Canadian Pacific Confirms Bull Case, What It Means Going Forward (NYSE:CP)

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NotYourAverageBear

All monetary numbers on this article are in Canadian {dollars} until famous in any other case.

Introduction

Canadian Pacific Railway (NYSE:CP) is my Seventh-largest holding and one in all my favourite dividend progress shares regardless of its low yield. The purpose is flawless execution, the pending merger with Kansas City Southern, creating the primary railroad connecting all North American nations, and its large footprint in agriculture – which I needed so as to add to my value-focused portfolio. In this text, we’ll talk about the corporate’s third-quarter earnings, which got here in increased than anticipated as CP was in a position to take care of excessive enter prices whereas enhancing its working effectivity. Moreover, the corporate reported robust progress in key transportation segments whereas hinting at extra energy regardless of recession fears (a recession is sort of sure at this level).

In this text, we’ll talk about all of that and extra.

So, let’s get to it!

Why 3Q22 Was Important

I at all times say that each quarter is essential as a result of one thing is at all times happening. In the third quarter, there are some things that I’ve been in search of. With financial progress beginning to sluggish fairly considerably, all eyes are on transportation volumes.

The chart under shows the ISM manufacturing index. The index is at 50.2, which is barely above the impartial 50.0 stage.

ISM Manufacturing Index

Wells Fargo

Moreover, with inflation working scorching, most transportation firms are struggling to keep up their margins. Inflation is in all places. Energy, labor, supplies, you identify it.

Moreover, as if that is not dangerous sufficient, most railroads are fighting the influence of the pandemic. The pandemic triggered volumes to implode. Railroads lowered employment and gear ranges. Then, demand got here again roaring, inflicting railroads to battle to service demand.

Now, railroads want to regulate to increased transportation volumes whereas additionally incorporating potential transportation headwinds down the street.

That’s tough.

3Q22 Volumes Were Great

I purchased CP for a lot of causes. One of them was its wonderful administration.

In its third quarter, Canadian Pacific generated $2.31 billion in income. That’s $40 million increased than anticipated and 19.1% increased in comparison with the prior-year quarter. It triggered earnings per share to return in at $1.01, one penny above expectations.

With that mentioned, let’s take a step again and have a look at freight numbers. After all, that is the place all of it begins. In the third quarter, whole carloads had been up 10%. Revenue ton-miles (“RTM”) had been up 6%. RTM is carloads adjusted for distance.

Or as Investopedia places it:

A income ton mile is a metric used within the transportation business. One income ton-mile is the income earned for transporting one ton of freight throughout one mile. Revenue ton-miles are used primarily by railroad firms.

RTMs had been weak in grains, coal, and vitality. Potash (a fertilizer), forest merchandise, metals, automotive, and intermodal had been robust.

Table

Canadian Pacific Railway

In this case, we will ignore grain weak point. It’s simply timing. The firm has continuously made the case that final 12 months’s poor harvests had an enduring impact. That is ending now as harvests are again in full drive.

According to the corporate:

We noticed this 12 months’s grain harvest actually begin to start the final couple of weeks of the quarter, and volumes have shortly now ramped up as we transfer into This fall. The most up-to-date expectation for the Canadian grain crop dimension is round 75 million metric tons. This would make it a top-five all-time crop and about 7% higher than the five-year common.

The timing couldn’t be higher as CP will obtain the final of the 5,900 new high-capacity grain automobiles it ordered in 2018. These hoppers permit the typical grain prepare to ship 15,000 tons of wheat, up from 10,400 when the corporate used smaller hoppers and shorter trains. Moreover, in 2017, the corporate serviced 12 8,500-foot succesful grain elevators. This 12 months, it might be 47. In 2024, that quantity is more likely to be 55.

In different phrases, these new hoppers shall be put to work.

Also, grains often make up 20% of Canadian Pacific’s enterprise, which is why the comeback of agriculture is so essential.

Table

Canadian Pacific Railway

Speaking of agriculture, potash volumes had been up 31%, delivering a record-breaking quarter for the corporate. International demand stays excessive, home producers are boosting output, and pricing allowed potash revenues to rise by 48%.

Coal was down due to an outage at a serious mine. This is predicted to influence fourth-quarter volumes as properly.

On the automotive entrance, the corporate noticed 31% increased revenues on 4% increased volumes. Although volumes had been a bit decrease than anticipated, the corporate sees that producers are benefiting from easing provide chains, permitting them to show backlog into completed merchandise. Moreover, the corporate signed a long-term settlement with Ford (F).

Moreover, in intermodal, the corporate reported numbers manner increased than I anticipated. Intermodal, which consists of containers and trailers, noticed 18% increased volumes. Revenue was up 44%. Both numbers are a report. The intermodal franchise benefited from each worldwide and home progress on account of natural progress, the expansions on the Port of Saint John, and the CMQ acquisition of 2020.

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Canadian Pacific Railway

With that mentioned, there’s extra excellent news.

CP’s Operations Improved, Boosting Margins

So far, I have not seen a single railroad earnings report that confirmed weak earnings progress. However, CP has confirmed that income progress of 19% was the results of each increased volumes and powerful costs.

Moreover, it is one of many few railroads that reported underperforming whole bills progress. In the third quarter, bills rose by 18%. This was the results of 80% progress in gasoline bills, 29% increased materials prices, and sub-10% increased prices in all different segments, together with labor, which noticed prices rise by 3%. However, foreign exchange and gasoline prices had been nonetheless a tailwind of 13% as the corporate was in a position to make use of gasoline surcharges to greater than offset these prices. That’s an enormous deal. It’s doubtless the results of surcharges lagging the worth of gasoline. Railroads can not cost for increased gasoline prices in actual time. It tends to lag by just a few weeks. While this creates headwinds once in a while, it’s now a tailwind as gasoline costs have come down from current highs.

Table

Canadian Pacific Railway

Moreover, the wage and compensation inflation fee of three% contains new workers. This 12 months, the corporate has employed 1,500 new conductors. The firm has additionally invested in bodily property, gear, and different network-related issues permitting it to be well-prepared for the aforementioned surge in grain demand – in addition to excessive potash and intermodal demand. That’s an enormous win for the corporate and its prospects.

As a results of underperforming bills progress, the corporate lowered its adjusted working ratio by 70 foundation factors to 58.7%. This is 100 foundation factors higher in comparison with the prior quarter.

According to CEO Keith Creel, the railroad is on tempo to report an exit working within the mid-50s on the finish of this 12 months, which might be completely terrific information if they’ll pull that off on this surroundings.

Moreover, with regard to firm operations, the prepare accident frequency improved by 76%, which is sweet information for apparent causes. However, it additionally exhibits that the corporate can preserve one of many most secure operators whereas constantly enhancing working efficiencies. That just isn’t essentially a given.

Now What?

The excellent news is that 3Q22 was really a improbable quarter.

The dangerous information is that the financial system is not wanting so good. For instance, the Fed’s favourite yield curve (10-year minus 3 months charges) is now inverted, indicating an nearly 100% recession chance.

TradingView (10Y-3M Yield Curve)

TradingView (10Y-3M Yield Curve)

This is what the corporate commented:

[…] whereas we’re all nonetheless watching the broader macro surroundings, my staff is staying near the shoppers and our working staff and can navigate any adjustments appropriately. We stay laser-focused on executing our playbooks and making our personal luck by delivering our distinctive self-health initiatives. As you consider it, with our robust bulk franchise, a pipeline of recent progress alternatives and CP-KC solely gaining momentum, we imagine now we have a very distinctive place as you look to 2023.

Even if financial progress continues to sluggish (which is probably going), it seems to be nearly like a finished deal that each grain and potash volumes proceed to develop. Moreover, intermodal is way stronger than it often goes right into a recession.

These are all elements that contribute to the truth that (New York-listed) CP shares are buying and selling simply 9% under their 52-week-high.

It additionally occurs that I’m not the one one who’s bullish. J.P. Morgan got here out the opposite day naming CP a prime decide within the transport and logistics sector. As reported by Seeking Alpha:

“We could see further upside to our 4Q22 growth target of 15.5% at the current grain run-rate and with CP’s 8,500ft hopper car fleet investment fully in place. CP also expects the current pricing momentum will continue, putting renewals on pace to exceed +5-6% reached at the prior cycle peak”

Notably, the step up in labor prices confronting U.S. rail friends beneath new labor agreements won’t have an effect on CP immediately, though incentive compensation headwinds will persist in This fall might influence the working ratio.

Looking forward, Canadian Pacific is predicted to learn from a brand new funding in a hopper automobile fleet. Ossenbeck additionally reminded that the Canadian Pacific-Kansas City Southern is progressing into the ultimate levels alongside constructive momentum on KSU refined merchandise and the second bridge to Laredo is coming to fruition sooner than anticipated.

The KSU merger is predicted to be accredited in early 2023.

With that mentioned, the corporate is buying and selling at 15.4x 2023E EBITDA. That is predicated on the 2023 numbers under and its $94.7 billion market cap. Moreover, I added $700 million in pension-related obligations.

Image

TIKR.com

That valuation is in no way low-cost. Or to place it otherwise, it would not look low-cost. After all, the market has began to cost within the merger advantages. Hence, when utilizing 2024 numbers, the valuation drops to 13.3x EBITDA. That is extra in step with historic valuations because it incorporates an EBITDA surge to $8.3 billion.

CP valuation

TIKR.com

Nonetheless, regardless of all the excellent news, it might be silly to make the case that all the pieces is okay. That is actually not the case. As properly as CP is working its railroad, financial circumstances are a problem.

As I have already got a major CP place, I’m wanting so as to add near $65 per share (New York-listed). I would not be shocked if the financial progress slowing development would trigger shares to drop once more.

Finviz Chart

FINVIZ

If it occurs, I fortunately add to my CP publicity as I imagine that CP would be the best-performing Class I railroad going ahead.

Takeaway

In this text, we mentioned Canadian Pacific’s third-quarter earnings. The firm benefited from robust top-line progress, underperforming progress in bills, a decrease working ratio (increased efficiencies), and energy in all main areas.

While grains had been weak, it is anticipated to show into a robust tailwind within the fourth quarter and past. The identical goes for fertilizers, rebounding coal shipments, and persevering with energy in intermodal.

Moreover, we’re only a few months away from what may be very doubtless going to be an STB merger approval.

The solely factor that bothers me a bit is the valuation in mild of the larger financial image. If the financial system had been in an uptrend, CP can be a no brainer purchase. While I stay bullish, I’m wanting so as to add to my place at a value under $70 to account for what I imagine are elevated financial dangers.

(Dis)agree? Let me know within the feedback!



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