Canadian Pacific Keith Creel. Source: Globe And Mail
Canadian Pacific (CP) reports earnings Oct. 28. Analysts expect revenue of $1.4 billion and EPS of $3.23. The revenue estimate implies a Y/Y revenue decline in the mid-single-digit percentage range. Investors should focus on the following key items.
Falling Rail Traffic
In 2019 railroads faced headwinds to their top lines. The pandemic has exacerbated the situation and business activity has free fallen. For the first 39 weeks of 2020, cumulative rail traffic for Canadian railroads was down 7.7%. Last quarter, Canadian Pacific’s rail traffic fell 14% Y/Y and its average selling price (“ASP”) rose over 5%. Over half of the company’s major product segments experienced revenue declines.
On a combined basis, Grain, Energy and Intermodal represented more than 65% of total revenue. Grain revenue was up 6% on a 5% rise in carloads and 1% rise in ASP. Lower Grain volumes in the U.S. partially offset record Grain volumes in Canada during the quarter. Revenue from the Energy, Chemicals, Plastics segment fell 1% on a 28% decline in carloads and 37% increase in ASP. COVID-19 triggered lower demand for crude and liquefied petroleum. Intermodal revenue was off 10% on a 5% decline in carloads and 5% decline in ASP. The segment should ebb and flow with the vagaries of the global economy.
Canadian Pacific’s carloads fell 14% Y/Y. Only three of its major product categories experienced increases in volume.
Carloads for Grain rose in the low-single-digit percentage range on the strength of volume in Canada. Intermodal volume fell 5% Y/Y and I expect it to face long-term headwinds. Intermodal represented more than 40% of the company’s total carloads, so its performance will likely have an outsized impact on Canadian Pacific’s total volume.
The company hiked prices 5%, a sharp departure from competitors who are experiencing a decline in ASP. Six of the company’s nine product categories experienced rising prices.
Will Canadian Pacific’s pricing power last amid a pandemic and dismal global economy? Sans price hikes, total revenue could fall in the double-digit percentage range until the economy fully reopens.
Operating Ratio Improved
I expected the loss off scale to hurt Canadian Pacific’s operating ratio. It did not. The company reported a 57.0% operating ratio, a 140-basis point improvement over the prior-year period. Compensation and benefits expense declined 9% to $347 million due to a decline in training costs, variable expenses, and incentive compensation. Headcount also fell by 10% as management furloughed employees. At 34% of total operating expenses, this remains the company’s largest expense item.
Fuel costs fell 44% due to lower volume and declining oil prices. It fell much more than revenue, creating efficiency gains. Falling fuel costs are likely a side benefit of declining rail traffic and a dismal economy. Total operating costs fell 12% Y/Y, which drove the improvement in the company’s operating ratio.
EBITDA was $965 million, down 4% Y/Y. The EBITDA margin was 54%, up about 300 basis points versus the year-earlier period. The decline in compensation costs and free fall in fuel costs drove the margin improvement. If the combination of price hikes and cost containment efforts does not materialize this quarter then EBITDA margins could deteriorate.
CP Still Appears Overvalued
Financial markets have melted up amid stimulus from policymakers and central banks. Stimulus, combined with progress on a vaccine for the pandemic, has aided markets and Canadian Pacific. The railroad has an enterprise value of $65 billion and trades at 16.3x run-rate EBITDA (first half EBITDA annualized). Canadian Pacific has done an excellent job of containing costs, which is likely reflected in the stock. Much of the recent quarter’s results were predicated on price hikes that other railroads have not been able to pass through. If Canadian Pacific’s pricing power wanes then it could hurt margins and hurt sentiment for the stock. That said, the global economy and rail traffic could face headwinds for the rest of 2020.
At over 16x run-rate EBITDA, CP appears overvalued. Sell the stock.
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