Summary

  • Canadian Pacific released its Q3 results on October 17. Despite the ~5% stock price increase subsequent to the earnings announcement, CP remains an attractive long-term investment.
  • Adjusted diluted EPS grew 6% to $2.90. CP has revised adjusted diluted EPS upwards to double-digit growth versus high single-digit growth from full year 2016 adjusted diluted EPS of $10.29.
  • Free Cash Flow for the 9 months of FY2016 and FY2017 amounted to $0.488B and $0.575B.
  • CP has recently expanded its geographic coverage through a new partnership with Genesee & Wyoming Inc.
  • CP has various expansion projects in the works and technological enhancements being implemented to improve efficiency levels.

NOTE: All financial results are expressed in Canadian dollars unless otherwise noted.

Introduction

On October 17, 2017 Canadian Pacific Railway (NYSE: CP) reported positive Q3 results. The stock price jumped ~5% but CP still remains an attractive long-term investment.

Business Overview

CP is a Class I transcontinental railway in Canada and the United States. Its peer group consists of the following:

  • Canadian National Railway Company (NYSE: CNI)
  • Norfolk Southern Corporation (NYSE: NSC)
  • Union Pacific Corporation (NYSE: UNP)
  • CSX Corporation (NYSE: CSX)
  • Kansas City Southern (NYSE: KSU)
  • BNSF Railway (privately owned by Berkshire Hathaway)

CP offers a suite of freight transportation services, logistics solutions, and supply chain expertise. It has direct links to eight major ports, including Vancouver and Montreal. Its rail network consists of 12,400 miles of main line track but its reach extends beyond its rail, through connections with other Class 1 railways, short lines, trucking and transload facilities.

On October 9, 2017, CP expanded its reach when it announced a new partnership with Genesee & Wyoming Inc. (NYSE: GWR) and Bluegrass Farms of Ohio. Management has stated that this new partnership will open up the Ohio Valley to its customers and further extend its reach into key North American markets.

CP is aggressively improving its transportation services in the Intermodal space, with a new service offering at the container level; Vancouver is CP’s bellwether. In addition it:

  • is improving inventory tracking support and reservation systems to better control costs;
  • has aggressive expansion projects in process with its grain customers;
  • is improving and increasing its presence in China and the same is to be undertaken in Singapore;
  • is rolling out AutoGate, a new technology, across all of its Intermodal terminals. This technology automates the process by which trucks access their terminals for container pickups and deliveries. Drivers will be able to manage all aspects of their delivery through a mobile app called FastPass. CP expects up to a 50% reduction in driver inbound processing time.

Labor Relations

During Hunter Harrison’s tenure as President and CEO, drastic changes were made to the working environment; it was not uncommon to read about low morale.

Upon Harrison’s departure, Keith Creel was appointed President and CEO. Almost immediately steps were taken to make peace with the company’s unionized work force.

Q3 2017 Results, Adjusted Diluted EPS, and FCF

On January 18, 2017, CP held its Q4 2016 Earnings call in which it provided guidance for FY2017.

Positive volume growth was projected and management was confident it would deliver high single-digit EPS growth. Factors that were included in its modeling for 2017 were:

  • pension income of $180 million in 2017 for its defined benefit and defined contribution plans (an incremental $100 million benefit from the income in 2016). This increase was driven by higher market related value of the plan assets;
  • Flat head count in 2017;
  • ~$60 million is land sales;
  • ~ $1.25B billion in capital expenditures with ~70% being spent on basic replacement with the balance going toward initiatives focused on improving productivity and service reliability.
  • No need to acquire new locomotives for the next several years as there were over 400 locomotives in storage. Some funds, however, were earmarked to modernize and improve the reliability of the existing fleet.

On October 17, 2017, CP released its Q3 2017 results and provided guidance for the remainder of the current fiscal year.

Source: CP Q3 2017 Earnings Call Presentation

As at Q3 2017, adjusted diluted EPS grew 6% to $2.90. Strong results have resulted in CP revising its 2017 guidance upwards. Adjusted diluted EPS is now expected to grow in the double-digits versus high single-digit from full-year 2016 adjusted diluted EPS of $10.29.

EPS guidance has been raised despite:

  • headwinds from a stronger CAD $ relative to that when projections were prepared;
  • YTD land sales of only ~$5 million and the very low probability of any significant land sales prior to the end of the year

Free Cash Flow for the 9 months and full year in FY2016 amounted to $0.488B and $1.007B respectively. Free Cash Flow for the first 9 months of FY2017 amounted to $0.575B.

Source: CP Q3 2017 Earnings Call Presentation

Dividends, Dividend Growth, and Stock Repurchases

CP’s recent sporadic dividend history can be found here and its CAGR is found below.

Source: CP website

Hunter Harrison was appointed President and CEO on June 29, 2012. Drastic changes were made to the manner in which CP was operated. One dramatic change was an immediate dividend freeze. It was not until mid-2016 when dividend increases were reinstated. In lieu of dividend increases, focus was placed on reducing the number of outstanding shares.

Source: Morningstar

Harrison abruptly departed CP on January 18, 2017. Within 2 quarters of his departure, CP’s dividend was increased.

In Q3, CP took advantage of the pullback in its share price and it repurchased 1.1 million shares at an average cost of $196/share.

Source: CP Q3 10-Q page 4

FCF and the dividend payout ratio are conservatively managed and there is no concern about CP’s ongoing ability to service its dividend payments.

Valuation

Management has revised projected adjusted diluted EPS from a high single digit increase to a low double digit increase. Using an 11% increase for modeling purposes, we get a full-year adjusted diluted EPS of $11.42 for FY2017. This is consistent with the current mean EPS $11.44 estimate from 22 brokers; the low and high are $10.74 and $11.65.

Estimates for FY2018 from 23 brokers is $12.87 with the low and high being $12.26 and $13.56.

Using the current stock price of ~$221 and a mean adjusted diluted adjusted EPS of $11.44, we arrive at a PE of 19.32. While not on sale, CP is reasonably priced for investors with a long-term investment time horizon despite the ~5.3% increase in price subsequent to the release of Q3 results.

Option Strategy

An alternative to buying CP shares outright could be the use of options.

At the time of writing this post you could sell a $220 April 2018 Put; you would receive ~$1075 for each contract ($10.75 x 100 shares).

If the option is exercised you would be obligated to acquire the shares at $220 but your effective cost would be ~$209.25 because of the premium you collected. If the option is not exercised you retain your premium.

There are multiple option strategies that can be pursued and the option strategy presented is merely an example of how one can generate income while not owning CP shares outright.

Canadian Pacific Railway Stock Analysis – Final Thoughts

Despite the recent jump in price, CP still represents an attractive purchase at current levels for investors with a long-term investment horizon.

I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this post. As always, please leave any feedback and questions you may have in the “Contact Me Here” section to the right.

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I currently do not hold a position in CP and have no intention of initiating a position within the next 72 hours.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.