CANADIAN PACIFIC RAILWAY LTD. $64 (Toronto symbol CP; Conservative Growth Portfolio, Manufacturing & Industry sector; SI Rating: Above average) provides freight service through a 13,500- mile rail network between Montreal and Vancouver. It also operates in the U.S. Midwest and Northeast through subsidiaries. Alliances with other rail companies extend its reach to Mexico.

Diverse cargo cuts risk

CP transports a wide variety of products, such as grain, coal and manufactured goods. That helps cut its reliance on a single industry or customer.

Revenue hovered around $3.7 billion from 2001 to 2003. Revenue improved to $3.9 billion in 2004, and to $4.4 billion in 2005, as strong demand for coal, metals and other resources led to higher freight volumes and rates. CP also benefited from the sharp rise in goods imported from Asia.

Profit rose from $2.34 a share (total $372.5 million) in 2001 to $3.06 a share ($487.5 million) in 2002, but higher fuel costs cut earnings in 2003 to $2.52 a share ($401.3 million). CP began passing along its higher fuel costs to its customers, and earnings grew to $2.60 a share ($413.0 million) in 2004, and to $3.39 a share ($542.9 million) in 2005.

Over 90% of the company’s contracts now include some sort of fuel surcharge, which cuts its risk. CP also hedges about 10% of its fuel needs.

In 2005, the company realized hedging gains totaling $48 million. It will probably realize $30 million from hedging gains in 2006.

The company is also doing a good job controlling its non-fuel costs. Its operating ratio (regular operating expenses divided by revenue — the lower, the better) fell to 74.2% in the third quarter of 2006, from 77.4% a year earlier. It will probably meet its operating ratio goal of 75% for all of 2006.

New lines will pay off

The company is currently expanding its lines in Western Canada. That will help it profit from a plan to expand capacity in Vancouver and other West Coast ports, to handle rising trade with Asia. It’s likely that most of this extra traffic will use railways, which are cheaper and more reliable than trucks.

CP spent $589.2 million on capital upgrades in the first nine months of 2006. But it generated $870.5 million in cash flow, so it can comfortably afford these outlays. It’s also using its growing cash flow to buy back stock, including $226.9 million in the first nine months of 2006.

More than doubled in five years

The stock has gained 150% since the break up of the Canadian Pacific Ltd. holding company five years ago. Despite the big gain, CP trades at just 16.2 times its forecast 2006 profit of $3.95 a share. The $0.75 dividend yields 1.2%.

Railways are cornerstones of the Canadian economy, and will continue to profit from expanding international trade. We feel every Canadian investor should own at least one high-quality railway stock such as CP.

CP Rail is a buy.