The COVID-19 pandemic—and this firm’s strong earnings growth in the latest quarter—highlight the importance of its rail networks to the Canadian economy.
While its efficiency and network improvements have had a short-term impact, they also position this industry giant for strong future gains.
CANADIAN PACIFIC RAILWAY LTD. (Toronto symbol CP; www.cpr.ca) transports freight over a 23,700-kilometre rail network between Montreal and Vancouver, and to hubs in the U.S. Midwest and Northeast.
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The shipment of bulk commodities, such as grain, coal, potash and fertilizers, contribute a key component of CP’s value for investors. Commodities supplied 40% of overall revenue in 2019, with merchandise, such as automotive equipment, metals, consumer products and forest products, accounting for a further 39%. The remaining 21% came from intermodal traffic, which consists of containers that travel by rail, ship and truck.
CP’s revenue fell 7.2%, from $6.71 billion in 2015 to $6.23 billion in 2016. That decline was largely because producers of commodities, such as oil, potash and minerals, shipped less product in response to lower selling prices.
Revenue then rose 5.2% to $6.55 billion in 2017 on stronger volumes of fracking sand, crude oil, chemicals and plastics, domestic intermodal, potash and Canadian grain. Revenue improved again in 2018 to $7.32 billion and to $7.79 billion in 2019.
Excluding unusual items, CP’s overall earnings fell 4.7%, from $1.63 billion in 2015 to $1.55 billion in 2016. However, due to fewer shares outstanding, investor saw earnings per share rise 1.9%, from $10.10 to $10.29.
Investors then saw earnings recover 7.6%, to $1.7 billion in 2017, while earnings per share, again on fewer shares outstanding, gained 10.7%, to $11.39. CP’s earnings continued to improve in 2018, rising to $14.51 a share (or a total of $2.08 billion) and to $16.44 (or $2.29 billion) in 2019.
In the quarter ended March 31, 2020, which captures the start of the Canada’s COVID-19 shutdown, CP’s overall revenue gained 15.6%, to a record $2.04 billion from $1.77 billion a year earlier. The higher revenue was mainly due to rising shipments of grain, fertilizers, crude oil, metals and automotive products. You should note that CP has been declared an essential service during the pandemic.
Earnings before unusual items in the quarter soared 54.8%, to $607 million from $392 million a year earlier. Due to fewer shares outstanding, per-share earnings rose an even higher 58.4%, to $4.42 from $2.79.
The key driver of that impressive earnings growth—and investor value—has been CP’s commitment to efficiency. For several years, it has invested heavily in locomotives, tracks, and software to optimize trainloads and speeds.
As a result, its operating ratio in the quarter improved to 59.2% from 69.3% a year earlier. (Operating ratio is calculated by dividing regular operating costs by revenue. The lower that ratio is, the better.)
The company also continues to make shrewd acquisitions to add value for investors. It recently paid $174 million for 774 kilometres of track in Quebec and Maine. This includes the line involved in the July 2013 Lac-Mégantic explosion.
The purchase is good news, as it improves CP’s access to east coast ports at Searsport, Maine, and Saint John, New Brunswick. That cuts its reliance on shipping goods to China through ports on Canada’s West Coast; it should also promote your long-term gains.
CP now expects the COVID-19 pandemic will cut its freight volumes by about 5% in 2020. Most of that drop is due to lower shipments of automotive equipment, crude oil and intermodal goods. However, rising grain and fertilizer shipments should partially offset those declines.
Good time to make upgrades
The company is also taking advantage of the lower traffic to upgrade its rail lines, locomotives and other infrastructure. As a result, it still plans to spend $1.6 billion on capital improvements in 2020.
That investment will put CP in a strong position to handle the uptick in demand when the pandemic ends. For example, it recently signed a new five-year contract with automaker Fiat Chrysler to distribute cars from CP’s new Vancouver automotive compound to dealers in Western Canada and the U.S. The contract is worth roughly $50 million.
The company’s strong balance sheet will also help it cope with the crisis. As of March 31, 2020, it held cash of $247 million, while its long-term debt of $9.8 billion is a moderate 20% of its market cap. The company can also borrow up to $1.9 billion under its current credit facilities.
What’s more, CP will probably generate free cash flow (regular cash flow less capital expenditures) of $1.2 billion in 2020.
That will let it maintain your current annual dividend rate of $3.32 a share, which yields 0.9%. Those payments will total just $450 million (or 38% of free cash flow) in 2020. However, to protect long-term value for investors, the company will delay any dividend increase until the economy improves.
CP has also suspended its share buybacks. In the first quarter of 2020, it repurchased $468 million in shares—or about 40% of its current plan.
Despite COVID-19 disruptions and lower freight volumes, investors can expect the company’s 2020 earnings per share to equal 2019’s $16.44. The stock trades at 21.7 times that forecast. Investors should see that as a reasonable multiple in light of CP’s importance to the Canadian economy and its focus on improving efficiency.
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