On track with Canadian Pacific & CN Railway

Once written off as a "sunset" industry, North American railroads are making money hand over fist. In short, the railways are benefiting from a rising tide and the companies have a lot going for them.

Here's a look at my newest recommendation, Canadian Pacific (CP), as well as my long-time favorite, CN Railway (CNI).

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 everything points to the rails having another banner year.

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.

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.

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!

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.

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.

The newest addition to my list of railway buys is Canadian Pacific. 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. I am adding Canadian Pacific Railway to my Buy list with an initial target of $75.

My long time favourite, CN Railway, continues to impress. Fourth-quarter earnings came in at $1.08 a share, up 20% year-over-year and in line with expectations.

As a result, the company made $4.20 a share in 2010 compared to $3.24 in 2009 and management celebrated by raising the dividend by 20% to $1.30 per share annually and announcing a 16.5 million share repurchase program.

Once again, CN demonstrated its tight management in a highly cyclical industry. There were no unpleasant surprises, earnings remain on track, and the 63.4% operating ratio is by far the best amongst the major rails.

Looking ahead, however, management will have to drive top-line growth in order to meet its guidance and I expect to see an increase of 3% or more in rates along with a 5% to 7% jump in intermodal and coal volumes.

This should generate earnings of almost $5 a share in 2011 and at least $5.50 next year. The only blemish is that the stock already reflects a lot of this progress.

Nevertheless CN remains my number one choice in the sector. CN Railway is a Buy with a new target of $76.