramatically. Moreover, CP's customers may turn elsewhere if there is prolonged uncertainty. The Canadian government is going to take a long hard look at any bid for CPR, one of our national icons. Note too that Pershing has already booked a substantial capital gain as a result of the intervention and that may have been one of its goals.
Action now: Canadian Pacific Railway becomes a Hold and I will monitor the situation closely.