CP Rail: The Making of a #1 Stock Pick

From the time the last spike was driven to complete the new railway in 1885, Canadian

Pacific has been an essential part of Canada’s history, transportation and business life. But pedigree alone does not make a top stock pick. The fact that CP has undergone so many transitions so successfully is what has made it one of our favourite stocks at TSI Network.

In 2012, CP Rail (Toronto symbol CP) faced two more upheavals. U.S. hedge fund Pershing Square Capital used the leverage of its 14% ownership to replace seven of the company’s 16 directors with its own nominees and seemed intent on installing former Canadian National Railway CEO Hunter Harrison as chief executive officer of CP. Then the railway’s workers went on strike, largely over the issue of pension benefits. The anxious reaction of businesses to the removal of the railway’s services served to underline the central role CP plays in the Canadian, and North American, economy.

To understand our appreciation for CP Rail, it helps to know the 3-part investment approach that we have relied on for many years at TSI.

1. Invest mainly in well-established companies that have a history of earnings and most often, dividends; they have the experience to survive and prosper despite setbacks.

CP Rail clearly fits our profile of a well-established stock.

2. Spread your money out across the five main economic sectors (Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities); in any setback, some sectors do much better than others.

The company primarily serves the first two of these sectors—Manufacturing and Industry and Resources and Commodities—and it is subject to changes in the economic climate. But it gives you a way of investing in these sectors through a conservative, dividend-paying stock.

3. Downplay or avoid stocks in the broker/media limelight; that’s where failed predictions can do the most damage to your finances.

Some might complain that CP Rail spent more than its fair share of time in the glare of the media in 2012. But this is not the limelight we worry about: negative headlines bring out the strengths in good companies and expose the weaknesses in bad companies. It is the fulsome praise and heightened expectations heaped on a stock by brokers and media that can lead to trouble. If those expectations are not met, the downturn can be brutal. If anything, many broker/media sources have underrated CP Rail and its growth potential over time. We do not.

Our coverage of CP began in the first issue of our flagship advisory, The Successful Investor, in January 1995. Subsequently, we covered the breakup of the conglomerate into fivedifferent companies early in the new century.

In the new decade, as the Canadian and global economies emerged from the recession of 2008, we published 3 major front-page articles on CP Rail, the most recent our selection of the stock as our #1 Stock Pick for 2012. Reproduced on the following pages, they give you an in-depth look at our ongoing analysis of a stock that has been a staple of our Conservative Growth Portfolio since the 1990s.

January 1995—our first report on Canadian Pacific Ltd. in The Successful Investor.

CANADIAN PACIFIC LTD. $21 (SI Rating: Above-average appeal; Toronto Exchange symbol CP) has a new president, David O’Brien, who formerly ran CP’s 87%-owned PanCanadian Petroleum subsidiary. Under O’Brien, PanCanadian was a top-performing part of CP, and he seems likely to do just as well in his new job. The company made around $0.95 a share last year, after three years of losses. It could earn $1.50 in 1995. Ottawa rejected CP’s recent bid for Canadian National’s eastern rail lines, which compete with CP. However, CP offered less than half of book value (what a company’s books say assets are worth, per share, after you deduct liabilities); it may do better with a revised bid. CP stands to gain from Ottawa’s transportation deregulation and deficit-cutting. Buy.

March 2001—Our report on Canadian Pacific’s impending break-up into 5 companies:

CANADIAN PACIFIC LTD. $57 (Toronto symbol CP; SI Rating: Above-average) shot up 15% after it said it will split into five separate companies: CP Rail, PanCanadian Petroleum, CP Hotels, CP Ships and Fording Coal. Canadian Pacific shareholders will receive shares in each of the five, but they’ll only be liable for capital gains taxes when they sell. The company hopes to complete the breakup by this fall. Canadian Pacific has been one of our most frequent recommendations over the years, partly because its broad asset base carried a lot of hidden value.

We’ll say more about the individual units as the break-up draws near. For now, hold.

CANADIAN PACIFIC RAILWAY LTD. $31 (Toronto symbol CP; SI Rating: Above average) operates a 14,000-mile railroad network that connects the main business centres of Canada and the U.S. Midwest and Northeast. Alliances with other railroads extend its reach to Mexico. Revenues between 1996 and 2000 hovered around $3.6 billion. Per-share profits jumped from $2.18 in 1996 to $2.98 in 1997, but fell to $2.29 in 1999. Profits climbed to $2.33 a share in 1999, and to $2.54 a share in 2000, mainly due to cost cuts. The company cut its expenses by 17% since 1996; it plans a further 10% cut by 2004. CP Rail is now one of the most profitable railways in North America. In the nine months ended September 30, 2001, profits climbed 8.0% to $1.89 a share from $1.75 a share a year earlier. When you remove special income tax benefits and charges related to the spin-off, profits for the latest period fell to $1.59 a share. Revenues were unchanged at $2.7 billion.

Gains in coal and domestic container shipments offset drops in forest products and international traffic. CP Rail’s operating ratio, a key measure of a railway’s productivity, grew to 78.9% from 77.5% a year earlier. CP Rail should gain from higher use of rail, especially by companies shipping goods across the Canada-U.S. border. Heightened security at border crossings has slowed truck traffic and it takes much less time to inspect rail freight. CP Rail’s debt at September 30 was 1.2 times equity. That’s up from 0.6 times at the end of 2000, due to debt assumed as part of the spin-off. The company has plenty of cash flow to handle the debt.

The stock now trades at 13.5 times the $2.30 it will likely earn in 2001, excluding unusual charges. The $0.56 a share dividend yields 1.8%. Canadian Pacific Railway is a buy.

November 2010: Front-page article on CP Rail in The Successful Investor

Railways have been around since the 19th century, and they are still the safest, most energy-efficient way to move goods over land. They also face little competition from new competitors, because of the high cost of building new rail lines.

Canadian Pacific remains our favourite railway for new buying. It has close relationships with major producers of coal, potash and other commodities. That gives it predictable revenue streams. As well, new, fuel-efficient locomotives and scheduling software are lowering CP’s costs.

CANADIAN PACIFIC RAILWAY LTD. $63 (Toronto symbol CP; Conservative Growth Portfolio, Manufacturing & Industry sector; Shares outstanding: 168.7 million; Market cap: $10.6 billion; Price-to-sales ratio: 2.3; Dividend yield: 1.7%; SI Rating: Above Average) transports freight over a 25,000-kilometre rail network between Montreal and Vancouver. It also connects with major hubs in the U.S. Midwest and Northeast. The U.S. accounts for 30% of CP’s revenue.

CP got 27% of its 2009 revenue by hauling shipping containers that contain a variety of goods. Grain supplied another 27%, followed by consumer and industrial products (18%), coal (11%), fertilizers (7%), automotive products (6%) and forest products (4%).

CP’s revenue rose 19.0%, from $4.4 billion in 2005 to $5.2 billion in 2008, mainly because of increasing trade with Asia. As well, CP bought Dakota, Minnesota & Eastern Railroad Corp. (DM&E) in 2008. DM&E, which operates a 4,000-kilometre rail network in eight midwestern states, also contributed to the higher revenue.

CP paid $1.5 billion U.S. for DM&E. A big part of its appeal is its access to the Powder River Basin in Wyoming, which is the largest U.S. deposit of low-cost thermal coal for electrical power plants. DM&E holds 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 billion U.S. through 2025.

Despite DM&E’s contribution, CP’s 2009 revenue fell 17.7% to $4.3 billion. That’s because the recession cut CP’s freight volumes by 17.2%.

Earnings rose 76.6%, from $527.8 million in 2005 to $932.1 million in 2007. Earnings per share rose 81.5%, from $3.30 to $5.99, on fewer shares outstanding. In 2008, the credit crisis forced CP to write down the value of asset-backed commercial paper it holds. As a result, its earnings fell 34.9%, to $607.2 million, or $3.91 a share.

Earnings rebounded in 2009

The improving economy and rising freight volumes pushed the company’s earnings up to $612.4 million in 2009. However, earnings per share fell 6.1% to $3.67, on more shares outstanding. If you exclude all unusual items, earnings per share would have fallen 30.8%, to $2.76 in 2009 from $3.99 in 2008.

CP’s operating ratio rose to 79.1% in 2009 from 78.9% in 2008. (Operating ratio is calculated by dividing a company’s regular operating costs by its revenue. The lower the ratio, the better.) That’s because it shipped less cargo due to the recession. That offset the benefits of lower fuel prices.

The company has made a number of moves to improve its efficiency. For example, it has bought new locomotives that are letting it operate longer trains. It is also using new software that cuts fuel consumption and track wear by ideally positioning the new locomotives within the longer trains.

CP is also expanding its terminals in Montreal, Regina and Edmonton. That will help these facilities handle the longer trains, and speed up the transfer of goods to trucks and other trains.

The company will probably spend between $670 million and $730 million on new tracks, locomotives and other equipment in 2010. It spent $722.4 million in 2009.

CP’s improving balance sheet will help support these improvements. On June 30, 2010, its longterm debt was $4.2 billion. That’s a moderate 40% of its market cap. As well, CP held cash of $373.6 million, or $2.21 a share.

Voluntary payments add stability

The company is also taking advantage of low interest rates to make voluntary payments to its employee defined-benefit pension plan. In September 2010, it sold $350 million U.S. of new long-term notes. This helped fund a $650-million (Canadian) contribution to this plan. This payment should help make its future pension-funding requirements easier to manage.

Despite the uncertain economic outlook, CP’s prospects remain strong. Unusually wet weather will depress this year’s Canadian grain harvest by about 15%. However, the U.S. is expecting a record grain crop. That should offset lower Canadian shipments.

As well, CP will continue to gain from rising shipments of potash and other fertilizers. It recently won a contract to haul potash from BHP Billiton Ltd.’s new Jansen mine in Saskatchewan. This mine should begin operating in 2015. CP should also benefit if BHP buys Potash Corp. of Saskatchewan. That’s because BHP wants to increase Potash Corp.’s production.

New 10-year coal deal cuts CP’s risk

The company is also the main rail carrier for Teck Resources Ltd., which sells coal from its mines in B.C. to steelmakers in Asia. CP and Teck recently signed a new 10-year transport contract.

This deal will also help CP profit from Teck’s plan to expand coal production by 50% over the next few years.

CP’s shares fell to $32 in March 2009, but more than doubled to $66 in September 2010. Despite this jump, they trade at a reasonable 16.7 times the $3.77 a share that CP will probably earn in 2010.

CP Rail is a buy.

October 2011: Front-page article on CP Rail in The Successful Investor

CP’s earnings have suffered lately, mainly due to bad weather. Avalanches during the winter disrupted its operations in western Canada, and spring floods washed out some of its lines in the Canadian Prairies and the U.S. Midwest.

However, these are short-term setbacks. As well, the company is now working on a number of improvements that should make it more efficient, and push up its profits.

CP’s upgrades mainly include improving its tracks and expanding its loading facilities so they can handle longer trains. That will extend the lives of CP’s locomotives, because they will have to make fewer stops and starts. These improvements will also help the company profit as shipping volumes rise.

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 withhubs 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.

February 2012: Our #1 Stock Pick in The Successful Investor

We’ve chosen Canadian Pacific Railway as our “Stock of the Year” for 2012.

Railways are highly cyclical. CP’s stock got as low as $30 in mid-2004, then shot up to briefly peak at $90 in mid-2007. It then fell to a low of $33 by March 2009, as the recession cut deeply into freight volumes. The stock more than doubled to $68 by February 2011 as the economy recovered. However, avalanches in B.C. and spring floods in the Prairies hurt CP’s volumes and earnings in 2011. The stock fell as low as $46 in September. It then began to rise in October, as the economic outlook and the stock market both improved.

The company now has a new plan for dealing with bad weather and raising its efficiency.

The recent involvement of a prominent American hedge fund may speed up CP’s earnings growth, and spur further gains in its stock price.

CANADIAN PACIFIC RAILWAY LTD. $69 (Toronto symbol CP; Conservative Growth Portfolio, Manufacturing & Industry sector; Shares outstanding: 169.7 million; Market cap: $11.7 billion; Price-to-sales ratio: 2.3; Dividend yield: 1.7%; TSINetwork Rating: Above Average; www.cpr.ca) transports freight between Montreal and Vancouver, and connects withhubs in the U.S. Midwest and Northeast. It gets 25% of its revenue from the U.S. CP’s revenue rose 16.7%, from $4.6 billion in 2006 to $5.3 billion in 2008, as rising Asian trade pushed up freight volumes. CP’s $1.5-billion purchase of Dakota, Minnesota & Eastern Railroad (DM&E) October 2008 brought in more revenue. DM&E operates a 4,000-kilometre rail network in eight midwestern states.

The recession cut CP’s revenue by 17.7% in 2009 to $4.4 billion. However, revenue rose 13.2%, to $5.0 billion, in 2010. Even with its weather-related problems in the first half of 2011, revenue for the full year probably rose to $5.2 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.

Focus on efficiency will benefit CP

Due to the bad weather, CP’s operating ratio worsened to 75.8% in the third quarter of 2011 from 73.7% a year earlier. (Operating ratio is calculated by dividing regular operating costs by revenue. The lower the ratio, the better.)

CP is now working on better ways to deal with bad weather and improve its efficiency. It has purchased snow-clearing equipment and snow fences. It is buying new locomotives, upgrading its tracks and using new software that optimizes trainloads and speeds. These improvements will lower CP’s fuel consumption.

As well, CP will consolidate its eight repair shops into four facilities by 2013. Each shop will work on several different types of locomotives instead of specializing in a single model. CP feels this will cut repair times by 30%.

These moves will add to CP’s costs for the next year or two. But they’ll cut its operating ratio to around 70% by 2015. CP is also in a good position to gain from rising grain prices, which will prompt farmers to plant more crops and ship more grain on CP’s trains. Higher grain prices will also push up fertilizer demand. Together, grain and fertilizers account for a third of

CP’s overall revenue.

CP is also in a strong position to profit from rising shale oil production in the Bakken formation, which covers parts of Montana, North Dakota and Saskatchewan. There are few pipelines in this region, so producers use railcars to ship their oil to refineries. These producers are also using rail to bring in drilling equipment and other materials.

Shale oil and gas have big potential

Carloads from Bakken rose to 13,000 in 2011 from just 500 two years earlier. CP feels its Bakken traffic could rise to 70,000 carloads over the next few years. CP’s operations in the northeastern U.S. should also benefit from rising production in the Marcellus shale gas field in Pennsylvania and Ohio.

The company is also taking advantage of low interest rates to strengthen its employees’ pension plan, which had a deficit of $673 million (Canadian) at the end of 2010.

It recently sold $500 million U.S. of new long-term term notes and will apply the cash to this deficit. This contribution will make CP’s future pension payments more predictable. CP’s long-term debt was $4.0 billion on September 30, 2011. That’s equal to 34% of its $11.7-billion market cap, so it can afford the extra debt.

The company’s 2011 earnings probably fell to $3.20 a share. The stock trades at 21.6 times that estimate. Earnings should rebound to $4.55 a share in 2012, which gives CP a more reasonable p/e ratio of 15.2. The $1.20 dividend yields 1.7%.

Hedge fund also likes CP’s prospects

CP’s recent setbacks have attracted U.S.-based activist investment firm Pershing Square Capital, which now owns 14.2% of the company. Pershing Square wants to install Hunter Harrison, the retired CEO of Canadian National Railway Co. (Toronto symbol CNR), as chief executive officer of CP. Harrison made CN more efficient, and Pershing feels he can do the same at CP.

Even if Pershing fails to add Harrison as CEO its involvement should continue to draw attention to CP’s strong prospects, and the long-term security of its key role in Canada’s economy.

CP Rail is our #1 buy for 2012.

CANADIAN PACIFIC RAILWAY LTD., $75.13, Toronto symbol CP, has resumed normal operations now that Ottawa has ended an eight-day strike by its locomotive engineers, conductors and yard workers.

The strike probably cut CP’s earnings per share in the second quarter of 2012 by around $0.20. It earned $0.82 a share in the first quarter.

At the recent annual meeting, U.S.-based activist investment firm Pershing Square Capital Management, which owns 14.2% of the company, succeeded in replacing seven of CP’s 16 directors with its own nominees.

This week, the new board appointed Pershing nominee Paul Haggis as CP’s new chairman. The board is now looking for a new chief executive officer. Pershing wants to install Hunter

Harrison, the successful former CEO of CN Rail, as CP’s CEO.

The board will probably make it decision by in the next months or two. Whatever the outcome, CP will continue to focus on improving its efficiency with new trains and schedules. It should also benefit from the recent drop in oil prices.

CP Rail is our #1 buy for 2012.