Value Investors Club / Canadian Pacific Kansas City (CP)

Description

LONG CP TP of ~CAD154 ~35% NTM return, 3YR TP of CAD200, +22% price IRR, ~24% with dividends. Canadian Pacific Kansas City (CP) is a railroad operator with a rail track that span ~20K route miles across Canada and into the United States and Mexico. CP-KC is the first and only single-line transnational railway in North America. The bedrock of the thesis is CP is a strong business with a strong mgmt. team. Embedded in this attractive return profile is: 1) upside to mgmt.’s 2024-2028 revenue synergy guidance of ~USD1.5bn out of its USD5bn identified opportunity, 2) margin benefits from synergies, extension of KCS’s length of haul, and a gamut of fixed cost leverage, 3) CP’s strong FCF generation that translate to ~40% cumulative shareholder yield over the next five years.

Source: Company Reports, Internal Estimates

Investment Thesis 1: CP is on the cusp of a multi-year outperformance cycle as it finishes majority of the integration period with KCS. CP has strong visibility on this growth given the underlying business model and industry structure of North American rails. Rails are virtual monopolies/duopolies in their territories and generate substantial FCF and ROIC (~80%-100% conversion and ~12%+, respectively) while growing LSD revenues and MSD-HSD profits through pricing over inflation. CP arguably has the best management team under Keith Creel (as evidenced by service metrics and OR and historical TSR pre-KCS merger) and now has the fastest growing rail. Keith Creel is incentivized by $30mn+ worth of options/incentives, which is driven by CP’s FCF/ROIC and TSR.

Investment Thesis 2: CP has USD5bn + of synergy and revenue opportunities and is poised to hit USD700-800mn by 2024 year-end. CP has soft committed to hitting USD1.5bn by 2028. CP will convert KCS’s short hauls into long hauls, which means revenue per car will grow faster than opex per car. This, in addition with synergies and cost-efficient new revenues, propel y/y OR improvement.

Investment Thesis 3: CP to see FCF and ROIC Inflection and Share-returns resumption. Factoring in CP’s flat capex of ~CAD2.6bn-2.7bn, its FCF conversion to Net Income should inflect from ~60%-70% historically to ~90% by 2026. CP targets ~2.5x net debt/EBITDA by year-end 2024 or 1H.25 as part of its merger integration. CP will likely hike its dividends (which has been flat for 4 years) and resume share buybacks (which has been zero since 2021). In concert with the profit growth, CP’s return on tangible capital should inflect from <9% (which has been the case since 2021) and climb back to pre-merger levels of ~15% by 2027.

Why Does This Opportunity Exist? While CP maybe deemed a consensus long, I believe the market has been overtly focused on the recent freight downturn and the slowing of CP’s business momentum as it integrated KCS following the merger. I believe the market underappreciates CP’s earnings runway.

COMPANY BACKGROUND

CP went public in 2001 but its modern incarnation started in 2012 when, after a successful activist campaign, Hunter Harrison and Keith Creel joined the company. CP went from one of the worst performers in the industry to the best by ~2014, and CP maintained its sector-leading status. In 2021, CP got approval to merge with Kansas City Southern (KSU/KCS). After review by its regulator, Surface Transportation Board (STB), the merger was approved on April 14, 2023.

Bulk Commodities account for ~40% of revenues, Merchandise ~40%, Intermodal ~20%. Canada accounts for ~50% of revenues, USA ~33%, Mexico ~17%.

Source: Company, BMO Capital Markets

Railroad Basics. Rails facilitate the flow of goods from manufacturers to middlemen and/or end consumers through their networks of rails and railcars. The industry has consolidated into six Class 1 Rails (those with annual revenues >USD900mn) following the Staggers Act of 1980 which deregulated the space. Class 1s account for ~90%+ of rail industry revenues.

While some of their railways do overlap, the entire rail landscape of North America can basically be split into 3 duopolies - CNR and CP (now the merged CPKC) in the North & South, BNSF and UNP in the Midwest, and CSX and NSC in the East.

From a broader level, rails benefit from an oligopolistic/monopolistic position across their territories, underpinned by near-irreplaceable assets (it costs USd4mn per rail mile to re-create the tracks alone; for CP, that's equivalent to ~$100bn or 30% above its market cap in USD). Most customers or volumes are captive to their provider due to geography (think ports in Vancouver or harvesters in Chicago or Midwest). CP and peers also invest in customer requested infrastructure such as dedicated grain terminals or liquid gas boxes.

Business Economics. Capacity is sold to move freight from point to point. Some are contracted exclusively or competitively on the spot. Ultimately what drives a rail’s success is their control over their entire network: maximizing asset velocity through resource planning and coordination with customers, which in turn challenges rails to curate their commodity and contract mixes through time, while still allowing for spot/bespoke contracts.

Origination and Destination volume mixes matter. It’s better to originate volumes to free up capacity at the yards/terminals, which grants more control over the network of the rail. Canadian Rails originate 90% of their volumes, UNP% at 80%, and the rest are 70% and below. Length of Haul (LOH) impact profitability and asset velocity too: the longer a rail can chain cars the more it could leverage its costs over more units.

Pricing (Inflation+) tends to be highly stable owing to the rail’s competitive positioning and rails tend to flex power in certain bespoke contracts. Consolidated volumes tend to be stable due to diversification and is pegged to IP.

There are two general types of trains: Unit (which are specific to a single commodity unit type) or Manifest (which mixes different commodities). The type of commodity influences the profitability and pricing power of the rails. Rails ship 3 broad categories of freight:

Bulk – Commodities such as Grain, Coal, Potash, Sulphur
Merchandise – Energy, Petro/Chemicals, Metals & Minerals, Consumer, Automotive, Forestry
Intermodal – TEU units that are the long-haul movement of shipping containers and truck trailers by rail

Research indicates that initial EBIT margins are ~55%-65% for Bulk, ~45%-55% for Merchandise, and ~35%-40% for Intermodal. However, incremental margins are higher for Intermodal as rails can double-stack these TEU units. Intermodals also tend to fetch expedited requests (as it is driven by ecommerce partly). Intermodals also have the highest ROICs as they require minimal additional investment: a simple car as opposed to bespoke oil containers or grain hoppers, for example.

Cost structures for rails are highly fixed (~50%, coming from Depreciation & Amortization, Rent, and the bulk of Labour). Primary sources of efficiency would come from fuel technology, automation technology for workers, and scaling over Purchased Services/Rents.

Rail’s cost structures are key for winning share against trucking companies as bulk of trucker’s cost structures are highly variable: Labour at ~45% and Fuel at ~25%.

Source: Company Reports, Internal Estimates

Some Nuance: Carloads are simply the number of cars you move from point A to point B. It does not account for how far apart point A and B are. It follows that the further point A and B are apart the more you get paid to transport the freight. As a result, you have another metric RTMs which takes into account the distance between point A and B. For example, route 1) a Grain car moving from Kansas City to the Gulf Coast or route 2) from the West Coast of Canada to the Gulf Coast. Both are still one car but have materially different RTMs due to the distance travelled and thus revenue generated. RTMs are what drive the P&L not carloads. Carloads do drive expenses.

Operating Ratios (lower=better) or “OR” is a KPI for the industry that measures how well the company manages its costs and network. It’s 1 – EBIT%. Like most rails, an OR orientation has historically been a part of value creation in how CP’s mgmt. thinks about its assets.

INVESTMENT THESIS

Revenues should grow ~8% through 2027, and MSD thereafter. Organically, CP and KCS grow through cycle 3%-4% via pricing and 1%-2% volumes and initiatives. The kicker to CP’s growth is its identified runway of USD5bn of total opportunities following the 2023 merger of CP and KCS, of which USD1.5bn was noted to be the floor by year 5 or 2028. Note that CP during its merger process highlighted CAD1.5bn or USD1.1bn of synergies by year 3 following the merger. The USD5bn total runway embeds both synergies and underlying business growth, likely due to downplay benefits of the merger from the regulators.

Another angle of simplifying the revenue growth algorithm is CP’s own high-level breakdown during its 2024 Investor Day: 3%-4% Base Growth, 3%-4% Inflation+ Pricing, 2%-3% Synergies. The arithmetic of 3% Synergies using 2023 combined CP + KCS as a base revenue translate to CAD2.0bn of synergies-based revenue, supporting the USD1.5bn floor quoted during the investor day. As of end-2023, CP said it has secured USD350mn worth of synergies and it plans to double the run-rate by year end 2024.

Source: Company Reports, Internal Estimates

With respect to the Base Growth, CP standalone grew revenues 6% CAGR (mostly from 4%-5% pricing) from 2016 through 2022, while KCS grew 4% around the same time, driven by 3% pricing. As will be explained in the productivity opportunities section, KCS’s book of business has much more scope for improved base pricing under a bigger network and stronger management with CP.

Source: Company Reports, Internal Estimates

What the above shows that the HSD revenue cadence algorithm stacks up with CP’s broad strokes guidance. I explore below the synergy buckets and specific initiatives.

Decomposing the USD5Bn amount. Combined CPKC touches 500M consumers in Canada, the U.S., and Mexico. It has 20K track miles and connects to 30+ ports, 30+ auto facilities, 200+ transloads, and 90+ short-lines.

CP’s Major Growth Levers Include:

80% of KCS's business in the past was interchanged, and CP intends to bring most of that in-house;
Rail-to-rail USD925M: (1) Share shift, especially in the north-south corridor, where CPKC creates the opportunity for customers to diversify carriers. (2) Direct route conversion, which is the opportunity to convert an interchange into a single-line haul.
The truck-to-USD1.4Bn opportunity will naturally come from the 2M addressable truck market.
Development/nearshoring USD1.5Bnopportunity will require infrastructure capital to build and involve some self-help
Other self-help USD1.1Bn opportunity is expected to come from new market outlets and transload/short-line partners benefiting from the new tri-nation access

Source: Company

Visible Synergies/Revenue Initiatives Include:

US/Mexico MMX 180/181 Service: Partnership with companies like Schneider. This flows into CP’s USD1.5bn domestic intermodal business. This is a truck competitive service. Initially quantified as USD200mn opportunity.
Temperature Controlled Shipments: USD150mn initiative that has signed on the largest cold storage REIT, Americold. Checks indicate more announcements should be made.
Lazaro Cardenas Mexico International Intermodal: 40% volume growth in 1H.24/ Quantified as a USD200mn opportunity.
Automotive Volumes out of Mexico: CP creates single-loops for OEMs that minimizes empty miles. Transports automotive inputs and outputs across the continent. Initially quantified as a USD250mn opportunity. Latest checks here indicate one of the big three US OEMs has a contract opportunity coming next year, and another large contract is expected in 2026.
ECP Contract with Shell: Part of a broader USD1bn Merchandise opportunity set.
New Grain Trains: CP’s seeing ~3% production growth in its grain end markets. CP’s investments include 30% shorter cycle trips and 44% more grain per train.
Lumber Products from Canada to Texas: From 0 monthly trains last year to a run-rate of 60 a month.
General Onshoring Benefits and Port Traffic into Canadian Ports and Mexican Ports: The congested Los Angeles and Long Beach ports continue to bleed share to Canadian Ports and more and more Mexican ports as shipments from Asia favor those destinations. Further, annual Foreign Direct Investment into Mexico has grown from USD33bn in 2019 to USD36bn in 2023.

On a sector-wide basis, Rails are primed to benefit from: Trucking share gains and capex growth in the USMCA. On a more idiosyncratic basis, exposure to Port terminal expansions, Mexico access, Intermodal growth, and Automotive growth are key growth kickers. These idiosyncratic kickers favor the Canadian rails owing to their tri-coastal networks and access to Mexico, as well as their in-built longer haul operations that’s primed to benefit from capex spend.

Trucking Share Gains. It costs shippers 20%-30% more to ship on trucks as opposed to rail and rails are 75% more GHG efficient than trucks. Rails only ship ~8% of the ~USD900bn US freight market whereas trucks account for ~60%. There is much scope for rail share gains, particularly for freight that travel >500miles.

~80% of all freight in the U.S. is moved 250 miles or less, with the remainder longer haul, according to the U.S. Census Bureau Commodity Flow Survey, of the total national road and rail ton-miles. That said, Rails have ~USD180bn of freight revenue it could steal from rails on the ~20% that travels >250miles.

Rails have ample opportunity to steal share from trucks, particularly in the longer haul of >500miles, given the growing headwinds of truck economics and increasing pressure for shippers, and retailers to address their GHG emissions.

Inflationary pressure from labor and fuel are pressuring trucking margins, causing truckers to raise rates. Trucks set the marginal price for most freight movements, creating a favorable (and rising) pricing for rails. As truck prices need to rise to offset inflationary costs, rails become more attractive, particularly over longer lengths of haul.

Crucial here is Trucks are more Labour and Fuel dependent, with both costs facing structural inflation.

On an ESG angle, freight by rail instead of trucks on average lowers greenhouse gas emissions by up to 75%. As companies increasingly focus on reducing scope 3 GHG, rails should handily benefit.

All said, while rails are unlikely to ever capture all truck market share, small shifts from a low base have a significant impact. As recently as two decades ago, rails had ~10% share of US freight, which would be a ~25% increase in volumes vs. today.

Source: Company, American Trucking Association | See Report

Source: Company, BLS, Morgan Stanley, Soroban

USMCA Capex. The large capital investment boom in the 2000s and the subsequent demand shock of 2008/the GFC resulted in substantial excess capacity through much of the 2010s, leaving little need for new capacity investment. This extreme underinvestment over the last decade is now colliding with pressure to reshore critical supply chains and invest for the capex heavy “green energy transition,” positioning the US for a robust industrial investment cycle. This large industrial capex will be disproportionally served by rails due to the large scale and heavy nature of materials.

The United States has experienced a striking surge in construction spending for manufacturing facilities. Real manufacturing construction spending has doubled since the end of 2021. The surge comes in a supportive policy environment for manufacturing construction: the Infrastructure Investment and Jobs Act (IIJA), Inflation Reduction Act (IRA), and CHIPS Act each provided direct funding and tax incentives for public and private manufacturing construction. While at odds with ongoing weakness in IP, these longer tailed projects should translate into multi-year demand for Metals & Mining, Automotive, Petrochemicals, and Forestry products, which are heavier commodities more suited for Rails.

Port Terminal Expansions. Share gains from the ports of Los Angeles and Long Beach have been a growth kicker for both Canadian rails over recent years. Beyond this, there are multiple port expansions across Canadian and U.S. ports that directly benefit continental wide networks such as those of CP, CNR, and BNSF. Port access are strategic assets that confer attractive revenue opportunities such as high Origination penetration of volumes and Intermodal flow. Key expansions are:

Mexico Access and Automotive. Transborder freight between the U.S. and Canada/Mexico totaled USD7.55tn between 2017 and 2022. Truck moves the lion’s share of the total value at 69.3% while rail transports the next highest proportion at 15.2% (average 2017-2022). By far, the busiest port is the port of Laredo, Texas, which handles 18.54% of the total trade by value (2017-2022). There are six gateways between Mexico and the U.S. over which freight rail can transport goods, with about 44% of the U.S.- Mexico surface transportation passing through the Laredo gateway.

Mexico’s top exports are vehicles and electrical machinery at 23.3% and 17.6%, respectively, of the total value of goods exported. Ninety percent of vehicles produced in Mexico are exported, with 76 percent destined for the U.S. Mexico is also the sixth largest manufacturer of heavy-duty vehicles globally and the leading exporter of tractor trucks, 95.1% of which are destined for the U.S. Mexico growth should directly benefit CP. CP’s new single-line service between all USMCA countries this growth rate could be enhanced further.

The production outlook for vehicles made in Mexico is very favorable, forecast to increase 41% by 2026 versus 2021 levels or a CAGR of 7.1%. This positive outlook not only reflects the expected recovery from pandemic lows but also the impact of several new plants coming online. KCS has a significant footprint servicing nearly 90% of the Mexican automotive assembly plants. KCS serves 17 of 19 Mexican automotive assembly plants or 89.5% of available plants with only a Ford plant at Hermosillo and a Toyota plant in Tijuana that is not served by the KCS network.

EBIT growth of ~14% through 2028, driven by HSD revenues, high incremental leverage, and productivity opportunities at KCS. The industrial logic behind CP and KCS’s merger is simple: CP runs from Canada to the US Midwest while KCS runs from Mexico to the US Midwest and putting them together allows for longer length of haul, which ultimately translates to high operating leverage as you need less people, less equipment, and less inputs per revenue mile. Moreover, ~70%-80% of KCS’s revenue book are agent volumes, which means KCS is more of an intermediary between larger railroads like Ferromex and other Class 1 rails. Further, KCS has a 500-700bps OR gap with CP owing to less than best-in-class management, shorter haul, and smaller scale, among others. This should be rectified over time as CP + KCS solidify as one network. Lastly, CP’s capex profile is peaking in 2024 at ~CAD2.7bn and will remain fixed at ~CAD2.6bn, translating to flat depreciation & amortization going forward.