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Topic: Dividend Stocks

CANADIAN PACIFIC RAILWAY LTD. $55 – Toronto symbol CP

CANADIAN PACIFIC RAILWAY LTD. $55 (Toronto symbol CP; Conservative Growth Portfolio, Manufacturing & Industry sector; Shares outstanding: 169.4 million; Market cap: $9.3 billion; Price-to-sales ratio: 1.9; Dividend yield: 2.2%; TSINetwork Rating: Above Average; www.cpr.ca) transports freight between Montreal and Vancouver. It also connects with hubs in the U.S. Midwest and Northeast. CP gets 25% of its revenue from the U.S.

In 2010, CP got 28% of its revenue by hauling shipping containers that contain a variety of goods. Another 23% of its revenue came from hauling grain, followed by consumer and industrial products (19%), coal (10%), fertilizers (10%), automotive products (6%) and forest products (4%).

CP’s revenue rose 16.7%, from $4.6 billion in 2006 to $5.3 billion in 2008, as increasing trade with Asia pushed up freight volumes. CP’s 2008 purchase of Dakota, Minnesota & Eastern Railroad Corp. (DM&E) for $1.5 billion also added to its revenue. DM&E operates a 4,000-kilometre rail network in eight midwestern states.

A big part of DM&E’s appeal is its access to the Powder River Basin in Wyoming, which is the largest deposit of low-cost thermal coal for electrical power plants in the U.S. DM&E has an exclusive option to build a railway in this region. However, if CP decides to build the line, it will have to pay DM&E’s former owners an extra $1.1 billion U.S. through 2025.

Even with DM&E’s contribution, CP’s revenue fell 17.7% in 2009, to $4.4 billion. That’s because the recession cut the company’s freight volumes by 17.2%. However, revenue rose 13.2% in 2010, to $5.0 billion.

Earnings rose 21.1%, from $5.02 a share (or a total of $796.3 million) in 2006 to $6.08 a share (or $946.2 million) in 2007. The recession pushed down CP’s earnings to $3.30 a share (or $550.0 million) in 2009. However, earnings rose 16.7%, to $3.85 a share (or $650.7 million), in 2010. Excluding unusual items, earnings per share rose 54.2%, from $2.51 in 2009 to $3.87 in 2010.

More efficient CP on the way

Flooding in the Prairies and North Dakota cut CP’s earnings by 23.2% in the three months ended June 30, 2011, to $128.0 million, or $0.75 a share. A year earlier, CP earned $166.6 million, or $0.98 a share. A 37% rise in fuel costs also weighed on its earnings. Even with the flooding, CP’s revenue rose 2.5%, to $1.26 billion from $1.23 billion.

The bad weather also caused CP’s operating ratio to worsen to 81.8% from 77.8% a year earlier. (Operating ratio is calculated by dividing regular operating costs by revenue. The lower the ratio, the better.)

CP aims to cut its operating ratio to around 70% in the next three to four years. To meet this goal, CP will run longer trains and work more closely with its main customers to speed up the loading and unloading of cargo.

A good example is CP’s new long-term deal with Teck Resources Ltd. (Toronto symbol TCK.B), which sells coal from its mines in B.C. to steelmakers in Asia.

Under the deal, CP is upgrading the tracks from Teck’s mines to handle longer trains. Teck plans to increase its production by 30% over the next two years, and longer trains will help CP profit from that expansion.

Focus on fuel efficiency should pay off

The company is also working to streamline the transfer of goods at its rail yards. It aims to cut the time that its trains spend in stations in half by mid-2012.

As well, the company is using new software that optimizes train loads and speeds. That should lower CP’s fuel consumption. At the same time, CP is rebuilding its locomotives with standardized parts. That will further improve fuel efficiency, and make its trains easier to repair. These rebuilds will take roughly four years to complete.

CP will likely spend between $950 million and $1.05 billion on new tracks, locomotives and other equipment in 2011, up from $726.1 million in 2010.

The company can comfortably afford these investments. On June 30, 2011, its long-term debt was $3.9 billion. That’s a manageable 42% of its market cap. As well, CP held cash of $267.8 million, or $1.58 a share.

The bad weather in the first half of the year will probably limit CP’s 2011 earnings to $3.39 a share. The stock trades at 16.2 times that figure. However, CP’s improving efficiency should push up its 2012 earnings to $4.47 a share. That gives the stock a more reasonable p/e ratio of 12.3. That’s particularly cheap in light of the critical role that CP plays in the Canadian economy.

Potential oil-sands profits add appeal

CP also stands to gain if oil-sands operators turn to trains to ship their products if regulators reject new pipelines, such as Enbridge’s Northern Gateway project.

CP Rail is a buy.

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