In Part 3 of “The Case for Investing in Canada – World Leaders in Your Backyard” I am excited to have Adam Staszewski, Equity Analyst with CI Global Asset Management discuss Canadian Pacific Railway (CP). CP is a special company to me given its fascinating history and purpose; it truly powers the North American economy. As Adam will share, CP went from being a laggard to a world leader over a short period of time. This was kickstarted by the legendary Hunter Harrison (former CEO) and has continued under the strong leadership of current CEO Keith Creel. Talking with Mr. Harrison about leadership, successful culture and execution prior to his passing remain some of the most interesting management interactions I have had.
Company: Canadian Pacific Railway (TSX: CP)
Canadian Equity Analyst: Adam Staszewski, MA
This dominate market position, lowest cost railway, excellent commercial strategy and shareholder-friendly capital allocations have helped CP outperform the broader Canadian Industrials group and the TSX Composite Index for years.
As a Canadian investor, it’s difficult to find companies with a more meaningful history and insurmountable barriers-to-entry than the Canadian railway companies. A lot has changed since the Canadian Pacific conglomerate spun-off its transportation, energy and hotel assets in 2001 when it started trading on the Toronto Stock Exchange. Today, CP operates a transcontinental network of over 20,000 km and 55,000 weekly carloads, spanning from the Canadian West Coast to East Coast and providing cross-border service into Chicago, the freight “Heart of America”. With wide economic moats, avenues for growth, a stellar management team, shareholder-friendly capital allocation, and industry leading returns on equity, CP is a holding to watch out for.
CP’s story (and valuation) can be thought of in four time periods: 1) the post-deregulation period of the 1980s to early 2000s that saw sweeping industry consolidation of underutilized networks; 2) the mid-2000s, when the industry shifted from price-takers to price-makers; 3) 2012-2015, which saw CP embark on significant railroad service enhancements through Precision Scheduled Railroading (PSR); and 4) the current growth phase.
The 2012-15 period is especially important for CP. After lagging the industry on returns and cost for years, an activist-led approach installed the now infamous Hunter Harrison as CEO of CP in 2011. Over the next several years, Mr. Harrison applied the PSR framework that was honed at Canadian National Railway (CN) in the early 2000s. At its core, PSR implements a strict schedule to each carload on the system rather than abiding by the customer’s schedule. While disruptive at first, it reduced redundant networks, locomotives, cars and terminals while improving idle time and average network speed. This created invaluable incremental capacity at low costs and improved service, while also leveraging CP’s natural geographical advantages to be the lowest cost rail in North America.
Over the last 5 years, CP has returned 122% vs. the TSX at 26%; The natural question becomes what’s next? As it turns out, quite a bit.
EARLY STAGES OF CP’S POST-PSR GROWTH MODEL
With PSR completing the heavy lifting on its cost structure and network efficiencies, CP shifted its strategy to marketing the improved service and network into “stickier” revenue growth. The commercial strategy involved using the excess capacity and improved service created through PSR for long-term customized solutions for its customers. Service is difficult to measure as it is customer specific, but the intangible benefits allow CP to continuously price well above its cost inflation (labour, fuel, materials, supplies etc.) while also attracting market share. This was most evident when CP wrestled a key intermodal contract from CN in 2019 on better service, signing a three-year contract with Yang Ming Marine Transport Corp., a global container ship leader. While much smaller than CN from a network perspective, CP became the major rail provider at the Port of Vancouver’s largest container terminal, Deltaport.
The other focus of the post-PSR commercial strategy has been to use excess land for customized solutions. CP added Fiat Chrysler Automobiles, Ford and Hyundai GLOVIS to its automotive franchise and a Maersk transload facility in Vancouver in the past 24 months alone. This leveraging capacity and service into long-term contracts with its customers, while also tying their supply-chains to that of CP’s is a compelling opportunity and one that is unique to CP. There remains a multi-year funnel for CP to utilize its assets into long-term customer relationships.
WINNING SHARE AND EXPANDING FROM COAST TO COAST
It’s often overlooked that Canadian railways’ strong service and geographical long-haul intermodal lanes have given Canadian ports a significant price advantage when shipping from Shanghai to Chicago, a key trade route. The cost of shipping a 40-foot international container on this route via Vancouver can be $300-$400 lower vs. Los Angeles, the U.S.’s largest port of origination. That has translated into market share gains for Canadian ports over the past few years as L.A. and the U.S. West Coast grapple with congestion, improved Canadian service and strong East Coast competition following the Panama Canal expansion in 2016.
A wave of consolidation has also seen the global container shipping industry shrink from 20 major ocean fleets to seven in just a few years, while container shipments have grown around 5% per year. This has created a more disciplined and stable shipping industry, giving major port operators visibility into volumes and encouraging port expansion plans. The Port of Vancouver is no different, with terminal capacity expanding by 40% by the end of 2021, and that is on committed capital spend alone. Proposed expansions could see that rise by a further 30-40% by the end of the decade with Canadian rails the direct beneficiaries.
The East Coast is also a promising opportunity that may not be fully appreciated. Both CN and CP are investing in this network, with CP acquiring Central Maine & Quebec Railway in 2020, giving direct access to the East Coast at the Port of St. John in New Brunswick. Controlling the shortest route from the East Coast to Chicago and a 400% planned capacity expansion by the port operator will provide CP years of intermodal growth opportunities.
CAPITAL INVESTMENTS FROM GRAIN NETWORK
Record grain crops over the past few years has been spurred by longer growing seasons, improved yields through technology and rising global demand. Making up the largest part of its revenue (22% fiscal year 2019), grain has elevated CP’s capital expenditures to invest $500 million by 2021 in a new fleet of high-capacity hopper cars to carry grain. In combination with new colossal 8,500-foot trains, grain hauling capacity will increase by at least 40%. Roughly 46% of these high capacity hoppers have already been added, with the remainder expected by the end of 2022. Grain producers and export terminal operators are also investing heavily in grain elevators and export capacity to accommodate this growth. CP is just starting to reap the benefits of this investment.
What do shareholder’s get with CP? Through efficiency gains, CP has translated a mid-single digit revenue CAGR from 2012-19 into 15-20% annual earnings growth. That powerful combination of incremental margins has driven ROEs in excess of 30% for years. Going forward, we see runway for further mid-single digit revenue growth while continued pursuit of labour efficiencies, longer trains, investments in automation and pricing above cost inflation should drive earnings growth of over 10% per year. The capital allocation strategy of 15%-20% dividend increases over the past few years and using excess cash flow to repurchase its shares in the $1.0 billion per year range should also continue. CP checks the boxes on what a World Leader is and we believe makes an effective core portfolio holding.
Thank you again for your continued support.
Source: CI Global Asset Management as at November 20, 2020
Glossary of Terms
CAGR: Compound annual growth rate
ROE: Return on equity
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Published December 10, 2020