CANADIAN PACIFIC RAILWAY LTD. $36 (Toronto symbol CP; Conservative Growth Portfolio, Manufacturing & Industry sector; Shares outstanding: 167.7 million; Market cap: $6 billion; Price-to-sales ratio: 1.2; SI Rating: Above Average) ships freight over a 25,000-kilometre rail network between Montreal and Vancouver. In the United States, its subsidiaries connect its Canadian lines to major hubs in the midwest and northeast. Alliances with other railways extend CP’s reach to Mexico.

CP made 29% of its 2008 revenues hauling shipping containers loaded with a variety of goods. Grain accounted for 20% of its revenues, followed by industrial products (16%), coal (13%), fertilizers (10%), automotive products (7%) and forest products (5%). CP’s many revenue sources cut its reliance on any single commodity or industry.

Thanks largely to expanding trade with Asia, CP’s revenue rose 20.6%, from $3.9 billion in 2004 to $4.7 billion in 2007. Earnings rose 87.1%, from $359.5 million in 2004 to $672.8 million in 2007. Earnings per share rose 91.2%, from $2.26 to $4.32 on fewer shares outstanding.

In October 2007, CP paid $1.5 billion U.S. for the Dakota, Minnesota & Eastern Railroad Corp. (DM&E), which operates a 4,000-kilometre rail network in eight midwestern states. CP did not fully integrate DM&E until October 2008, when American regulators approved the purchase.

CP’s overall 2008 revenue rose to $4.9 billion, partly due to $58.5 million in revenue from DM&E. CP increased its freight rates in order to offset lower volumes caused by the slowing North American economy. However, its 2008 earnings fell to $631.5 million, or $4.06 a share, because of higher fuel and labour costs.

Wyoming coal has big potential

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, low-sulphur thermal coal in the U.S. (Many power plants burn thermal coal to generate electricity.) DM&E holds an exclusive option to build a railway in this region. If the company decides to build this line, which would be the third railway in this area, it would have to pay DM&E’s former owners an extra $1 billion U.S. through 2025.

CP’s 2008 operating ratio rose to 78.6%, from 75.3% in 2007. (Operating ratio is calculated by dividing a company’s regular operating costs by its revenue. The lower the ratio, the better.)

CP is restructuring, and plans to temporarily lay off 4% of its workers. It has also put 20% of its locomotives and railcars in storage until freight volumes improve. CP aims to save more money by cutting its 2009 capital spending to about $800 million from $1.1 billion in 2008.

At the end of 2008, CP held $117.6 million, or $0.76 a share, in cash. Its long-term debt stood at $4.7 billion. This is a high, but manageable, 78% of its market cap. CP’s debt repayments are a low $28.3 million in 2009, but will increase to $375.3 million in 2010 as more of its loans comes due.

The company also holds asset-backed commercial paper (ABCP) with a face value of $143.6 million. Due to the lack of investor interest in these securities, CP had to write down their carrying value by almost half, to $72.7 million.

As part of a court-approved plan to restructure the ABCP market in January 2009, CP received replacement notes with a total settlement value of $142.8 million. The market value of these replacement notes is close to the $72.7 million fair value of the old notes, so further writedowns are unlikely.

New shares offset rising pension costs

In February 2009, CP issued 13.9 million new common shares at $36.75 each. The company will use the resulting $510.8 million to cover its pension costs, which will rise from $95 million in 2008 to between $150 million and $195 million in 2009. In 2010, CP estimates these costs will continue to climb, to between $295 million and $345 million.

Record crops in Canada and the U.S. should spur higher grain volumes for CP this year. A strike lowered fertilizer volumes in 2008, so revenues from this segment should also rise. These gains should help offset lower revenues from forest products and automotive goods. CP has already locked in prices for 80% of its 2009 contracts.

CP is negotiating a new contract with Teck Cominco, which owns the large Elk Valley coal mining complex. (Teck is CP’s largest single customer.) Teck ships most of its coal to steelmakers in Asia. Slowing global demand for steel will probably force Teck to cut its shipments by 10% this year.

Still, lower fuel costs should help CP cope with the drop. (Fuel is CP’s second-largest expense, after employee salaries, and accounted for 20% of its 2008 revenue.) The company also gets about 25% of its revenue from the U.S., so it stands to gain from a low Canadian dollar, which increases the contribution from its American operations.

Low p/e for a Canadian stalwart

Despite these positives, CP’s 2009 earnings will probably slip to $3.95 a share. The stock trades at 9.1 times this amount. That’s cheap in light of the critical role CP plays in Canada’s economy. Railways should also keep luring customers away from the trucking industry, which must deal with traffic and border delays. CP pays a $0.99 dividend, which yields 2.8%.

CP Rail is a buy.