Canadian Rail Matchup & 1 Takeover Target

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As any observer could tell you, the rail industry has been hit badly by a poor outlook in coal. However, there are still several catalysts that companies are taking to build shareholder value during this challenging time period. From intermodal to operational restructuring, the industry is well positioning itself for a full recovery. Since railroad companies concentrate in certain regions, I encourage diversifying for broad global exposure. Below, I review 3 stocks and provide my opinion on whether they can provide an ideal return.

Canadian National Railway (NYSE: CNI) Vs. Canadian Pacific (NYSE: CP)

CN has been on a consistent run since the start of 2009 and has gained 16.5% for the year to date. While Warren Buffett may own Burlington Northern in Berkshire Hathaway's largest takeover ever, his billionaire friend Bill Gates is the largest shareholder of CN. Management has beaten expectations several times in a row, and it has particularly delivered on carloading and revenue ton-miles. If it can generate the 10.2% EPS growth rate that it is expected for, it's on its way to outperforming when you factoring in the 1.7% dividend yield.

Canadian Pacific, not to be confused with CN, also recently hit a 52-week high after announcing a plan to cut costs. It will lay off 23% of its workforce by 2016 and that 1,700 of the 4,500 worker reduction will be completed by the end of this year. In my view, the decision to not meet with the union indicates management's strong leverage over labor and will only boost the bargaining power going forward.

CN trades at a respective 15x and 14.8x past and forward earnings versus 24.3x and 17.2x for Canadian Pacific. The latter, however, is forecasted for 16.2% annual EPS growth over the next 5 years, which is more than 600 bps faster than CN's growth rate. Assuming Canadian Pacific meets expectations, 2016 EPS will come out to just north of $9. At a multiple of 15x, this translates to a future stock value of $135. This means Canadian Pacific will only generate an average annual return of 8.8%--not the kind of return you want for active investing. In present terms, the company should be worth $83.82 per share, which implies it is around 15% overvalued in today's terms. I therefore prefer the safer pick, Canadian National.

Taking Over Providence & Worcester (NASDAQ: PWX)

If you are looking for the highest returns, the small cap space is the place to be. P&W trades at only 0.9x book value, is worth only $63.7 million, and has virtually no debt on the balance sheet. Long-term debt to equity stands at 5.2x versus 79.4x for the industry average. Its tracks cover Massachusetts, Rhode Island, New York, and Connecticut, and intermodal operations are serviced in Worcester, Massachusetts. At this cheap multiple and top destinations, the company ought to be taken over and integrated for greater connections.

The company could also do well through this catalyst, because current operations have fared poorly. Over the past 5 years, EPS has fallen by an annual rate of 3.4%. ROA, ROE, and ROI are all in the low single-digits. By contrast, Union Pacific, the leading railroad, generates returns ranging from the high single-digits to 20.3%. P&W's return on invested capital is equally terrible at 1.3% versus an industry average of 12.$%. Accordingly, P&W has been run poorly despite its attractive geographical position. This is a railroad that isn't moving.

A takeover by the Eastern rail companies, like CSX, would enable the company to be better connected to top export markets and allow for greater train velocity. Productivity would increase and drive shareholder value for both the suitor and target. If Union Pacific was built through takeovers, it only makes sense for this small rail to be consolidated as well.

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TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Canadian National Railway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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