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CP Rail (CP) Stock | NYSE: CP | TSX: CP.TO

Covered by Stratosphere

The Coast-to-Coast Railroad

The Canadian Pacific Railway ("CP Rail") is a historic Canadian Class I railway incorporated in 1881. CP Rail spans across seven provinces of Canada and the United States, connecting North America to the rest of the world. The company is guided by its three core values of accountability, diversity, and pride. It aims to provide superior transportation services for customers. CP Rail believes in reinvesting in business for long-term, sustainable, and low-cost growth.

Stratosphere Score

7

Growth

2

Valuation

5

Quality

7

Margins

9

Dividend

5

Balance Sheet

4
Adrian Iwanicki

Author

Adrian Iwanicki

Equity Analyst

Investment Thesis

  1. CP Rail is a powerful contender of CN Rail, its closest competitor, boasting a dense east-west network in North America and industry-leading operating margins.

  2. CP Rail obtains its competitive edge from its fortress position as a massive railroad incumbent, short routing options, innovation and technology, and bulletproof balance sheet.

  3. The proposed acquisition of Kansas City Southern ("KCS") would expand CP Rail's market reach and provide new competitive transportation options. If approved, the merger will create the first US-Mexico-Canada rail network.

  4. CP Rail's profitability improvement has been nothing but impressive over the years. With the improved network efficiency and disciplined operating mindset, CP Rail has a best-in-class position to grow whether the KCS acquisition is approved or not.

Key Company Metrics

A set of metrics we constantly keep updated to monitor the investment thesis.

Competitive Advantages

The Geographical Fortress

CP Rail owns a railroad network in North America that connects the Canadian east and west coasts, as well as several Midwest US states.

With access to eight major ports and key markets across North America, CP Rail is able to carry a wider variety of goods compared to its competitors. Additionally, vast geographical coverage also means CP Rail's customer base and business mix is quite diversified.

The geographical fortress shows through in CP Rail's financials. Revenue ton miles (i.e., "RTM" or revenue earned for carrying one ton of freight over one mile) and freight revenue per RTM have been rising steadily. Demand for shipping goods on CP Rail's railroad network is rising, causing rates for each ton mile to consistently increase over time.

Unless the industry were to de-consolidate, high barriers to entry will likely always exist. It is simply unfeasible for any new entrant or eager entrepreneur to obtain, spend, and expect a reasonable return on billions of dollars of capital spend each year.

Capital expenditures for maintenance and growth are in the billions for CP Rail. The industry is also heavily regulated, especially in the US by the Surface Transportation Board ("STB"), meaning large upfront expenses must be incurred by new entrants to obtain regulatory approval to build a rail network.

Adding to the list of issues in entering the market is the utter lack of opportunities to consolidate operationally and the stringent regulatory environment in place that discourages mergers and acquisitions ("M&A") in an already-consolidated industry. New entrants likely have negligible opportunities to partner with, or purchase Class I railroads in North America.

Where its rails currently exist, there is next to no chance a new entrant can uproot the massive industry incumbent, CP Rail, plain and simple.

CP Rail's Railroad NetworkSource: CP Rail Official Website

Lowest Cost Wins

Even though aircrafts, trucks, and ocean liner transportation businesses compete with railroads, railroads are the lowest-cost option in areas where no efficient waterway connections exist. This is especially true with bulk commodities, CP Rail's largest business segment.

CP Rail's dense and vast 13,000-mile network makes it almost impossible for new entrants to compete based on its low marginal costs and ability to allocate capital towards growth opportunities and technology. Lowest cost wins.

Time is Money

In contrast to its closest competitor, CN Rail, CP Rail boasts a network with plenty of short routing options for customers to choose from in key lane areas. For example, CP Rail connects Vancouver to the US Midwest, Chicago and Detroit, and the East and West Canadian coasts with shorter transportation services than CN Rail.

In addition to these short routing options, CP Rail also has a plethora of connections with other Class I railroads in Canada and the US. It does not end there — CP Rail partners with smaller short-line partners to expand its reach, provide exceptionally efficient services to customers, and make sure customers are getting the most bang for their buck.

In our consumer-centric part of the world, time is money. As a result, we believe CP Rail's short routes in key lanes is an underrated competitive advantage from which pricing power can be drawn.

The Innovative Railroad

CP Rail recognizes that the leading transportation services of tomorrow must invest in technology and streamline operations today.

The company's high margins are supported by its efforts to nail down incredible performance. CP Rail operates under a precision railroading using such methods like Precision Scheduled Railroading ("PSR"), a strategy using point-to-point stops across its network of track and terminals to pick up and drop off train carts.

CP Rail also created the Railway Performance Monitoring ("RPM") and Trip Plan systems. The former allows it to increase the volume of deep internal performance data and the latter helps CP Rail keep track of shipments from pick-up to drop-off.

PSR, RPM, and Trip Plan are some of the efforts that collectively contribute to CP Rail's exceptional operating performance. Over the past few years, train speed, terminal dwell, train weight, and train length are all trending in directions that imply better services and more value to customers.

CP EfficiencySource: CP Rail Investor Relations

Other notable technologies leveraged by CP Rail include:

  • Predictive Analytics - big data analytics to anticipate issues and prevent service interruptions and damage.

  • Intermodal Demand Management - smoothing demand across the week based on customer delivery requirements to prevent bottlenecks.

  • Mobile Workforce - use of mobile devices to automate inventory management and provide crews with safety documents at a whim.

  • CP FastPass - self-serve kiosks and mobile apps that reduce time spent by drivers at terminals dropping off or picking up loads.

  • Robotic Process Automation - automation of repetitive, high-volume tasks to save time and money.

  • Track Asset Management - inspection application providing broad view of overall track conditions and health.

These efforts, in conjunction with consistent reinvestment to improve processes and technologies, mean that CP Rail is able to inspect tracks and railcars quickly, improve safety, save on input costs (e.g. fuel), and provide a better service to customers at the end of the day. These efficiencies are exemplified in CP Rail's financials - the company has the best margins of all the Class I railroads.

We expect operating metrics to continue to improve throughout the intermediate time horizon as these efforts translate into efficient spending and growing revenues.

Room on the Balance Sheet

Despite the capital-intensive nature of the industry, CP Rail is (surprisingly) in a very strong financial position. Competition is fierce and capital expenditures for growth are on the forefront of the railroads' priorities, but CP Rail still has a low amount of net debt (total debt including leases less cash) as a multiple of EBITDA.

CP Rail's leverage ratio has been declining due to disciplined cost management, margin expansion, top-line growth, and prudent capital allocation.

We believe these efforts are bearing fruit, giving the company financial optionality to take on large projects and investments without being overburdened by intolerable levels of debt. We think investors should be excited in this regard.

Opportunities Ahead

  • If the deal is ultimately approved by regulators, the CP Rail and Kansas City Southern merger would be a once-in-a-lifetime opportunity to capture what will likely become an exceptional tri-coastal network, connecting the Canadian coasts with the US south, through to Mexico City and beyond. This deal looks expensive in the short run and will result in CP Rail's balance sheet to look worse, but we think this is a remarkable opportunity looking out 10-20+ years. We think it will be close to impossible for any other North American railroad to expand its network to this extent for centuries given the level of consolidation the industry has gone through.

  • Whether the deal goes through or not, management points to three foundational areas that could be expanded or built upon to absorb higher freight demand and grow as a company:

    1. Excess train capacity and ability to increase train length

    2. Network and terminal capacity

    3. Surplus land

  • CP Rail owns about 2,100 acres of vacant land and a number of adjacent underutilized buildings across its network. With minimal investments, these properties can be spruced up to meet a variety of new and emerging needs, such as:

    • growing existing intermodal capacity in Vancouver, Canada's largest trade gateway;

    • co-locating customers for efficient access to rail; and

    • general capacity buildout and repurposing, important to absorbing demand should re-shoring and de-globalization occur in light of adverse geopolitical events impacting supply chains in recent years.

  • In pursuit of building greater grain elevator and train capacity to meet growing demand, CP Rail is working with customers to upgrade existing grain supply chains to support high-capacity 8,500-foot trains, called High Efficiency Product ("HEP") trains. Today, less than half of the grain elevators CP Rail serves handle the new HEP trains, a large opportunity for expansion and ability to open up Canadian grain business to the world.

    In contrast to the low-capacity 7,000-foot trains, HEP trains can increase grain volume per train by over 40%. By the end of 2022, CP Rail expects to have 7,400 high-capacity hoppers in service, a substantial overachievement of the four-year target of 5,900 hopper acquisition goal set out in 2018. Investments like these result in pricing power tomorrow - greater efficiency, reduced shipping times, and increased capacity help drive the premium value proposition that is inherent in CP Rail's current and future rail network.

CP-KCS Combined Network MapSource: CP Rail Official Website

Risks

Merger Concerns

While we believe the CP-KCS merger will bring various opportunities to the table, it also carries potential pitfalls. Given the fact that CP Rail offered a premium to purchase KCS and subsequently raised its bid as the feud with CN Rail picked up, it exposes CP Rail to the risk of "overpaying" - not realizing the full synergetic potential it had originally set out to obtain and ultimately destroying shareholder value.

The timing of these synergies are also uncertain and may not materialize. Nonetheless, we are optimistic on the prospects of the combined company should the STB ultimately grant full acquisition approval.

Revenue Cyclicality

Most of CP Rail's revenues are generated from freight, which include commodities from industries that fluctuate with the market. When the economy does poorly, or any of these sectors struggle, CP Rail's financials could face strong headwinds in the near term.

CP Rail's heavy exposure to grain can also result in near-term performance weakness compared to peers. Western Canada is facing poor growing conditions. Low crop yields may mean that CP Rail will have substantially less product to ship, hurting the top and bottom line to a potentially large extent.

Regulation

Since CP Rail carries freight for chemical and energy, it exposes CP to legal liability if any of the hazardous material leaks or spills and harms the immediate environment.

In addition, Joe Biden's recent executive order issued to the STB to examine rail competition may set a new precedent in the market that puts consolidation further out of favour and hurts profitability for the railroads, including CP Rail.

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