CANADIAN PACIFIC RAILWAY LTD. $69 – Toronto symbol CP

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 with hubs 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.

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