We welcome back contributing editor Tom Slee who has returned to soggy Toronto after a mid-winter break in a warmer climate. He didn't get there by train but his mind is very much on the railways these days as he explains in this report. Tom managed pension money in the insurance industry for many years and is an expert in tax planning. Over to him.
Tom Slee writes:
Once written off as a "sunset industry", North American railroads are making money hand over fist. Last year the six major carriers posted a 45% average growth in earnings as they booked increased volumes and increased rates. Admittedly we were coming off a weak 2009 but even so it was a remarkable performance. And the companies still have momentum. Intermodal volumes jumped 17% in February while total carload traffic rose 8%. Everything points to the rails having another banner year as the recovery takes hold and their massive restructuring programs start paying off. The stocks look very attractive.
Now I am not suggesting for a moment that we are going to have another 45% leap in profits. We could, however, see 20% average earnings growth, perhaps even a little more. There is still slack in the system. For instance, coal volumes, accounting for almost 50% of all U.S. rail traffic, remain 9% below 2008 levels because utilities have been drawing down their inventories. Those stocks are now depleted and carriers such as Norfolk Southern (NSC, Financial) are going to benefit when coal volumes return to normal. The railways are also going to keep raising freight rates in order to pass along higher energy costs and boost their bottom lines.
Most importantly, the railroads are poised to take advantage of skyrocketing oil prices and grab more market share in 2011. It's now obvious that the present disturbances in the Middle East are not isolated incidents. So we are facing a prolonged period of uncertainty with high and perhaps rising fuel costs for the foreseeable future. That gives the railways a big advantage over the truckers. In fact, when it comes to fuel efficiency there is no contest. To put it simply, a train can ship one ton of cargo 400 miles on one gallon of diesel. A truck can ship one ton of cargo 125 miles on that same gallon. End of story!
The railroads are in the happy position of either raising rates in lockstep with the truckers or keeping their price increases modest and bidding for more market share. They will probably do a little of both.
We are also going to see more productivity. The railroads are already lean and mean because they moved quickly during the downturn to trim overheads. As a result, their operating ratios, the percentage of revenues needed to run and maintain the systems, remain respectable. Labour cost control, especially at Canadian National is extremely good. As a matter of fact, some U.S. carriers are still shedding jobs. This year, though, there is another, more basic factor at work. Entire railway systems will become more efficient as the industry's long-term capital improvements start paying dividends.
Let me give you an example of what is involved. Trains are going to become much longer, a move that makes better use of crew, locomotives, and fuel. It's an obvious improvement but until recently there were constraints on the number of cars a company could add. Locomotives lacked power, siding lengths were relatively small, air brake lining pressure was limited, especially in cold weather, and there were long assembly times. All of these problems have been largely overcome. The new locomotives and brakes are more efficient and some of the sidings are now almost two miles long. Assembly times have been reduced.
Computers too are making a big difference. As Kenneth Kremar, an economist with Global Insight, recently pointed out: "The key to this business (railways) is knowing where all of your cars are all of the time". In fact, until the advent of sophisticated tracking devices, companies were never able to pinpoint their thousands of constantly moving units strung out over three countries. Now, at last, the controls are in place and management can wring more dollars out of that expensive rolling stock.
Finally, the Republican victories last November have provided a better regulatory environment. This is a big plus for the railroads who found it tough dealing with the Democrats. As a matter of fact, the Surface Transportation Board decided against the rails in several rate cases in the past three years. There are bills before the Senate limiting the industry's price-setting power and even talk of reregulation. From now on, though, Congress is likely to be much more receptive to the industry's needs.
In short, the railways are benefitting from a rising tide. The companies have a lot going for them. As always, though, some are going to perform better than others. So shop carefully. This recovery is still fragile and the trucking industry is going to fight hard to protect its business. Moreover, the shares have already had a good run. That having been said, some of the stocks still offer good value and have a lot of upside potential.
I have a new railroad pick this month, as well as updates on previous recommendations.
The new addition to my list of railway buys is Canadian Pacific (CP, Financial). The company is finally getting a handle on its costs and was number one amongst the major rails in unit cost and labour productivity gains last year. Its operating ratio has fallen 360 basis points to 77.6% and this, coupled with a 13% increase in revenues, resulted in fourth-quarter earnings of $1.12 a share compared to $0.76 in 2009. Analysts had been expecting $1.08. It was a good performance although I should point out that a 77.6% operating ratio is still nothing to write home about. (CN is at 63.4%.)
The most encouraging thing about CP Rail right now is that 43% of its revenues came from bulk commodities such as grains, fertilizers, and coal. With the economy gaining strength, this is where we are going to see rapid volume growth. At the same time, the company's new ten-year agreement with Teck Resources is going to put a floor under its coal shipment rates. The contract, which accounts for as much as 12% of the company's revenues, should stabilize earnings. CP's recent acquisition of Dakota Minnesota and Eastern Railroad was another good move.
Over the years I have steered clear of CP because, quite frankly, the railway seemed accident-prone and CN was always a better alternative. Right now, though, Canadian Pacific seems to have its act together and we could see a 20% increase in profits to about $4.75 a share this year with a further increase to the $5.50 range in 2012. Applying a modest 14.5 multiple that gives a $77 value. This could be Canadian Pacific's year.
The stock currently pays an annualized dividend of $1.08 a share for a yield of 1.7% based on Friday's closing price. There has been speculation about a dividend increase but this is unlikely. The company generated $500 million of free cash flow last year but needs all of it to pay down debt and reduce pension obligations.
Action now: I am adding Canadian Pacific Railway to my Buy list at C$63.03, US$64.96 with an initial target of $75. I have set a $58 revisit level.
Tom Slee writes:
Once written off as a "sunset industry", North American railroads are making money hand over fist. Last year the six major carriers posted a 45% average growth in earnings as they booked increased volumes and increased rates. Admittedly we were coming off a weak 2009 but even so it was a remarkable performance. And the companies still have momentum. Intermodal volumes jumped 17% in February while total carload traffic rose 8%. Everything points to the rails having another banner year as the recovery takes hold and their massive restructuring programs start paying off. The stocks look very attractive.
Now I am not suggesting for a moment that we are going to have another 45% leap in profits. We could, however, see 20% average earnings growth, perhaps even a little more. There is still slack in the system. For instance, coal volumes, accounting for almost 50% of all U.S. rail traffic, remain 9% below 2008 levels because utilities have been drawing down their inventories. Those stocks are now depleted and carriers such as Norfolk Southern (NSC, Financial) are going to benefit when coal volumes return to normal. The railways are also going to keep raising freight rates in order to pass along higher energy costs and boost their bottom lines.
Most importantly, the railroads are poised to take advantage of skyrocketing oil prices and grab more market share in 2011. It's now obvious that the present disturbances in the Middle East are not isolated incidents. So we are facing a prolonged period of uncertainty with high and perhaps rising fuel costs for the foreseeable future. That gives the railways a big advantage over the truckers. In fact, when it comes to fuel efficiency there is no contest. To put it simply, a train can ship one ton of cargo 400 miles on one gallon of diesel. A truck can ship one ton of cargo 125 miles on that same gallon. End of story!
The railroads are in the happy position of either raising rates in lockstep with the truckers or keeping their price increases modest and bidding for more market share. They will probably do a little of both.
We are also going to see more productivity. The railroads are already lean and mean because they moved quickly during the downturn to trim overheads. As a result, their operating ratios, the percentage of revenues needed to run and maintain the systems, remain respectable. Labour cost control, especially at Canadian National is extremely good. As a matter of fact, some U.S. carriers are still shedding jobs. This year, though, there is another, more basic factor at work. Entire railway systems will become more efficient as the industry's long-term capital improvements start paying dividends.
Let me give you an example of what is involved. Trains are going to become much longer, a move that makes better use of crew, locomotives, and fuel. It's an obvious improvement but until recently there were constraints on the number of cars a company could add. Locomotives lacked power, siding lengths were relatively small, air brake lining pressure was limited, especially in cold weather, and there were long assembly times. All of these problems have been largely overcome. The new locomotives and brakes are more efficient and some of the sidings are now almost two miles long. Assembly times have been reduced.
Computers too are making a big difference. As Kenneth Kremar, an economist with Global Insight, recently pointed out: "The key to this business (railways) is knowing where all of your cars are all of the time". In fact, until the advent of sophisticated tracking devices, companies were never able to pinpoint their thousands of constantly moving units strung out over three countries. Now, at last, the controls are in place and management can wring more dollars out of that expensive rolling stock.
Finally, the Republican victories last November have provided a better regulatory environment. This is a big plus for the railroads who found it tough dealing with the Democrats. As a matter of fact, the Surface Transportation Board decided against the rails in several rate cases in the past three years. There are bills before the Senate limiting the industry's price-setting power and even talk of reregulation. From now on, though, Congress is likely to be much more receptive to the industry's needs.
In short, the railways are benefitting from a rising tide. The companies have a lot going for them. As always, though, some are going to perform better than others. So shop carefully. This recovery is still fragile and the trucking industry is going to fight hard to protect its business. Moreover, the shares have already had a good run. That having been said, some of the stocks still offer good value and have a lot of upside potential.
I have a new railroad pick this month, as well as updates on previous recommendations.
The new addition to my list of railway buys is Canadian Pacific (CP, Financial). The company is finally getting a handle on its costs and was number one amongst the major rails in unit cost and labour productivity gains last year. Its operating ratio has fallen 360 basis points to 77.6% and this, coupled with a 13% increase in revenues, resulted in fourth-quarter earnings of $1.12 a share compared to $0.76 in 2009. Analysts had been expecting $1.08. It was a good performance although I should point out that a 77.6% operating ratio is still nothing to write home about. (CN is at 63.4%.)
The most encouraging thing about CP Rail right now is that 43% of its revenues came from bulk commodities such as grains, fertilizers, and coal. With the economy gaining strength, this is where we are going to see rapid volume growth. At the same time, the company's new ten-year agreement with Teck Resources is going to put a floor under its coal shipment rates. The contract, which accounts for as much as 12% of the company's revenues, should stabilize earnings. CP's recent acquisition of Dakota Minnesota and Eastern Railroad was another good move.
Over the years I have steered clear of CP because, quite frankly, the railway seemed accident-prone and CN was always a better alternative. Right now, though, Canadian Pacific seems to have its act together and we could see a 20% increase in profits to about $4.75 a share this year with a further increase to the $5.50 range in 2012. Applying a modest 14.5 multiple that gives a $77 value. This could be Canadian Pacific's year.
The stock currently pays an annualized dividend of $1.08 a share for a yield of 1.7% based on Friday's closing price. There has been speculation about a dividend increase but this is unlikely. The company generated $500 million of free cash flow last year but needs all of it to pay down debt and reduce pension obligations.
Action now: I am adding Canadian Pacific Railway to my Buy list at C$63.03, US$64.96 with an initial target of $75. I have set a $58 revisit level.
